What do sex, kittens and Victoria’s Secret have to do with the economy? For Bill Gross, they help put into perspective that clients’ toughest portfolio questions are nothing compared with difficult questions from your kids about the birds and bees.
Bill Gross, portfolio manager of the Janus Global Unconstrained Bond Fund, wrote of such a question from his then 14-year-old son in his monthly market commentary.
When his own mother asked him if he knew where kittens came from, a young Gross replied, “the pet store.” Years later, he had a similar conversation when his son discovered a Victoria’s Secret catalog and instead of explaining what the “plain and unattractive models” were selling, deflected with the kitten question, sighing with relief when he got the same answer.
Important questions about the economy are a little easier to answer, and Gross listed five that deserve consideration.
First, when might a credit-based financial system break down? “When investable assets pose too much risk for too little return,” according to Gross. That won’t happen immediately, but “at the margin, low/negative yielding credit is exchanged for figurative and sometimes literal gold or cash in a mattress. When it does, the system delevers as cash at the core, or real assets like gold at the risk exterior, become the more desirable assets.”
Central banks can maintain reserves, he explained, but they aren’t obliged to lend if it’s deemed too risky. The “secular fertilization” of credit may stop working at the zero bound, he said.
Does that mean capitalism can’t function efficiently at the zero bound?
Not well, anyway. Low interest rates can raise asset prices, but they “destroy savings and liability-based business models in the process,” Gross wrote. Banks to pension funds to small business owners lose their retirement benefits and their ability to pay future debts, he explained. “Central banks seem oblivious to this dark side of low interest rates. If maintained for too long, the real economy itself is affected as expected income fails to materialize and investment spending stagnates.”
What about central banks’ continued quantitative easing efforts? Reuters reported in July that the European Central Bank and the Bank of Japan are purchasing about $180 billion of assets every month, “with the ECB, BOJ and even Bank of England all expected to expand their QE programs soon to try and bolster fragile growth and lift stubbornly low inflation.”
Gross believes the banks can keep up with this buying plan although eventually the pool of high-quality assets available will shrink and cause “significant technical problems involving repo, and of course negative interest rates.”
Central banks are essentially issuing debt for free, as they rebate almost all of their interest payments back to their respective treasuries, according to Gross. Promises to sell debt back to the private market are “promises that can never be kept,” he said.
“The ultimate end for QE is a maturity extension or perpetual rolling of debt,” Gross wrote. “The Fed is doing that now, but the BOJ will be the petri dish example for others to follow, if/when they extend maturities to perhaps 50 years.”
So how will investors know if these monetary policies will work? Keep an eye on nominal GDP, he wrote. “Almost all assets are a bet on growth and inflation,” Gross wrote – hopefully real growth but at least nominal growth. Nominal growth is “critical,” he added, because “it allows a country, company or individual to service their debts with increasing income, allocating a portion to interest expense and another portion to theoretical or practical principal repayment via a sinking fund.”
When that doesn’t happen, “a credit-based economy ultimately devolves into Ponzi finance, and at some point implodes.” Gross said nominal growth between 4% and 5% is “necessary” in the United States, with rates between 3% and 4% in the eurozone and 2% and 3% in Japan.
Ultimately, what should investors do? “In this high risk/low return world, the obvious answer is to reduce risk and accept lower than historical returns,” Gross wrote. “Negative returns and principal losses in many asset categories are increasingly possible unless nominal growth rates reach acceptable levels.”
Gross wrote that he doesn’t like bonds or stocks or private equity. Real assets like land, gold and tangible plant and equipment are favored, but more difficult to buy for the average consumer.
— Read Answering the Hardest Question in Economics on ThinkAdvisor.