Photo: Bloomberg TV
The latest Bill Gross letter is out, and it’s all fairly subdued by his standards. He discusses what happens when interest rates can’t get any lower, and the rally in long-dated bonds finally comes to an end.The basic story he tells is that in a levering world, financial assets outstrip real assets, and so therefore in a delevering world, real assets will outstrip financials assets.
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.
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 labour 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 favourable 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.