Mr. William H. Gross, the founder, managing director and co-CIO of PIMCO discussed in an article his investment outlook, views on Bernanke, inflation and investment conclusions. This article discusses his views and investment ideas considering the outlook provided by Gross.
I would first provide excerpts from the article followed by my views and investment conclusions. According to Gross -
Well, the answer is sort of complicated but then it's sort of simple: They just make it up. When the Fed now writes $85 billion of checks to buy Treasuries and mortgages every month, they really have nothing in the "bank" to back them. Supposedly they own a few billion dollars of "gold certificates" that represent a fairy-tale claim on Ft. Knox's secret stash, but there's essentially nothing there but trust. When a primary dealer such as J.P. Morgan or Bank of America sells its Treasuries to the Fed, it gets a "credit" in its account with the Fed, known as "reserves." It can spend those reserves for something else, but then another bank gets a credit for its reserves and so on and so on. The Fed has told its member banks "Trust me, we will always honor your reserves," and so the banks do, and corporations and ordinary citizens trust the banks, and "the beat goes on," as Sonny and Cher sang. $54 trillion of credit in the U.S. financial system based upon trusting a central bank with nothing in the vault to back it up. Amazing!
But the story doesn't end here. What I have just described is a rather routine textbook explanation of how central and fractional reserve banking works its productive yet potentially destructive magic. What Governor Bernanke may have been referring to with his "essentially free" comment was the fact that the Fed and other central banks such as the Bank of England actually rebate the interest they earn on the Treasuries and Gilts that they buy. They give the interest back to the government, and in so doing, the Treasury issues debt for free. Theoretically it's the profits of the Fed that are returned to the Treasury, but the profits are the interest on the $2.5 trillion worth of Treasuries and mortgages that they have purchased from the market. The current annual remit amounts to nearly $100 billion, an amount that permits the Treasury to reduce its deficit by a like amount. When the Fed buys $1 trillion worth of Treasuries and mortgages annually, as it is now doing, it effectively is financing 80% of the deficit for free.
Yet the common sense of John Law - and likewise that of Ben Bernanke - must have known that only air comes for free and is "essentially costless." The future price tag of printing six trillion dollars' worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold.
Investors should be alert to the long-term inflationary thrust of such check writing. While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the "out" years towards which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies. In addition, be aware of PIMCO's continued concerns about the increasing ineffectiveness of quantitative easing with regards to the real economy. Zero-bound interest rates, QE maneuvering, and "essentially costless" check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs.
My Opinion -
As pointed out by Gross, I had discussed in one of my earlier articles on why the Treasury bond bull market is over. With the Federal Reserve being the largest buyer of Treasury bonds in the last 3 years, free money is essentially being used to fund the deficits. The same is evident from the chart below, which gives the Fed's gigantic balance sheet expansion.
The key point made by Gross is that the money printing exercise is just backed by government or central bank trust. If investors doubt the capability of the sovereign to repay the debt, the bond market might not take much time to collapse. More importantly, it makes perfect sense to print money if it leads to an incremental impact on real GDP growth.
However, in the current scenario, the real economic activity remains weak (lowest money velocity in last 50 years) along with the weak real unemployment rate (U6). Therefore, it is time for the Fed to pause and introspect on its policies than to continue printing money. As mentioned by Gross, there is no doubt that the economy is headed for much higher inflation in the long term if the current policies are perused with.
Continuing with the discussion on free money and debt growth, the diminishing impact of debt on the US economy underscores Gross's point on inflation.
From 1960 to 1980, the total credit market debt increased by USD3.9 trillion. In the same period, the GDP increased by USD2.4 trillion. In other words, one dollar of debt had an incremental impact of 61 cents on the GDP. From the year 1980 to 2000, the total credit market debt increased by USD20.7 trillion. The GDP in these 20 years increased by USD9 trillion. Therefore, one dollar of debt had an incremental impact of 44 cents on the GDP. Coming to the most recent decade, the total credit market debt from 2000 to 2011 increased by USD27 trillion while the GDP increased by USD5.2 trillion. The impact of debt on GDP growth during this period has witnessed a sharp decline. For every one dollar of debt, the incremental impact on GDP was just 19 cents.
I would also like to add here that besides the money printing exercise, near-zero interest rates are damaging for the economy and individuals in the medium-to-long term. This is especially true for savers. As the chart below shows, the real Fed fund rates have slumped to negative zone since the beginning of the crisis. I am of the opinion that real Fed fund rates will never be positive again if the Fed continues with current policies.
Gross is also of the opinion that easy money and QE's are bound to destroy financial business models and stunt investment decisions. I am in complete agreement with this view. I am especially concerned about crowding out of the private sector investment due to excessive government spending. A bigger concern is that the government spending is largely directed towards funding its defense program and social security programs. The positive impact of this spending is minimal to nil for the real economy. As the government debt balloons, it might not be surprising to see tax increases for the private sector. This will discourage investments, which can prop up economic activity. The CBO projects USD10 trillion deficits for the US over the next ten years. Given this fact, I don't see a reduction in government debt anytime soon. Instead, investors can expect more debt monetization and it would not be long before the Federal Reserve becomes the largest holder of government debt.
Gross also talks about inflation in the form of devaluation of currencies relative to each other or to hard assets (with relatively less supply compared to paper money). This shows that Gross is in favor of investing in precious metals and commodities in order to prevent erosion of purchasing power of individuals. I also completely agree with Gross that Treasury bonds are a good investment with a short-term perspective. Over the long term, all paper currencies will perform poorly against hard assets and government bonds might not be the risk-free assets anymore. With 29 hyperinflations in the last 100 years, the central banks have proved that paper money finally returns to its intrinsic value (precisely zero). Therefore, investors need to guard their savings.
Further, the surge in M2 in the United States underscores my point on high inflation going forward. As a most recent example, inflation in Zimbabwe surged with an increase in money supply. I am certainly not suggesting that US will have a hyperinflation like Zimbabwe. All I am suggesting is that high inflation does arise from an increase in money supply (with a time lag). Therefore, investors need to design their portfolio accordingly.
My Investment Conclusions -
Based on the likely scenario discussed above, I would consider exposure to precious metals, commodities, corporate bonds and equities in order to beat inflation. Specifically, I would consider investment in the following ETF's/Stocks -
SPDR Gold Shares ETF (GLD) - Investors can consider exposure to the hard asset for the long term. In the near term, some more correction in the precious metal is entirely likely. However, expansionary monetary policies, artificially low interest rates and demand from Asian central banks will trigger long-term upside in the precious metal. The GLD ETF seeks to replicate the performance, net of expenses, of the price of gold bullion.
iShares Silver Trust ETF (SLV) - Very similar to the argument for gold, I am also bullish on silver for the long term. Investors can consider exposure to silver through the purchase of physical metal or the ETF, which seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities.
Seadrill Limited (SDRL) - I like Seadrill, as it caters to the oil and gas sector, which I am bullish on for the long term. Also, the company offers a high dividend yield. SDRL provides offshore drilling services to the oil and gas industry worldwide, and is also an excellent long-term buy, in my opinion. The company has a diverse asset base of 24 drillships & semi-submersibles, 21 jack-up rigs and 21 tender rigs. Further, 18 newbuilds would serve as long-term revenue drivers once they come into operation in 2013 and 2014. SDRL currently has an order backlog of USD19.7 billion, which gives revenue visibility in the foreseeable future. Being the second largest ultra-deepwater player also serves as an advantage for SDRL in the long term. Investors can consider the gradual accumulation of this exceptionally high dividend yield (9.2%) stock.
Vanguard Energy ETF (VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term.
iShares MSCI Emerging Markets ETF (EEM) - Global diversification is necessary, and exposure to emerging markets is critical. Over the long term, emerging markets will outperform developed markets in terms of equity price appreciation. The cumulative mutual fund inflow into emerging markets has been higher in the last five years compared to developed markets. The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly-traded securities in emerging markets, as represented by the MSCI Emerging Markets Index.
Vanguard Long-Term Corporate Bond ETF (VCLT) - I am of the opinion that quality corporate bonds are a better and safer long-term investment option than government bonds with artificially low yields (negative, when adjusted for inflation). Further, the private sector has acted more rationally after the crisis compared to the government sector. Therefore, it is not surprising to see the private sector being the major economic growth driver post the crisis. In line with this rationale, I would consider exposure to the Vanguard Long-Term Corporate Bond ETF. The ETF invests in long-term investment grade corporate bonds and has an expense ratio of 0.14%.
Besides these stocks and ETF's, investors can also consider exposure to the SPDR S&P 500 ETF (SPY). It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.