PIMCO bond manager Bill Gross expects 2014 to be a positive year for investors — but quite possibly the last positive year during the era of quantitative easing.
Writing in his new monthly investment outlook, the bond manager chose a literary metaphor from William Butler Yeats’ 1919 poem “The Second Coming” to describe a market uniquely dependent on central banks’ artificial monetary stimulus:
“Turning and turning in the widening gyre The falcon cannot hear the falconer; Things fall apart; the centre cannot hold.”
In Gross’ analysis, investors are the falcon, the Fed and other central banks the falconer, and turning and turning in the widening gyre is the investor’s search for higher investment return across the risk-return spectrum.
Gross pictures asset categories as a series of concentric circles with the fed funds rate, overnight repo and T-bills in the center, then moving further out in the widening gyre to various higher risk assets such as bonds, stocks and real estate.
As long as the falcon (investor) can hear its master’s message, it will go out in search of investment alpha.
But it is not just the central bank’s policy rate, which has been set at an artificially low price, that has resulted in investors’ asset binge. It is also “investor expectations and confidence” in central bank policies that has kept things from falling apart and the center holding, Gross writes.
Today’s heightened uncertainty, however, stems from changing policy guidance from the Fed and other central banks from quantitative factors — based on “unemployment rate thresholds that now are about to be breached” — to qualitative ones.
Thus, central banks have a more difficult burden of convincing markets of their credibility. If they can do this, and for now, Gross thinks they can, then stocks and bonds should outperform cash:
“Show me a perpetually low policy rate at the center, tell me that falcon investors are listening and believe in their masters, and it is reasonable to forecast at least a 12-month future where risk assets on the periphery can outperform the safest assets in the center,” Gross writes.
If “the longevity and effectiveness of that artificially low policy rate comes into question,” Gross continues, “then the center…may not hold.”
While Gross says today’s new qualitative guidance is credible, therefore leading to profitable investments, he warns that Sharpe ratios heighten risk and thus lower risk-adjusted return in relation to cash.
The PIMCO manager, on the assumption of 2% GDP growth, is a buyer in today’s bond market but warns that tapering will eventually threaten corporate bonds and a reemergence of inflation will make current pricing unattractive.
Therefore, “2014 may be the last of the years in which falconer and falcon act in capitalistic unison,” and timing the market exit will be the new challenge for investors, he concludes.