Basketball living-legend Lebron James shot an air-ball during last Thursday night's Game 1 of the NBA Championships; he also threw up a brick at a key moment in Game 1 of the series against the Chicago Bulls that didn't even touch rim. That ugly-looking heave by "King James" reminded me of a recently published essay entitled "Wounded Heart," penned by "The Bond King" Bill Gross, a living legend in the investment field. King James' embarrassing off-balance, double-clutch, fade-away floater reminded me of The Bond King's essay because the latter struck me as containing some of most fundamentally unsound economic and financial analysis I have ever seen published by a respected analyst - much less from an investment hall of famer.
In "Wounded Heart," Gross argues that US Federal Reserve policies such as QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) are destroying the "beating heart" of the US economy by suppressing the "carry" offered to financial investors and thereby quashing incentives for entrepreneurial investment in the real economy. Now, I happen to be aligned with Gross in believing that current Fed policies may be sowing the seeds of future problems for the US economy. However, I am writing this review of "Wounded Heart" because I believe that it is important that investors understand that the challenges faced by the US financial system and economy in this respect are nearly opposite of those that Gross posits, and for nearly the opposite reasons.
Summarizing Gross's Central Thesis In "Wounded Heart"
The following is a summary outline of the central thesis of Gross's widely cited "Wounded Heart":
1. "Carry" is the "beating heart" of the US Economy. According to Bill Gross, "'Carry' constitutes the beating heart of our financial markets and ultimately our real economy as well." Gross defines "carry" as follows:
"The carry or return I speak to is most commonly assumed to be a credit or an equity risk "premium" involving some potential amount of gain or loss to an investor's principal."
2. "Carry" is the "oxygen" that nourishes the US economy and there is too little of it. According to Gross, "Carry" is the oxygen that feeds financial assets," and the problem is that "it is clear to all… that there is a lot less of it now than there used to be."
3. Central Banks are "wounding" the US economy by implementing policies that eliminate the "carry." Central banks, including the US Federal Reserve are "wounding" the "beating heart" of financial markets and the economy as a whole by depriving them of the "oxygen" they need to fuel sustainable economic growth. Gross goes on to say , "no matter how much blood is being pumped through the system as it is now, with zero-based policy rates and global quantitative easing programs, that the blood itself may become anemic, oxygen-starved, or even leukemic…."
In sum, Gross's thesis in "Wounded Heart," is that Central Bank policies around the world have failed to stimulate sustainable growth because they have destroyed "carry." And by destroying "carry" central banks are quashing the incentive for financial markets investors to assume risk and for entrepreneurs to invest in the real economy. Again, here is Mr. Gross describing what he sees as the problem in his own words:
If the "carry" or potential return… were no more than the 25 basis points offered by today's fed funds rate, then who would take the chance?"
Analysis of Gross's Central Thesis in "Wounded Heart"
On the surface, Mr. Gross's argument may not immediately appear to be illogical. However, it only takes a little bit of digging beneath the surface to realize that the argument is, in fact, a dreadful muddle.
First, it will be apropos to make some observations about Gross's muddled use of metaphors to frame the discussion. For example, Gross refers to "carry" as being a "beating heart" in one sentence, and then as "blood" a few sentences later. This is illogical: A thing can be a heart that pumps, or it can be blood; it cannot be both. Gross then transmits further confusion by likening the money supply being "pumped" into the economy by Central Banks as "blood" that, with zero-based policy rates and global quantitative easing programs, may become "anemic, oxygen-starved, or even leukemic." Again, this usage is illogical. "Blood" can either be the "money" as he just alluded to, or it can be "carry" as he made reference to earlier; it cannot be both. Finally, Gross's metaphorical use of the concept of "pumping" is perplexing: Is "pumping" done by the "carry" that he referred to earlier as the "beating heart" or is it "central banks" as he suggests later? Or are central banks the beating heart? Or is it all of the above?
Despite this stumblin' bumblin' use of metaphors, Gross's intended message is pretty clear. However, as we shall see, the bloody mess that Gross makes of his metaphorical descriptions of "carry" - simultaneously conflating the concept with, "beating heart," "blood," "central banks" and "money" - is indicative of the ghastly confusion that pervades the entire analysis.
Without further ado, let us no proceed to evaluate the substance of The Bond King's central argument.
1. Gross claims that "carry" is grievously low: False. Gross claims that "carry" is so low that financial market participants do not have an incentive to assume risk through investment. This is an assertion that is demonstrably false. For example, if we understand "carry" as the spread between the short-term rate of interest at which financial institutions and other financial markets participants can obtain money and the rates of return that they can obtain by investing in financial assets cited by Mr. Gross such as "corporate and high yield bonds, stocks, private equity and emerging market investments," then said "carry" is not particularly low by historical standards. Even though nominal yields on most investments are indeed low, the actual "carry" is reasonably high due to the fact that short-term interest rates are near zero.
For example, the "equity risk premium" measured as the difference between the risk-free T-Bill rate and the earnings yield on the S&P 500 (SPY) is near all-time highs. Similarly, the spread between the T-Bill rate and equity dividend yields are near historic highs. Finally, the "credit risk premium" or spread between the yield on T-Bills and the yields provided by investment grade corporate (LQD) and/or high yield credit is also not particularly low. Indeed, the fact that pace of junk-bond (JNK) issuance is has been proceeding for many months at all-time highs, should be a clear sign that financial investors are not being overly discouraged by central bank policies from assuming risk. Therefore, Mr. Gross's dramatic lamentations about "wounded hearts" caused by the lack of incentives being offered to financial investors to assume risk are without much factual merit.
2. Gross claims that "carry" is the beating heart of the real economy: False. Gross argues that the lack of "carry" being enjoyed by financial investors is somehow crippling the real economy. Or as he puts it: "Financial markets require "carry" to pump oxygen to the real economy." Gross has the arrows of causation exactly wrong. The reality is that "oxygen" is "pumped" into financial markets by the aggregate profitability of businesses within the real economy - and this profitability in the real economy is transmitted to investors via a healthy carry. The positive carry is a symptom, not the cause, of health in the real economy.
In a healthy economy with well-functioning financial markets, the risk-free rate of interest will tend to rise as the profitability of alternative more-risky investments rises. Since most investments in the real economy are characterized by relatively long-duration, when long-term investment alternatives are profitable, a long-term "carry" (or spread) emerges between the prospective yields on short-term and relatively riskless investments on the one hand, and relatively longer-term and risky investments on the other. Contrary to Gross's upside-down argument, carry is not the "beating heart" of the real economy; profitability in the real economy is the mother's milk of sustainable carry for financial investors.
3. Gross claims that QE discourages financial risk-taking: False.
Gross again gets it exactly wrong. As a point of fact, the central banks have been successful in encouraging more financial investor/trader demand to flow towards risk assets - a fact demonstrated by rising prices and lowered yields of financial assets all across the risk spectrum. And it is even more dramatically illustrated by all-time high issuances of high-yield low-grade debt instruments.
It is instructive to ponder how the Fed has achieved this. Organically speaking, investors have been very risk-averse since the 2008 crisis. All things remaining equal, investors have preferred low-yielding risk-free investments such as iShares Barclays 20+ Year Treasuries (TLT) to higher yielding risky investments such as iShares iBoxx $ High Yield Corporate Bond (HYG). As a consequence (not a cause) of this risk-aversion, central banks have endeavored to remove long-duration risk-free (treasuries) and low risk (agency mortgage-backed securities) assets from circulation and otherwise lower yields on long duration assets in order to force or lure investors to purchase more risky assets for their portfolios.
Indeed, it is becoming increasingly likely that the effects of easy-money central bank policies have gone too far and that risk assets have become mispriced (i.e. too expensive) due to the excess demand created by excess liquidity and zero-bound short-term interest rates. Therefore, it is probably nearer to the truth to say that Fed policies are encouraging too much risk-taking in some sectors of financial markets than to assert as Gross does that they are encouraging too little risk-taking in financial markets. Furthermore, contrary to what Gross has claimed, it is not that the Fed has discouraged risk-taking in financial markets by causing the yields on risky assets to decline. The truth is quite the opposite: The Fed has encouraged risk-taking behavior by financial investors and traders and this is reflected in the declining yields of risky assets.
4. Gross assumes risk-taking in financial markets automatically translates to risk-taking in the real economy: False. Gross seems to assume that if financial market participants were to assume more risk, there would be more investment, employment and production in the real economy. Unfortunately, if there is one thing that has been proven in the past few years is that this is not really true. Right now, there is clearly a disconnect between the elevated risk-taking that is taking place in many sectors of the financial markets (as measured by the stretched valuations of various financial assets and frenetic issuance of risky debt instruments), and the muted propensity of entrepreneurs to hire and invest in the real economy. Banks such as Bank of America (BAC) are not lending to businesses in the real economy, and businesses with access to financing and/or high cash balances such as Apple (AAPL) are otherwise not investing and hiring, because entrepreneurs and their bankers are simply not seeing enough profit opportunities via prospective consumer demand and/or potential productivity enhancements. Therefore, with organic profitability already being perceived as meager, it defies common sense to suggest as Gross does that entrepreneurs will invest and hire more if the interest rate at which they can obtain funds is raised. The truth is more nearly the opposite.
On this point it seems that there has arisen a fundamental confusion between very different types of rates/yields: Examples: 1) The yield savers can obtain from short-term savings vehicles; 2) The rate at which an entrepreneur can obtain capital; 3) The rate of return that an entrepreneur can earn from his investments in the real economy. Gross seems to think that the first determines the third. However, to assume that the low rates of interest that savers can currently obtain from instruments whose interest rates are more or less determined by the Fed (e.g. savings and money market accounts) are also the cause of the low rates of return that entrepreneurs are currently projecting for their investments is a to confuse factors, causes and effects. Indeed, the arrows of causality are more nearly opposite: When entrepreneurs can earn attractive profits from their investments in the real economy via healthy organic demand and productivity enhancements, there emerges an increased competition (demand) for funds that causes the rate at which capital (debt or equity) can be obtained from savers to rise. By contrast, any Fed-induced rise in short-term interest rates that is not matched by a healthy rate of profitability in the real economy will not be sustainable.
In sum, Gross's musings that QE is depressing the profitability of businesses in the real economy and discouraging investment are conspicuously without theoretical merit or empirical foundation. The truth of the matter is very different. Profitability in the real economy has been hindered primarily by other factors, including excessive indebtedness by the household sector that constrains consumption-led demand growth (which accounts of 70% of US GDP) as well as by insufficient productivity growth in the business sector.
So what, if any, has been the effect of low risk-free rates? As a point of fact, cheap money has boosted consumption beyond what it would otherwise be as credit has been made more available to consumers than would otherwise be the case. This has occurred for two reasons: 1) More consumer credit is made available to consumers because the carry earned by banks is made more attractive by their ability to obtain funds at near-zero cost; 2) Lower interest rates make credit more affordable to consumers.
In terms of the impact of QE on business expenditures, entrepreneurs have invested more than they otherwise would have as a result of access to cheap money because their "carry" (i.e. the rate at which they can obtain funds versus their prospective rate of return on capital) is more positive than it would have been otherwise. Furthermore, as alluded to earlier, businesses have been drawn to invest more than they otherwise would have since demand by their customers is growing faster than it otherwise would have without access to relatively cheap consumer credit.
I believe that it should be clear by now that far from being a hindrance to economic activity in the real economy as Gross asserts, cheap money provided by central banks has stimulated economic activity to a level far greater than it otherwise would have been. That is not to say that central bank policies have been highly successful in stimulating vigorous economic growth. The key point is that economic activity has been greater than it otherwise would have been without the monetary stimulus.
Therefore, it follows that the problem faced by the US is not that there has been too much of this monetary blood "transfused" into the economy, as Gross muses; the real challenge faced is how the economy is going to function without it. A further challenge is this: How is the imbalance between the frenetic level of risk-taking in financial markets and the meager prospective profitability available in the real economy going to be resolved? These sorts of problems are precisely the opposite of those that Bill Gross is fretting about in "Wounded Heart".
Next Article: Gross's Other "Coagulants"
I hope it is now evident that the real challenge faced by the US economy is not that monetary stimulus is wounding the "beating heart" the real economy through the reduction of the carry available to financial investors. Gross's central thesis in this regard is clearly inaccurate empirically, theoretically unsound and contrary to common sense. If anything, central banks are fueling too much risk-taking in financial markets given meager organic profit opportunities in the real economy. And this imbalance could ultimately prove costly.
I wish I could leave the analysis at that. But, unfortunately, Gross compounds the confusion generated by the presentation of his central thesis by extending the use of his sanguineous metaphors to cite five other central-bank induced "coagulants that seem to block the financial system's arteries at zero-bound interest rates and unacceptably narrow "carry" spreads."
In my next article I shall review this rather extraordinary prolongation of confusion. But make no mistake: Just as I would love to have "King James" on my basketball team despite all the air-balls that he has every shot in his career, I would love to have "The Bond King" on my investment team -- even if he has stunk up the joint with a few of his public writings from time to time, including just recently.