The credit-powered global economy is running out of fuel and will eventually stall out if economic and monetary policies don’t change, according to legendary bond fund manager Bill Gross.
“This expansion appears to be reaching an ending of sorts, at least in its current form,” writes Gross about the global economy. “The ever expanding supply of available credit has facilitated economic prosperity much like the sun has been the supply center for energy/food and life’s sustenance,” writes Gross. But now “finance itself is burning out like our future sun.”
In his latest economic outlook for Janus Capital Group, where he manages the Janus Global Unconstrained Bond Fund (JUCTX), Gross laments the explosion of credit in the global economy – including a 58-fold increase in the U.S. since the early 1970s. And, as he’s done before, Gross blames the quantitative easing policies of central banks and negative interest rates for the credit explosion and slowdown of the global economy.
“With quantitative easing and negative interest rates, the concept of nurturing credit seems to have morphed into something destructive as opposed to growth enhancing,” writes Gross. “Our global, credit-based economic system appears to be in the process of devolving from a production-oriented model to one which recycles finance for the benefit of financiers.”
Not benefiting from the those policies are the households that can’t save enough to pay for college, retirement or medical bills; insurance companies that have trouble covering claims because they can’t earn enough returns on bond and stock portfolios; and pension funds, which similarly can’t earn enough to cover their liabilities, writes Gross. But he singles out the banking sector — the sector that employs some of those financiers – as among the most damaged because their “profit margins are threatened as the yield curve flattens and net interest rate margins narrow.”
The yield curve measures the difference between short- and long-term rates, and the net interest rate margin is the spread between the rate a bank charges on loans and the rate it pays out in deposits. Both limit the rate that banks can charge on loans, which hurts their profit margins and, in turn, bank stocks.
“The recent collapse in worldwide bank stock prices can be explained not so much by potential defaults in the energy/commodity complex, as by investor recognition that banks are now not only being more tightly regulated, but that future ROEs will be much akin to a utility stock,” writes Gross. The KBW Bank Index (BKX) is down 11.8% year to date — four times the drop in the S&P 500. But Gross paints an even more dramatic picture of the slide in bank stocks by comparing current prices to prices in 2007 “post-Lehman.” Although Lehman was in trouble in 2007, it didn’t file for bankruptcy until mid-September 2008.
Since 2007, however, Citibank (C) shares have fallen about 92%, Bank of America shares (BAC) are off about 75% and Deutsche Bank’s (DB) are down 85%. Given these low prices, “banking/finance seems to be either a screaming sector ready to be bought or a permanently damaged victim of write-offs, tighter regulation and significantly lower future margins,“ writes Gross. He chooses the permanently damaged outlook, and not only for banks.
Gross advises investors to avoid reaching “for the tantalizing apple of high yield or the low price/book ratio of bank stocks” as well as “the seemingly momentum-driven higher prices of Bunds and Treasuries that negative yields have produced.” A 10 basis point increase in a 30-year Treasury trading at 2.5% “can wipe out your annual income in one day,” warns Gross.
He recommends instead that investors own bonds with short maturities, borrow at current low yields and match those low yields with “investments that are less volatile and least affected by changes in monetary policy” such as closed-end funds currently trading at deep discounts or arbitrage stocks involved in “highly certain” acquisitions. Gross concludes: “Be prepared for change.”
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