All of the money being created and freed up is elevating asset prices, but those prices are not causing corporations to invest in future production.
Mostrando postagens com marcador PIMCO. Mostrar todas as postagens
Mostrando postagens com marcador PIMCO. Mostrar todas as postagens
quinta-feira, novembro 01, 2012
Time to vote!
All of the money being created and freed up is elevating asset prices, but those prices are not causing corporations to invest in future production.
quinta-feira, outubro 11, 2012
Beware the ‘central bank put’ bubble
By Mohamed El-Erian, Financial Times
The Federal Reserve remains the best friend of many investors. It is among several key western central banks that are supporting asset prices not as an end in itself but as a means to promote growth and jobs.
In the midst of the global financial crisis, the Fed aggressively injected emergency liquidity and intervened to fix disrupted and malfunctioning markets. In the process, it rescued investors from what would have been irrecoverable losses.
Essentially, the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals. And investors in virtually every market segment – including bonds, commodities, equities, foreign exchange and volatility – have benefited handsomely. In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there.On several other occasions, the Fed acted to counter the disruptive “left tail” of deflation and recession. Market valuations responded favourably as the institution successfully offset both internal and external risks.
Now the Fed is attempting to meet a more ambitious objective: to deliver better economic outcomes, defined as more robust growth, lower unemployment, and stable low inflation. And last week’s release of the minutes of the last policy meeting leaves little doubt: the Fed intends to keep its foot on the policy accelerator well into an economic recovery.
Central bank action, both real and perceived, rules the investment day, and will continue to do so for now. This is also the case in Europe.
Judging from last week’s policy announcements, the European Central Bank will not hesitate to buy unlimited government securities provided the targeted countries apply for help and deliver on the policy front. It is committed to countering unwarranted risk premia related to currency convertibility risk and financial market fragmentation. Even though it is yet to be made operational, this has already translated into a major boost to investors in most European assets; and it will continue to do so if governments also come through.
Yet with the recent surge in markets, investors would be well advised to remember some basic truths as they continue to position their portfolios (and scale their risk exposures) on the basis of unusual central bank activity:
• The assets likely to be impacted the most and longest are those under the immediate influence of central bank measures – namely the securities they buy directly.
• The more investors venture beyond these assets (and the larger and more illiquid their risk positions), the greater their conviction that unconventional central bank policies will eventually succeed in engineering more robust economic and financial fundamentals.
• It is hard to pin such conviction on detailed analytics or historical experience.Central banks are neck deep in extreme policy experimentation mode, and getting inadequate support from other government entities.
• The longer this persists, the higher the risk that policy benefits will be offset by collateral damage and unintended consequences; and the greater the political heat on central banks.
• If the critical hand-off to fundamentals does not materialise, the reaction of markets will not be pleasant. Positioning on the basis of the “central banks’ put” is a particularly crowded trade. Also, it involves some investors being overconfident in the powerful omnipresence of these institutions, some believing in immaculate economic recoveries, and some feeling they can wait for markets to peak decisively and then exit smoothly.
The summary takeaways for investors are quite straightforward, and important for both generating returns and managing risk.
Investors should definitely pay attention to western central banks and respect the market influence of unconventional policies. But they should do so while keeping a wary eye on how far, and for how long, valuations can be divorced from fundamentals.
Risk exposures should evolve accordingly. Differentiation, both within and between asset classes, should increasingly underpin portfolio construction – with emphasis on companies and countries with both strong balance sheets and positive cash flow. And this need not crowd out exposures to other parts of the world, particularly emerging economies (such as Brazil, Indonesia and Mexico) where central banks are less active but markets are better supported by solid economic and financial fundamentals.
Finally, investors should take with a pinch of salt the operational feasibility of maintaining a maximum “risk-on” position until the markets turn, then making a quick exit. It is an idea that risks sounding better in theory than it works in practice.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco
The Federal Reserve remains the best friend of many investors. It is among several key western central banks that are supporting asset prices not as an end in itself but as a means to promote growth and jobs.
In the midst of the global financial crisis, the Fed aggressively injected emergency liquidity and intervened to fix disrupted and malfunctioning markets. In the process, it rescued investors from what would have been irrecoverable losses.
Essentially, the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals. And investors in virtually every market segment – including bonds, commodities, equities, foreign exchange and volatility – have benefited handsomely. In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there.On several other occasions, the Fed acted to counter the disruptive “left tail” of deflation and recession. Market valuations responded favourably as the institution successfully offset both internal and external risks.
Now the Fed is attempting to meet a more ambitious objective: to deliver better economic outcomes, defined as more robust growth, lower unemployment, and stable low inflation. And last week’s release of the minutes of the last policy meeting leaves little doubt: the Fed intends to keep its foot on the policy accelerator well into an economic recovery.
Central bank action, both real and perceived, rules the investment day, and will continue to do so for now. This is also the case in Europe.
Judging from last week’s policy announcements, the European Central Bank will not hesitate to buy unlimited government securities provided the targeted countries apply for help and deliver on the policy front. It is committed to countering unwarranted risk premia related to currency convertibility risk and financial market fragmentation. Even though it is yet to be made operational, this has already translated into a major boost to investors in most European assets; and it will continue to do so if governments also come through.
Yet with the recent surge in markets, investors would be well advised to remember some basic truths as they continue to position their portfolios (and scale their risk exposures) on the basis of unusual central bank activity:
• The assets likely to be impacted the most and longest are those under the immediate influence of central bank measures – namely the securities they buy directly.
• The more investors venture beyond these assets (and the larger and more illiquid their risk positions), the greater their conviction that unconventional central bank policies will eventually succeed in engineering more robust economic and financial fundamentals.
• It is hard to pin such conviction on detailed analytics or historical experience.Central banks are neck deep in extreme policy experimentation mode, and getting inadequate support from other government entities.
• The longer this persists, the higher the risk that policy benefits will be offset by collateral damage and unintended consequences; and the greater the political heat on central banks.
• If the critical hand-off to fundamentals does not materialise, the reaction of markets will not be pleasant. Positioning on the basis of the “central banks’ put” is a particularly crowded trade. Also, it involves some investors being overconfident in the powerful omnipresence of these institutions, some believing in immaculate economic recoveries, and some feeling they can wait for markets to peak decisively and then exit smoothly.
The summary takeaways for investors are quite straightforward, and important for both generating returns and managing risk.
Investors should definitely pay attention to western central banks and respect the market influence of unconventional policies. But they should do so while keeping a wary eye on how far, and for how long, valuations can be divorced from fundamentals.
Risk exposures should evolve accordingly. Differentiation, both within and between asset classes, should increasingly underpin portfolio construction – with emphasis on companies and countries with both strong balance sheets and positive cash flow. And this need not crowd out exposures to other parts of the world, particularly emerging economies (such as Brazil, Indonesia and Mexico) where central banks are less active but markets are better supported by solid economic and financial fundamentals.
Finally, investors should take with a pinch of salt the operational feasibility of maintaining a maximum “risk-on” position until the markets turn, then making a quick exit. It is an idea that risks sounding better in theory than it works in practice.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco
terça-feira, março 27, 2012
The Great Escape: Delivering in a Delevering World
Bill Gross, PIMCO
• When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
• In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
• We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
The term delevering implies a period of prior leverage, and leverage there has been. 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 elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. 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, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, 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 in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.
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. PE 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.
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 – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.
How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.
To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.
This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie staring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.
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: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% 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 much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.
That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.
Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.
In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) Real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread 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, for which developing vs. developed nations should dominate. (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 higher 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.
And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.
With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”
“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.
Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.
And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.
• When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
• In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
• We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
The term delevering implies a period of prior leverage, and leverage there has been. 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 elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. 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, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, 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 in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.
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. PE 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.
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 – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.
How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.
To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.
This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie staring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.
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: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% 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 much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.
That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.
Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.
In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) Real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread 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, for which developing vs. developed nations should dominate. (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 higher 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.
And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.
With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”
“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.
Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.
And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.
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