In his February investment letter, Bill Gross, the manager of the biggest bond fund around at PIMCO, warns investors to “be careful.”
A combination of smaller government deficits and tapering of the Federal Reserve’s quantitative easing program could be bad news for credit expansion, which Gross argues is bad news for risky assets like stocks and good news for bonds.
In his note, Gross writes:
[Credit] used to grow pre-Lehman at 8 — 10% a year, but now it only grows at 3 — 4%. Part of that growth is due to the government itself with recent deficit spending. A deficit of one trillion dollars in 2009 — 2010 equaled a 2% growth rate of credit by itself. But despite that, other borrowers such as households/businesses/local and foreign governments/financial institutions have been less than eager to pick up the slack. With the deficit now down to $US600 billion or so, the Treasury is fading as a source of credit growth. Many consider that as a good thing but short term, the ability of the economy to expand and P/Es to grow is actually negatively impacted, unless the private sector steps up to the plate to borrow/invest/buy new houses, etc. Credit over the past 12 months has grown at a snail’s 3.5% pace, barely enough to sustain nominal GDP growth of the same amount.
Is there a one-for-one relationship between credit growth and GDP? Certainly not. That is where velocity complicates the picture and velocity is influenced by interest rates and the price of credit. But with QE beginning its taper, and interest/mortgage rates 150 basis points higher than they were in July of 2012, velocity may now negatively impact the equation. MV=PT or money X velocity = GDP is how economists explain it in old model textbooks. Actually the new model should read CV=PT or credit X velocity = GDP but most economists are classically trained to the Friedman model, which viewed money in a much narrower sense.
Against this backdrop, Gross advises caution.
“Our PIMCO word of the month is to be ‘careful’,” he writes.
“Bull markets are either caused by or accompanied by credit expansion. With credit growth slowing due in part to lower government deficits, and QE now tapering which will slow velocity, the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume. Perhaps the whisper word of “deflation” at Davos these past few weeks was a reflection of that. If so, high quality bonds will continue to be well bid and risk assets may lose some luster.”