by Chris Becker
Former PIMCO boss Bill Gross goes all out uber bear in his latest investment missive titled “Ides“:
Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over.
Gross’ viewpoint encompasses that of the super debt cycle and the general unwillingness of monetary and fiscal authorities to arrest the dire feedback loop:
For the past few decades, the secular excess has been on the upside with rapid credit growth, lower interest rates and tighter risk spreads dominating the long-term trend.
There have been dramatic reversals as with the Lehman Brothers collapse, the Asia/dot-com crisis around the turn of the century, and of course 1987’s one-day crash, but each reversal was met with a new and increasingly innovative monetary policy initiative on the part of the central banks that kept the bull market in asset prices alive.
Each downward spike in the economy and its related financial markets was met with additional credit expansion generated by lower interest rates, financial innovation and regulatory easing, or more recently, direct central bank purchasing of assets labeled “Quantitative Easing.”
Even with the recognition of the Minsky Moment in 2008 and his commonsensical reflection that “stability ultimately leads to instability,” investors have continued to assume that monetary (and at times fiscal) policy could contain the long-term business cycle and produce continuing prosperity for investors in a multitude of asset classes both domestically and externally in emerging markets.
Herein lies the danger as the global economy staggers into 2015 with the realisation that lower and zero bond rates cannot continue to sustain real economic growth in the face of lowering aggregate demand:
While such yields almost automatically result in higher bond prices and escalating P/E ratios, their effect on real growth diminishes or in some cases, reverses. Corporate leaders, sensing structural changes in consumer demand, become willing borrowers, but primarily to reduce their own outstanding shares as opposed to investing in the real economy.
The Alice in Wonderland fact of the matter is that at the zero bound for interest rates, expected Returns on Investment (ROI) and Returns on Equity (ROE) are capped at increasingly low levels. The private sector becomes less willing to take a chance with their owners’ money in a real economy that has a lack of aggregate demand as its dominant theme.
Making money by borrowing at no cost for investment in the real economy sounds like a no-brainer. But, it comes with increasing risk in an environment of secular stagnation, demand uncertainty, and with the ROI closer to zero itself than an entrepreneur is willing to bear.
When will it end? Gross contends that financial markets will indicate when too little return for too much risk turns into a deleveraging:
If real growth in most developed and highly levered economies cannot be normalized with monetary policy at the zero bound, then investors will ultimately seek alternative havens. Not immediately, but at the margin, credit and assets are exchanged for figurative and sometimes literal money in a mattress. As it does, the system delevers, as cash at the core or real assets at the exterior become the more desirable holding.
Increasingly, however, it is becoming obvious that as yields move closer and closer to zero, credit increasingly behaves like cash and loses its multiplicative power of monetary expansion for which the fractional reserve system was designed.
Finance – instead of functioning as a building block of the real economy – breaks it down. Investment is discouraged rather than encouraged due to declining ROIs and ROEs. In turn, financial economy asset class structures such as money market funds, banking, insurance, pensions, and even household balance sheets malfunction as the historical returns necessary to justify future liabilities become impossible to attain. Yields for savers become too low to meet liabilities. Both the real and the finance-based economies become threatened with the zero-based, nearly free money available for the taking.
Gross puts a loose timetable in place somewhere in 2015, and gives some idea of where to go beforehand, although this runs counter to the hyper-inflation brigade asset allocators:
High-quality assets with stable cash flows. Those would include Treasury and high-quality corporate bonds, as well as equities of lightly levered corporations with attractive dividends and diversified revenues both operationally and geographically.
For Australian investors this precludes the traditional dividend queens, the uber-concentrated and risky banks and suggests defensives with high exposure to foreign revenue. But not much else unfortunately.