The lifeblood of America’s ailing economy—the Fed’s emergency monetary infusion via QE—may be “anemic, oxygen-starved, or even leukemic,” warns bond king Bill Gross in his June missive to PIMCO shareholders.
While the fund firm founder devotes just a single, final sentence to actionable advice—“investors should look for a pacemaker to follow a less risky, lower returning, but more life sustaining path”—it’s clear he thinks they should be generally heading for the market’s exits.
That is because his analysis is explicit that risk assets “are at risk due to artificial pricing.” And what are those assets?
“Corporate and high yield bonds, stocks, private equity and emerging market investments are financial assets that immediately come to mind,” Gross writes.
The PIMCO manager’s analysis is based on the concept of “carry,” which he defines as “return over and above the fixed, if mercurial, yield on an economy’s policy rate (fed funds).”
More common terms are “equity risk premium” or “credit risk premium,” which suggest that investors are willing to put their capital at risk if they can potentially earn a return greater than the risk-free rate they can obtain on short-dated government bonds.
“If the ‘carry’ or potential return on these asset classes were no more than the 25 basis points offered by today’s fed funds rate, then who would take the chance?” Gross (left) asks.
By sustaining a zero-rate environment, Gross fears the Fed is depriving the economy of risk.
“Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions,” he writes.
That is because quantitative easing and zero-rates “have lowered carry and risk premiums.” While the lowering of interest rates was probably necessary to avert a Great Depression-style debt deflation, he says sustaining that policy beyond the initial crisis has stunted economic growth by dis-incenting risk-taking.
Gross says the global monetary policy response in the recent period is historically unprecedented, meaning that interest rates in the U.S. and U.K. have never been so low, such that “never have investors received less for the risk they are taking.”
“Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment.”
Gross challenges this notion, arguing that in the real economy low rates generate low income which limits consumption and economic growth.
Further, they destroy business models. “If banks, insurance and investment management companies can no longer generate sufficient ‘carry’ to support employment infrastructures, then personnel layoffs quickly follow,” citing as an example the 189,000 job losses from just the four biggest U.K. banks since their peak employment levels. “The entire financial industry is now similarly threatened,” he warns.
While capital-starved financial companies are hurting, the low rates serve to sustain less competitive “zombie corporations,” he says, thereby further stunting economic growth.
Another insidious effect of low rates is that it drives corporations to return capital to investors rather than risk it through investment. “Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks.”
And in the bond market, “most new Treasuries wind up in the dungeon of the Fed’s balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth,” thus depressing credit expansion, he says.
Gross says these negative effects are acknowledged by Fed Chairman Ben Bernanke but justified as a necessary temporary measure to return the economy to “old normal” growth.
“Well it’s been five years Mr. Chairman and the real economy has not once over a 12-month period of time grown faster than 2.5%,” the PIMCO manager protests.
Gross concludes that “more and more debt cannot cure a debt crisis” and advises investors to reduce risk-related assets. That is a frequent PIMCO theme these days. Gross’ partner, PIMCO CEO Mohamed El-Erian, has also recently warned it is time to exit markets.
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