Posted by: Bevan | January 7, 2012

Gross Outlook

Bill Gross is a well known US Investment Manager.  He founded Pacific Investment Management (PIMCO) in 1971.  He manages the Total Return Fund which is the world’s largest bond fund with assets under management of over $240 billion earlier this year.  He was in the news recently as the fund had the first net outflows in its history last year, with poor performance due to his well publicised short bet on US Treasuries,which proceeded to rally through the year.

His monthly Investment Outlook is always a good read (see here for the latest one) and this month’s has garnered much attention.  Entitled Towards the Paranormal it explores what Gross describes as an increasingly ‘fat tailed’ distribution of future economic outcomes.  Effectively this means instead of stability being highly probable, with extreme events being very unlikely at the ends of the distribution of possibilities, instead there are two dichotomous possible outcomes at each end of the range of outcomes which both have out sized probabilities.

These outcomes are in the context of thirty to forty years of debt addition by world economies, especially in the West.  As we proceed through the fallout from that, namely a secular bear market and unprecedented deleveraging, profound changes and surprising policy responses are all on the cards.  Gross makes a worrying point as well – we aren’t actually even deleveraging yet.  Certainly the US isn’t according to this chart, and with expansionary monetary policy responses in Europe, the UK and Japan similar graphs could probably be drawn there and in many developing economies as well:

Total US Debt 2012

Hardly Delevering

The two ‘fat tailed’ outcomes that Gross identifies are:

  • Economic expansion and higher inflation: this outcome has been anticipated especially with large QE initiatives, and is a big part of stories like the Gold boom.
  • Implosion and actual delevering: owning Sovereign debt now contains default risk as well as interest rate risk.  Instead of the traditional model of cheap Sovereign money fueling real economy lending and investments by banks, banks deposit short term holdings with the central bank.

The continuing disintegration in the EU has graphically illustrated the second possibility playing out, with ECB printed money (i.e. 3 year loans to banks) being promptly redeposited overnight with the ECB at a loss to the banks, rather than being reinvested in the real economy or being used to buy Sovereign debt (Italy’s last long term debt auction was under-subscribed).  Banks cannot make profit as they invest at near zero yields afraid of counterparty risk, hence the large redundancies we are beginning to observe (10,000 jobs at RBS last week).

Central banks will probably engage in another race to attempt to reinflate, however there are risks.  As the market observes long term low yields, fears reinvestment and doubts that inflation will persist (as market participants would have noticed with the feeble and temporary inflationary consequences of QE2) these expectations could further stimulate the deflationary/deleveraging scenario.

Applying these scenarios to my own situation (and I will continue thinking about this in coming months):

  • My property investments will protect and benefit if inflation and growth is successfully stimulated.  Unfortunately this scenario seems less likely, and it is more likely that for the medium term I will have to continue with my expensive deleveraging and de-risking activities in order to realise the long term benefits.
  • Futures trading using Trendfollowing will potentially benefit in both scenarios, with currency and bond markets providing opportunity in either scenario.  Commodities are more likely to be profitable (that is yield longer cycles of beneficial volatility) in an inflationary outlook.
  • Shares and bonds need to come into play aggressively.  My retirement fund is skewed to bank deposits and fixed interest.  The two funds have produced growth of 2.65% and 4.88% over the past year.  I would like to expand my investments with self managed options, favouring stocks with sound yields and cashflow and good quality bonds.

The last area is one I need to research much more.  Adopting a Tactical Allocation model ala Mebane Faber is interesting, something I will be researching and sympathetic with my Trendfollowing approach.  I like simple robust models which accept return where it is presented, get out when its wrong and which don’t try to be too ‘smart’ and perfect in timing every nuance of the market.


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