Is Bill Gross emotionally exhausted? One would think so from reading his latest outlook, one that is surprisingly subdued. No pondering the meaning of life; no obscure sports or literary references or allusions to … ahem, long-held rumors about actor Richard Gere.
His posit, titled “The Great Escape: Delivering in a Delevering World,” is a straightforward discussion of what happens when interest rates can decline no further and mild inflation takes hold.
“When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wide,” Gross, chairman of bond behemoth PIMCO, writes. “In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.”
The risk to which he refers involves the use of high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
Launching into a historical review of “leverage” and how we arrived at this present point of “delevering” (his word), Gross takes readers from the Bretton Woods Accord, through the abandonment of the gold standard by the Nixon administration and into the crisis of 2008.
Today, Gross writes, “Global financial markets are only selectively delevering. What delevering there is is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece …The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.”
In such a world, he adds, financial assets outperform relative to real assets as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.
“This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums—a state of financial repression as it has come to be known, that promises to be with us for years to come.”
Forgetting himself, he writes that, “It reminds me of an old movie starring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943 … it was their duty as British and American officers to try to escape and get back to the old normal. Similarly though it is your duty to try to escape today’s repression.”
In plain speak, he concludes that for bond markets, PIMCO favors higher quality, shorter duration and inflation protected assets. For stocks, it favors developing over developed. Favor shorter durations here, too, which means consistent dividend paying as opposed to growth stocks. For commodities, it favors inflation-sensitive, supply-constrained products. Lastly, for all asset categories, “be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.”