- Bill Grosss' views on the new normal Fed funds rate and the implications on capital markets.
- How will investors earn return in an environment of zero growth.
- Ideas on positioning a portfolio in an environment with no growth.
As far back as 2012, wise market participants began pondering one of the piercing questions about the current state of the capital markets. How do we find alpha (we are all Seeking alpha I presume) in a 0% growth world. This question has been the topic of extensive discussion in all corners, better yet, this zero growth economy has been the topic of very many articles and debate ( see Washington post: "Have we reached the end of economic growth" or " can capitalism cope without growth.") Granted, these articles and the myriad of others that echoed similar tones were written between 2010 and 2011, a time when it seemed like no one would get employed, and we would be lucky to see 2% GDP growth, in contrast to today when we tout a recovering US jobs market and GDP growth of 4%. However, we must understand the conditions from then till now, the changes that are at foot, and why one of the greatest minds in investing, Bill Gross, believes this is an area that we should refocus on.
On this second installment of Gross watch; a series in which I profile the ideas and market perspective of Bill Gross, co-founder and fund manager at Pacific Investment Management Company (PIMCO), I will further discuss the implications of Mr. Gross's big investment idea, the new neutral FED's funds rate (See installment 1 for background.) The new neutral basically explain why Mr. Gross challenges the market assumption that the long run average of the Feds fund rate is and has been stable at around 2% and asserts that the real rate is closer to 0% and 2% inflation brings a nominal rate of 2%. Thus at current market levels the case Schiller P/E ratio is not as inflated as it would ordinarily seem. This month, he explores the effect this new normal market conditions has on growth in the capital markets.
Naturally, insight from an acclaimed "bond king" is steered in part, if not entirely by the Federal Reserve and its actions. Thus, it stands to reason that we begin exploring the ideas that Bill Gross outlined by exploring how the FEDs actions have affected economic growth, and why the discussion of finding returns in a zero growth world is "so passé". Since 2008, the Federal Reserve has undertaken various monetary strategy initiatives to ensure that we experience growth. By some accounts, these have proven to be successful and quelled the search for growth. But with the tides turning, slowly as they may, we approach a time when the propping up of the economy by the FED will be no more. We have reached the beginning of the end of an era with peaceful asset appreciation propped up by its primary driver; low interest rates. Markets have to once again rely on fundamentals to generate returns for participants.
After the end of an era of policy that has seen the expansion of the balance sheets of the BOJ, BOE and the FED, markets must look to a historically defiant global economic growth for returns. The global economy suffers from a supply demand gap due to the period of artificially low interest rates. Supplies are in excess because consumers are reticent to enter the market place due to their still heavy debt load, their age and their job positions which are becoming increasingly automated. So, as markets being to depend on growth instead of a lowering interest rate environment, can investors find the needed growth anywhere in the world.
Well, South America is experiencing a recession because of its big three nations; Brazil, Argentina, and Venezuela are all experiencing economic turmoil of one sort or another. Europe is still trying to get above water since its recent default scares and unaligned fiscal and monetary policy; not to mention some European nations with >20% unemployment. Russia is neck deep in geopolitical turmoil while Japan and China "show growth due to paper not productivity."
All these condition point to asset price head winds that serve to curve capital appreciation expectations for returns. Mr. Gross believes that despite the lack of growth conditions globally, asset prices won't go down, however, they won't go up as much as people expect and in order to combat this lethargy in the markets wise investors will seek income as a driver of future returns. "We will continue in this artificially priced market (neither bear nor bull) because of the new neutral. If policy rates rise by less than expected then asset prices and P/E ratios are better supported."
He advises that investors should reassess their expectations, be well aware of the risks in all investment decision and that income is more crucial than ever as it serves as the stable source of return in an indolent market. Furthermore, it pays to take into account the following when constructing or restructuring a portfolio in this market.
- Expect flatten yield curve.
- Spreads are tight and may remain so.
- Fed will be on hold till mid-2015 and hike to 2% by 2017.
- Income is an investor's best friend in times like this.
That is all for this installment of Gross watch. Per the advice of investment greats such as Warren buffet, I tend to rely on a margin of safety when choosing an investment. Two excellent sources of such a tool are value and income. Income tends to provide a monetary buffer for the errant ways of the market while value tends to be the logical pillar on which all investments must rely. Regardless of ones opinion on the validity of Mr. Gross's perspective, his guiding principles remain in line with those of the intelligent value investor.