Bill Gross is out with his latest missive, which is followed by the full transcript of his ‘infamous’ speech at the Morningstar Conference.
Bill Gross – One Big Idea via PIMCO
Investing and business success can often depend on one BIG idea and its timing. The peaking of short-term interest rates at 20% in the early 1980s and the bursting of the DotCom and NASDAQ bubble 20 years later were excellent examples of big ideas that made or broke investment portfolios. A similar tale was told by the late Peter Bernstein as he recalled his early career in the 1950s when investing for income was rapidly becoming old hat, appropriate perhaps for widows and orphans, but not for red-blooded business executives focusing on a new era of growth. He writes that one client told him, “Please remember, I just can’t stand more income.” Back then, Bernstein suggests, income was for “sissies.”
In 2014, the tide may be turning again as demographics, fear of another Lehman, or just income-starved insurance companies and similarly structured liability-influenced institutions, reach for anything they can get. The era of income may be, at the margin, replacing the era of capital gains, despite artificially low current yields.
If so, the proper analysis of where to find high, yet relatively safe, income should be one of the top priorities of any investment management company. In addition to bottom-up credit analysis, the timing and ultimate destination of PIMCO’s New Neutral short-term interest rate thesis will be critical.
For example, if The New Neutral real FF (federal funds) rate is 0% instead of the Fed’s currently presumed 1¾%, then not only bonds but all financial assets might logically be repriced relative to historical experience. Even after accepting the historical validity and predictive capability of Robert Shiller’s CAPE (10-year cyclically adjusted P/E ratio), it may be necessary to make adjustments to it, if in fact real policy interest rates over the long term have settled into a lower New Neutral. At PIMCO, we are amazed that little outside analysis has been applied to this concept that to us affects the array of financial assets available to investors. One has only to apply Gordon’s dividend discount model to measure the potential effect that a 0% real policy rate would have on stock prices versus the presumed 1¾ – 2% of an “old normal.” P = D/R-G, states the Gordon model, with R in this case being the real rate of interest that may be substantially lower than prior levels. Ex-Fed Chairman Ben Bernanke has argued in private conversations that R is lower because G (growth) will be equally lower in future years. We agree, but would add that in a highly levered world, R has been and must remain reduced more than G in order to keep our financed-based economy functioning. If we are correct, Shiller’s CAPE may have to be adjusted from an historical median 17x P/E to something resembling 20-22x. That would not mean that today’s 16-multiple P/E market should be elevated to an immediate 20x, but that the current CAPE of 25x, as shown in Chart 1, is less bubbly than presumed. Fed officials who cite bubbly aspects of “financial conditions” should therefore be less alarmed. If the real New Neutral is significantly lower than 10 or 20 years ago, P/E ratios should be higher, credit spreads should be tighter, and home prices less bubbly than presumed if, in fact, The New Neutral is “neutral” and can lead to historical levels of asset volatility. The New Neutral is critical to future investment success. This currently is PIMCO’s “one big idea.”
The following is an excerpt from a recent speech given at the Morningstar Investor Conference in Chicago that more fully explains our logic concerning this New Neutral concept:
The New Neutral is simply the ‘biggest, most critical, most significant, most important’ element in asset pricing today. The policy rate, along with forward expectations, as well as volatility, corporate and equity risk premiums, has always provided the fundamental foundation for asset prices, aside (that is) from the inevitable bouts of exuberance and fear. But the neutral policy rate – in real and certainly nominal terms, changes over time. Irving Fisher back in the 1930s came up with the concept of a neutral policy rate, but he surmised it would change only with inflation. In other words, the real rate would be constant. History has proved otherwise. In the nearly 80 years since his theory was introduced, real policy rates have fluctuated from 0% to 8% during periods of positive inflation, and importantly, asset prices – bonds and stocks – have been significantly influenced by them. Do you wonder why stocks sold at P/Es of 6-7 times in 1981? Wonder no longer. It’s because nominal FF traded at 20%, and real FF at 7% or 8%. Equity risk premiums had to go up because real FF went up, which sent P/Es to what were rock bottom prices. Same thing with long Treasuries at 15%. It’s not that the market expected real funds to trade at 7-8% forever. But the forward path was exceedingly high, higher than Fisher could ever have imagined. For the next 30 years it came down, down, down and finally over the past few years real FF have been negative. 25 basis points nominal with 1.5% inflation has equaled a minus (1.25%) average real FF rate for much of the period.
So the real policy rate changes, and as Janet Yellen has recently agreed, there is an evolving neutral policy rate – a Goldilocks rate, which is “not too hot or not too cold, but just right” to promote Fed targets of 2% inflation and 3% real growth, which is nominal GDP of 5%. I might add, this neutral policy rate will now be expected to maintain moderate financial conditions and keep exuberance contained, an evolving third leg to Federal Reserve policy.
What is this real policy rate and is it really different than what we’ve seen for the past 25 years? Well, it’s likely not the current negative (1.25%), although that rate plus 1 trillion dollars of QE per year has been insufficient to generate 5% nominal GDP. What it has generated are what appear to some observers to be bubbly asset markets, and so perhaps they presume it must be raised to prevent popping. It will be, but by how much is the question. Nor, however, is the real rate likely to be 2% positive as markets experienced pre-Lehman. That was the rate embedded in the Taylor rule, formulated in the early ‘90s which worked quite well, until it didn’t, namely 2006–2007 when we had a real rate too high for a levered economy that it became the precursor to the Great Recession. The 2% Taylor real rate was a rate consistent with a significantly less levered financial economy than we have today. To return