In what may be his most apocalyptic monthly letter in a series that for years now has been explicating the “new normal,” PIMCO bond manager Bill Gross is warning investors that America’s money economy is like a supernova—a bright shining star that suddenly burns out.
Titled “Credit Supernova!,” Gross’ February shareholder letter relies on the pioneering work of economist Hyman Minsky, who is credited nowadays for a model thought to have foreseen the recent financial crisis. Nearly 40 years ago, Minsky wrote about “Ponzi finance” that occurs when rapidly accelerating credit is needed just to finance interest payments on debt.
But Gross (left) notes that Minsky formulated his theory at a time when U.S. credit outstanding totaled $3 trillion.
“Today, at $56 trillion and counting,” Gross writes, “it is a monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet, in the process begins to consume itself.”
As evidence that our credit supernova is burning out, Gross notes that “each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result.”
The result is a new normal in which GDP growth has averaged around 2% annually rather than the 3.5% growth Americans have enjoyed over the previous 50 years.
A byproduct of the Ponzi-fueled financial instability of America’s rapid credit creation is the near-zero rate policy, which Gross says “cripple savers and business models previously constructed on the basis of positive real yields and wider margins for loans.”
Because bank lending is less profitable, there is less investment in the economy and an erosion of real growth. Gross cites the case of Japan as a laboratory example of what the U.S. is currently facing. Japan had a decade-long head start on near-zero interest rates, and Japanese investment as a percentage of GDP declined steadily. Gross shows that the same is currently taking place more precipitously in the U.S.
The investment implications of all this are quite ominous. In the current environment, Gross says “credit is now funneled increasingly into market speculation as opposed to productive innovation.” The credit supernova is on track to burn out and he writes that “the countdown begins when investable assets pose too much risk for too little return.”
Signs of the credit supernova flaming out would include low bond yields relative to duration risk, tight credit spreads relative to default risk and P/E ratios that are high relative to growth risks. People stuffing their mattresses with cash and turning to real assets like gold and diamonds would also be symptoms.
With somewhat shocking frankness, Gross, manager of the world’s largest bond fund, writes:
“One of our Investment Committee members swears he would buy land in New Zealand and set sail. Most of us can’t do that, nor can you. The fact is that PIMCO and almost all professional investors are in many cases index constrained, and thus duration and risk constrained.”
While PIMCO can’t buy land around Auckland that is not represented in an index, with seeming pathos, he writes that as investors increase their real assets at the margin they should “think of PIMCO in this transition. We hope to be ‘Your Global Investment Authority.’ We have a product menu to assist.”
He also counsels investors to buy inflation protection through TIPS, shorten durations and expect lower future returns on bonds, stocks, real estate and derivative strategies.
While the Fed is behind the zero-rate policy he decries, Gross helpfully warns investors not to fight the U.S. or other nations’ central banks, but rather “anticipate them by buying what they buy first.” He also recommends foreign sovereign bonds with positive real interest rates like those of Mexico, Italy and Brazil.
Finally, as if his letter were not sufficiently frightening, Gross ominously warns: “Be cognizant of property rights and confiscatory policies in all governments.”
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