In Bill Gross’ last monthly missive he aptly summarized the past half-century of financial history and discussed the implications it would likely have on asset class returns going forward. Because many of the views he expressed parallel our past commentaries, we thought it might be insightful to provide an abridged version of his letter. So we present to you a paraphrased version of The Great Escape: Delivering in a Delevering World by Bill Gross.
A short history of credit expansion
Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s… And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives… Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system… by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep the economy ticking.
The impact of unbridled leverage (credit)
This combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. Stocks for the Long Run was the almost universally accepted mantra, but it was really a period – for most of the last half century – of ‘Financial Assets for the Long Run’ – and your house was included by the way… As nominal and real interest rates came down, down, down and credit spreads were compressed through policy support and securitization, then asset prices magically ascended. P/E ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.
Where we stand today
And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed.
What we can expect going forward
What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift (with)… yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 3% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks, and real estate becomes problematic and certainly more difficult… the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited.
Implications for asset allocation
Still there is a place for all standard asset classes. The question is, what has the potential to deliver the most return with the least amount of risk... (1) Real as opposed to financial assets… (2) Financial assets with shorter spreads and interest rate durations because they are more defensive. (3) Financial assets for entities with relatively strong balance sheets that are exposed to higher real growth... (4) Financial or real assets that benefit from favorable policy thrusts from both monetary and fiscal authorities. (5) Financial or real assets which are not burdened by excessive debt and subject to future haircuts.
In plain speak…for bond markets favor high quality, shorter duration and inflation-protected assets. For stocks favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks. For commodities: favor inflation sensitive, supply constrained products.
If you would like to read the full letter, you can find it on Pimco’s website.