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

In his monthly commentary for July, Bill Gross of PIMCO warms to the theme he’s been exploring lately: the “new net neutral.”

This is the notion promoted by PIMCO that the “real” fed funds rate (FFR) is closer to zero than it is to the Federal Reserve’s “currently presumed 1¾%,”  and if you accept that notion, the investing world looks different. If it’s zero, he argues, “then not only bonds but all financial assets might logically be repriced relative to historical experience .”

Specifically, in his commentary Gross cites the Gordon dividend discount model to show how a 0% FFR would affect the intrinsic value of a stock (that model says that P = D/R-G, where P is the price of a stock, D is the expected dividend/share in one year’s time, R is the real interest rate and G is the growth rate in dividends). Gross writes that when it comes to R, the “real rate of interest…may be substantially lower than prior levels,” and says PIMCO agrees with former Fed Chairman Ben Bernanke’s private comment that “R is lower because G (growth) will be equally lower in future years.” But Gross then says that “in a highly levered world, R has been and must remain reduced more than G in order to keep our financed-based economy functioning.”

If that’s the case, Gross says that Robert Shiller’s CAPE (10-year cyclically adjusted P/E ratio) may need to be “adjusted from an historical median 17x P/E to something resembling 20-22x.” That adjustment would not mean that “today’s 16-multiple P/E market should be elevated to an immediate 20x, but that the current CAPE of 25x… is less bubbly than presumed. Fed officials who cite bubbly aspects of ‘financial conditions’ should therefore be less alarmed.”

So if the real FFR is significantly lower than 10 or 20 years ago, he continues, “P/E ratios should be higher, credit spreads should be tighter, and home prices less bubbly than presumed if, in fact, The New Neutral is “neutral” and can lead to historical levels of asset volatility.”

Gross then proceeds to focus on the New Neutral from his own speech at the Morningstar Investment Conference in Chicago two weeks ago (see this writer’s article on that presentation, and a subsequent blog that was written in response to Gross’ performance in Chicago.)

In the speech, Gross argued that the “neutral policy rate — in real and certainly nominal terms, changes over time,” and that in the past 80 years, “real policy rates have fluctuated from 0% to 8% during periods of positive inflation, and importantly, asset prices — bonds and stocks — have been significantly influenced by them. Do you wonder why stocks sold at P/Es of 6-7 times in 1981? Wonder no longer. It’s because nominal FF traded at 20%, and real FF at 7% or 8%. Equity risk premiums had to go up because real FF went up, which sent P/Es to what were rock-bottom prices. Same thing with long Treasuries at 15%.” Over the past few years, he argued in the speech, “real FF [rates] have been negative. [Twenty-five] basis points nominal with 1.5% inflation has equaled a minus (1.25%) average real FF rate for much of the period.”

He then cites current Fed Chairwoman Janet Yellen’s agreement that “there is an evolving neutral policy rate — a Goldilocks rate, which is ‘not too hot or not too cold, but just right’ to promote Fed targets of 2% inflation and 3% real growth, which is nominal GDP of 5%. I might add, this neutral policy rate will now be expected to maintain moderate financial conditions and keep exuberance contained, an evolving third leg to Federal Reserve policy.”

If the New Neutral is “closer to 0% real…then all asset markets, which are priced off of it, are less bubbly than they appear at the moment.” If the real rate were closer to 2%, “then bear markets in all asset classes await. We think not.”

So in PIMCO’s view, “this means that asset returns will be low, but less volatile than in prior periods. Perhaps that is why the VIX and Treasury volatility are so low currently.” Admitting that he is focusing on real rates in the U.S. alone and not overseas, Gross goes on to say that “We think, at the margin at least, that stock market appreciation will slow significantly and that credit spreads will stop tightening.”

As for what PIMCO would recommend to investors, “We expect bonds to return 3%-4% over the next five years and stocks perhaps 4% to 5%…we would favor credit and equity risk premiums (stocks) as well as volatility sales and the middle of the curve, as opposed to outright duration, although we would acknowledge, as I have, that the alpha heyday of all risk premiums is over. They are too tight to produce substantial capital gains, and their “carry” even when mildly levered lies in the 3%-5% annual return range.”

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