Bill Gross on ‘Animal Spirits’ in Markets: Be Concerned

While generally praising Janet Yellen, the fixed income fund manager explains what is keeping him up at night

Bill Gross speaks at a Morningstar conference. (Photo: Jim Tweedie) Bill Gross speaks at a Morningstar conference. (Photo: Jim Tweedie)

There’s plenty of talk about the impact President Donald Trump is having on the stock market, and not all of it is positive.

Some Wall Street executives, notably JPMorgan CEO Jamie Dimon, are jubilant about the bull run. Confidence has “skyrocketed because [the president’s] a growth agenda,” he said, in a recent interview with Bloomberg.

“If he gets it done, even part of it, it will be good for growth, good for jobs, good for Americans,” Dimon explained. “I’m really confident he will get that done.”

Janus fixed income fund manager Bill Gross has a different take.

“‘Don’t lose it’ is my first and most important conceptual lesson for [my children], despite the Trump bull market and the current 'animal spirits' that encourage risk, as opposed to the preservation of capital,” he said in his March investment outlook.

Gross goes on to explain why he sees the glass as more half empty than half full, as Dimon does.

Today’s global economy, he says, has way too much credit.

It has created more credit relative to GDP “than that at the beginning of 2008’s disaster,” he says.

“In the U.S., credit of $65 trillion is roughly 350% of annual GDP and the ratio is rising. In China, the ratio has more than doubled in the past decade to nearly 300%. Since 2007, China has added $24 trillion worth of debt to its collective balance sheet,” the Janus fund manager explained.

While credit keeps capitalism going – i.e., turning loans into “pizza stores, cell phones and a myriad of other products and business enterprises” – its creation does have limits, he argues. The cost of credit, meaning interest rates, “must be carefully monitored so that borrowers (think subprime) can pay back the monthly servicing costs.”

If rates move too high, along with credit as a percentage of GDP, “then potential Lehman black swans can occur,” Gross says. Yet if rates fall too much and credit as a percent of GDP dips, the system “breaks down, as savers, pension funds and insurance companies become unable to earn a rate of return high enough to match and service their liabilities,” he points out.

A Tightrope

This is the fine line that central banks try to walk, so they can generate “mild credit growth” which is paired with nominal GDP growth, while at the same time making sure the cost of the credit at a yield “is not too high, nor too low, but just right,” says Gross.

In other words, Federal Reserve Board Chair “Janet Yellen is a modern-day Goldilocks,” according to the bond specialist.

Gross acknowledges that Yellen is doing well. The recovery, though weak by historical standards, has led to steady job growth, and the markets are “suggesting happier days ahead.”

But the Janus fund manager says the booming market serves as a façade.

The highly levered financial system is “like a truckload of nitroglycerin on a bumpy road. One mistake can set off a credit implosion where holders of stocks, high-yield bonds, and yes, subprime mortgages all rush to the bank to claim its one and only dollar in the vault,” he explains.

This is precisely what happened nine years ago, when central banks could lower yields and buy trillions of dollars via quantitative easing, which prevented a run on the system, Gross states.

But no more.

Central bank flexibility in 2017 is “not what it was back then,” he adds.

We have yields that are close to zero or negative. Some QE programs are closing in on their limits “as they buy up more and more existing debt, threatening repo markets and the day-to-day functioning of financial commerce.”

(Note: This writer watched several speakers, including Gross, outline such negative predictions before the financial crisis at one or two fund conferences sponsored by Morningstar. The clarity of analysis shared by Gross and his then-colleagues at Pimco has stood the test of time.)

“Don’t be allured by the Trump mirage of 3-4% growth and the magical benefits of tax cuts and deregulation,” he said.

This country and other major economies are “walking a fine line” as leverage rises, as does the risk that interest rates will move too high or too low, which would devastate what he sees as our already stressed financial system.

“Be more concerned about the return of your money than the return on your money in 2017 and beyond,” he wrote.

--- Check out Pimco’s New Bond Chief Is Nailing It on ThinkAdvisor.

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