Bill Gross Warns of Credit Supernova, but Gives Six Investing Stategies

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Bill Gross of PIMCO, aka the Bond King, probably got tired of having to fade the heat after his call about the death of the cult of equity. Bill Gross has been rather vocal about how investors have to expect low returns from stocks and bonds and how they need to invest in things that will either rise with inflation or at least withstand inflation. In his February 2013 Investment Outlook, Gross has a warning: “Credit Supernova!”

Mr. Gross even started out his outlook with a catchy phrase, “They say that time is money. What they don’t say is that money may be running out of time.” He also warned that our current monetary system seems to require perpetual expansion to maintain its existence. Gross also wrote in bold, “Well, first I will admit that my supernova metaphor is more instructive than literal. The end of the global monetary system is not nigh. But the entropic characterization is most illustrative.”

The warning signs have been flagged. Gross points out that our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic. He said we are running out of energy and time, and said that the countdown will begin when investable assets pose too much risk for too little return. Gross even said that this is when lenders desert credit markets for other alternatives such as cash or real assets.

We would like to point out one thing here, or two things, on our own outside of Gross’s points: The 5-year Treasury Note has risen 16 basis points in the last month, but the yield is still only 0.86%. If you invest $100,000 in the 5-Year note you only receive a total of $4,300 in interest income over the entire five-year period. That is only $860 per year, and you get to pay tax on that interest to boot. If you are really talking about too much risk for too little return, is that a good risk-return scenario? Hell no.

Gross also said that there would be visible first signs for creditors: 1) long-term bond yields too low relative to duration risk, 2) credit spreads too tight relative to default risk and 3) PE ratios too high relative to growth risks.

The good news is that the third scenario is arguably not present. The second risk he highlighted is looking either “present or coming soon” if you consider how junk bond spreads narrowed to about 500 basis points or so. The first risk of long-term yields being too low for duration risk. Investors buying a 30-year Treasury get 3.17% in yield per year today. If interest rates rise only 1% unilaterally in a fairly short period of time, Long Bond investors might be taking on a risk of about 15% of their investment value for that 3%+ yield. Is that a good risk-reward scenario? The answer depends upon whom you ask.

Gross goes on to say, “Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase… The element of time is critical because investors and speculators that support the system may not necessarily fully participate in it for perpetuity.”

Gross does warn investors not to surrender and he gave six strategies. You better take a close look at some of these, because you can be right on your initial strategy but that doesn’t mean it cannot be taken away from you. Some of this is very self-serving as well, but you can’t exactly expect that Bill Gross would not “talk up his book.”

(1) Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don’t fight central banks – anticipate them by buying what they buy first; look as well for offshore sovereign bonds with positive real interest rates (Mexico, Italy, Brazil, for example).

(2) Get used to slower real growth: QEs and zero-based interest rates have negative consequences. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico and Canada are candidates.

(3) Invest in global equities with stable cash flows that should provide historically lower but relatively attractive returns.

(4) Transition from financial to real assets if possible at the margin: buy something you can sink your teeth into – gold, other commodities, anything that can’t be reproduced as fast as credit. Think of PIMCO in this transition. We hope to be “Your Global Investment Authority.” We have a product menu to assist.

(5) Be cognizant of property rights and confiscatory policies in all governments.  

(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.

Gross warned that the total U.S. credit market debt now stands at $56 trillion and counting. The total U.S. statement of public debt is now more than $16 trillion of this. Here is a chart on total public debt, but be advised: Gross ends with a footnote reminding you that the total outstanding credit includes all government debt as well as corporate, household and personal debt, but it does not include “shadow” debt estimated at $20 trillion to $30 trillion.

Gross supernova

FULL GROSS/PIMCO OUTLOOK

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