Bill Gross Explains What "Keeps Him Up At Night"

Tyler Durden's picture

The choice extracts from Bill Gross' just released latest monthly letter:

What keeps us up at night? Well I can’t speak for the others, having spoken too much already to please PIMCO’s marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the “New Normal” characterization of our post-Lehman global economy, now focuses on the possibility of a” T junction” investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world.

 

This year’s April taper talk by the Federal Reserve is perhaps a good example of this forward path of asset returns. Admittedly the reaction in the bond market was rather sudden and it precipitated not only the disillusioning of bond holders, but also an increase in redemptions in retail mutual fund space. But then the Fed recognized the negative aspects of “financial conditions,” postponed the taper, and interest rates came back down. Sort of a reverse “Sisyphus” moment – two steps upward, one step back as it applies to yields.

 

... investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets, basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets. “You have no other choice,” their policies insinuate. “Get used to negative real interest rates, move out on the risk spectrum and in the process help heal the real economy,” they seem to command.

In brief: Gross now sees investors as desperate guinea pigs in the Fed's behavioral experiment.

Stock investors, however, were only mildly discouraged and continued their faith-based, capital gain dependent investments despite what should be the obvious conclusion that QE and low interest rates were as critical to their market as they were to bonds. “What other choice do we have?” has become the mantra of stock investors globally, which speaks more to desperation than logical thinking.

The punchline: the moment when the reflexive bubble pops ("we know that they know that we know that they know" courtesy of The Burbs), and the Fed's worst fears come true.

... Deep in the bowels of central banks research staffs must lay the unmodelable fear that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose momentum after the real economy fails to reach orbit, even with zero-bound yields and QE.

And that is the game over point (although fear lies in bowels?).

And the full letter below:

On the Wings of an Eagle

I’ve always liked Jack Bogle, although I’ve never met him. He’s got heart, but as he’s probably joked a thousand times by now, it’s someone else’s; a 1996 transplant being the LOL explanation. He’s also got a lot of investment common sense, recognizing decades ago that investment managers in composite couldn’t outperform the market; in fact, their alpha would be negative after fees and transaction costs were factored in. His early business model at Vanguard promoting index funds was a mystery to me for at least a few of my beginning years at PIMCO. Why would most investors be content with just average performance, I wondered? The answer is certainly now obvious; an investor should want the highest performance for the least amount of risk, and for almost all measurable asset classes, index funds and many ETFs have done a better job than almost all active managers primarily because of lower fees.

The “almost all” caveat is the reason I can write so freely and with such high praise for Vanguard. I am, after all, supposed to be promoting PIMCO in these Investment Outlooks, and PIMCO is a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what he himself labeled in a recent Morningstar interview the “PIMCO effect.” To paraphrase his interview, he spoke to index managers beating almost all active managers, but then “there was the PIMCO effect.” We at PIMCO thank him for that with a “back atcha, Jack!” There’s actually a place for both of our firms and investment philosophies in this age of high finance. If Bogle’s concept of indexing was metaphorically similar to finding a cure for the cancerous devastation of high fees, then perhaps PIMCO’s approach could be similar to mapping the investment genome and using it to produce consistently high alpha. There’s room for each of these investment laboratories. I will admit that there are other active management labs as well that are worthy of not only recognition, but investor confidence and dollars. I have nothing but the highest of praise for Bridgewater’s Ray Dalio and GMO’s Jeremy Grantham and their staffs. Their voluminous thoughts occupy a special corner of my desk library. Each has a distinctly different approach to active management – Dalio’s focusing on a levering/delevering template and Grantham’s on a historical reversion to the mean for most asset classes.

Neither Vanguard, PIMCO, Bridgewater nor GMO, however, has discovered a cure for the common cold. Our performance periodically, and sometimes for frustrating long stretches, stuffs our noses or aches our heads, and makes us wonder why we hadn’t been more careful about washing our hands during flu season. Our firms make mistakes, even if, in Vanguard’s case, it’s the indexed mantra of being fully invested in an overvalued market.

Where might our future mistakes be hiding? What keeps us up at night? Well I can’t speak for the others, having spoken too much already to please PIMCO’s marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the “New Normal” characterization of our post-Lehman global economy, now focuses on the possibility of a”  T junction” investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world. We are both in agreement on the perilous future potential of market movements. Mohamed’s T, I believe, was meant to be more descriptive than literal, and is a concept, like the New Normal, that may gain acceptance over the next few months or years. But aside from a financial nuclear bomb à la Lehman Brothers, our actual scenario is likely to play out more gradually as private markets realize that the policy Kings/Queens have no clothes and as investors gradually vacate historical asset classes in recognition of insufficient returns relative to increasing risk. The actual T might in reality be shaped something like this: perhaps a winged eagle signifying something more gradually sloping left or right. This year’s April taper talk by the Federal Reserve is perhaps a good example of this forward path of asset returns. Admittedly the reaction in the bond market was rather sudden and it precipitated not only the disillusioning of bond holders, but also an increase in redemptions in retail mutual fund space. But then the Fed recognized the negative aspects of “financial conditions,” postponed the taper, and interest rates came back down. Sort of a reverse “Sisyphus” moment – two steps upward, one step back as it applies to yields and more of a , than a T. Investors now await nervously for news on the real economy as well as the medicine that Janet Yellen will apply to it.

That medicine, however, will most assuredly include negative real interest rates that at some point will give bond and stock investors pause as to the continued potency of historical total return policies generated primarily by capital gains. Bond investors found that out in May, June and July after 10-year Treasuries had bottomed at 1.65%. Stock investors, however, were only mildly discouraged and continued their faith-based, capital gain dependent investments despite what should be the obvious conclusion that QE and low interest rates were as critical to their market as they were to bonds. “What other choice do we have?” has become the mantra of stock investors globally, which speaks more to desperation than logical thinking.

Well, my point about the gradual as opposed to sudden disillusioning of investors worldwide is just that. The standard “three musketeers” menu for retail investors has always been 1) investment grade and 2) high yield bonds as well as 3) stocks. In recent years, institutional investors have gravitated into 4) alternative assets, 5) hedge funds and 6) unconstrained space, and so for them there appears to be an increasing array of higher return alternatives. All of the above 1-6, however, contain artificially priced assets based on artificially low interest rates. Some are unlevered, like Treasury bonds, but nonetheless priced too high by the Fed in an effort to encourage migration to riskier bonds and/or asset classes. Others, such as many alternative assets, depend on the levering of portfolios themselves, borrowing at 10-50 basis points in overnight repo and investing at higher rates of return despite their artificiality. But investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets, basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets. “You have no other choice,” their policies insinuate. “Get used to negative real interest rates, move out on the risk spectrum and in the process help heal the real economy,” they seem to command.

Yet this now near 5-year migration across the global asset plains in search of taller grass and deeper water has had limits, both in price and real growth space. If monetary and fiscal policies cannot produce the real growth that markets are priced for (and they have not), then investors at the margin – astute active investors like PIMCO, Bridgewater and GMO – will begin to prefer the comforts of a less risk-oriented migration. If they cannot smell the distant water or sense a taller strand of Serengeti grass, astute investors might move away from traditional risk such as duration as opposed to towards it. Deep in the bowels of central banks research staffs must lay the unmodelable fear that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose momentum after the real economy fails to reach orbit, even with zero-bound yields and QE.

In gradually moving away from traditional risk assets, I again refer to my August Investment Outlook called “Bond Wars.” In it, I suggested that bonds and bond portfolios contain a number of inherent “carry” risks and that duration/maturity was but one of them. I suggested that if the Fed and other central banks had artificially lowered yields and elevated bond prices, then a traditional bond fund should underweight duration and perhaps overweight other carry alternatives such as volatility, curve and credit. This we have done, and our relative performance reflects it. The “PIMCO effect,” as Jack Bogle calls it, is alive and well in 2013. Our primary thrust has been to focus on what we are most (although not totally) confident about, that the Fed will hold policy rates stable until 2016 or beyond. While this and its conjoined policy of QE may have only redistributed wealth as opposed to creating it (picking savers’ pockets while recapitalizing banks and the wealthiest 1% of our population), it is a policy that a Janet Yellen Fed seems determined to pursue. The taper will lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved. If so, front-end Treasury, corporate and mortgage positions should provide low but attractively defensive returns. We have positioned our bond wars portfolio – heavily front-end maturity loaded along with credit, volatility and curve steepening positions, with the aim of outperforming Vanguard as well as many other active managers.

There is no doubt, however, that this portfolio construct is dependent on the eagle’s wingsas opposed to the junction of a T. Overlevered economies and their financial markets must at some point pay a price, experience a haircut, and flush confident investors from the comfort of this Great Moderation Part II. We at PIMCO will prepare for that day while hopefully consistently beating Vanguard along the way.

Eagle’s Speed Read

1) Be confident in the “PIMCO effect,” as Jack Bogle calls it.

2) Look for constant policy rates until at least 2016. Front-end load portfolios. Don’t fight central banks, but be afraid.
3) Global economies and their artificially priced markets are increasingly at risk, but the unwinding may occur gradually. Think!

William H. Gross
Managing Director

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Longing for the old America's picture

Is there some actual actionable advice here?

Occident Mortal's picture

The real economy is waiting for the correction before re-investing.

 

Access to credit is no longer holding the economy back, artificially elevated asset prices are.

GetZeeGold's picture

 

 

How can we get a correction in a totally managed economy?

 

OK managed badly.....but still managed.

 

dryam's picture

The Fed is simply recapitalizing the banks which are completely insolvent. The Fed doesn't give a shit about growth. They just say they do.

Honey Badger's picture

I could not agree more or green arrow enough times.

CheapBastard's picture

Bill and Mohammed just need New Memory Foam matresses. The old ones too filled with Dust Mites.

 

stewie's picture

The system is based on an exponential growth of total credit.  So the Fed does care about growth in the spirit of perpetuating the ponzi scheme.  They just don't care where the growth comes from.

Occident Mortal's picture

Real corporations are flush with cash, most don’t need credit to grow and have been in this position for at least 2 years.

The Fed should Taper, because a falling stock market =/= a recession. Asset prices need to come back down so that corporations can spend their cash on CAPEX.

 

WE ARE ALL WAITING FOR THE REMOVAL OF EMERGENCY MEASURES, SO WE CAN SPEND OUR CAPEX AT SUSTAINABLE PRICE LEVELS.

 

Only the worst CEO would allocate real cash to CAPEX during a time of emergency monetary support. Remove the support already, there is plenty of credit now and we want to invest our cash. FFS.

I am more equal than others's picture

 

 

This market is the definition of helpless.  There is no 9-1-1, there is no market savior, and this will end bad for everyone.  We are helpless in this condition.  Frustrated because there is no way out other than walking through the bond fire of fiat. 

Occident Mortal's picture

I disagree,

 

What if the Fed were to announce an extremely shallow taper?

e.g. go from $85bn a month to $84bn a month?

 

The bond market will not revolt if the taper is pointlessly shallow. In fact it would rally on the anticlimax. This is what the Fed should have done in September. They should taper in a pointlessly shallow vector in order to remove the anticipation.

 

Sadly they are not intelligent enough to even realise such basic strategies. Instead leaving the market to speculate on the polar options of 'no taper ever' and 'steep taper soon'. Pods.

Greater Fool's picture

Sorry, don't agree. The "taper talk" happens not because the Fed intends to taper--they won't for the foreseeable future--but instead to push a little air out of the bubble. The sole purpose of the talk is to induce small corrections. Since no natural market forces could ever cause one (all natural market forces have essentially been abolished), the Fed has to provide this along with the monetary support that keeps the general progress inexorably upward.

Its the central bank version of doing a controlled burn to clear fuel out of a forest, or a controlled release of water down the Grand Canyon to simulate seasonal flooding that no longer happens because of the dams.

Smokey FOMC Trader says: "Only you can prevent asset bubbles!"

max2205's picture

The eagle has been shot...now what

stant's picture

Exactly and it's coming between jan and june

Rainman's picture

yah, those wings ain't eagle wings .... they are clearly swan wings. 

monkeyboy's picture

And here I was thinking it was it was viagra.

Is this a metaphor for, "Should have taken the blue pill?"

Cacete de Ouro's picture

"but I will give you some thoughts about what keeps Mohamed and me up at night"

Sharing a Twitter account is one thing, but this is starting to sound like pillow talk

Colonel Klink's picture

You can't spell Bond shILL without BILL!

Sudden Debt's picture

yes, that reading all this is fun but you also need a hobby on the side...

Winston Churchill's picture

OT

Barclays Channel Islands have just announced restrictions on Intnl. wire transactions.

50k pounds per day per recipient.100k per day max overall.

The global bail in is coming soon.

cossack55's picture

How do bail-ins effect trickle-down funds that I am still waiting for.

Sudden Debt's picture

Jeez... explain that to the misses when she goes shopping... 50K limit a day...

Seasmoke's picture

All the exits are locked. That is what keeps me up at night. 

NoDebt's picture

No new ideas.  Moving on.

fonzannoon's picture

no new ideas, and same question remains (below).

Moe Hamhead's picture

If you are a republican in Utah, we know what keeps you "up" at night !

LawsofPhysics's picture

People selling PIMPco? I am shocked, just shocked.  Keep talking that book Bill. I hope california taxes the crap out of this insider.

fonzannoon's picture

When the fed finally owns all of, or a substantial majority of the bond market, which should not be too far off now...does anyone care to take a crack at how exactly everything will pop? It seems like it is the exact opposite scenario. It seems like they will have so much influence that the possibility of anything popping will go extinct. 

No offense to ZH but it seems more noticeable by the day that it is Stock that truly matters in the end game and not flow. Unless someone can point out to me how the fed buying up the bond market will lead to a collapse of some sort. I am sure there will be some people that will say it will end in a currency crisis for the dollar. But I think that is more wishful thinking than reality at this point.

Also nice of Gross to finally notice that investors are just desperate guinea pigs in the feds behavioral experiment. It only took him 5 years to notice!

LawsofPhysics's picture

That's the whole problem with letting a select few use "mark to fantasy" accounting, eventually everybody wants to...

and when fraud becomes the status quo, possession is the law.

fonzannoon's picture

I must be in fantasy land because when I look at this...

http://finance.yahoo.com/q/bc?s=SPY+Basic+Chart&t=5y

I see less and less turbulence as it goes. So we can all sit here and say the usual "time is not on the feds side" when it seems like the complete freakin opposite to me.

I just think people can't get it out of their heads that the market and the economy can have absolutely nothing to do with each other.

NoDebt's picture

It ends with a Japan-like scenario. More and more QE, more and more government debt, deflation in wages, inflation in cost of living. Just look around- it's already happening and has been for the last 5 years.

The Fed will never buy everything because the government will not stop issuing debt in huge amounts. First, because they can never balance the budget in this environment (huge increases in entitlements to rich and poor alike, plus a stagnant economy) and secondly because interest rates are already rising which makes the carry cost of the existing debt that much higher. No, we haven't done a moon-shot, but 2.75 on a 10 year is a lot more than 1.75.

In addition, let's not forget, Treasuries aren't the only junk debt they can buy (half of QE is buying MBSs out of the banks at who knows what kind of "mark to Unicorn" prices).

I know you're looking at the "stock", but respectfully, if that was it, Japan would have gotten there well ahead of us.

LawsofPhysics's picture

Define "fantasy", the paper promises I have continue to buy real assets...

So long as the Fed wants to keep giving them away, just say thank you and

hedge accordingly.

 

fonzannoon's picture

That's what I don't understand about this place. At least take the gift of the market and the paper gold market and buy one and short the shit out of the other and take the gains and fund your purchases.

But then I get guilt tripped on here for mentioning that because somehow it is immoral. I often wonder how many people on here have "beat me hard" tatoo'd on one ass cheek and "born to lose" tatoo'd on the other.

TucoSalamanca's picture

At least take the gift of the market and the paper gold market and buy one and short the shit out of the other and take the gains and fund your purchases.

Fonzannoon - Can you explain ?

Thanks,

Tuco

new game's picture

why does the fed have to mark anything to its real value? in fed world it don't matter.

neg rates; think as if you could print money today and manipulate the world from your perspective(of control).

point being constantly missed is yesterdays rules do not apply as the tool box is evolving and tools are being created.

like fonz's dam of money story from a friend/acqu9intance. the sluece of money can be deverted or increased or decreased as sea of liquidity sits and sits and really doesn'r fucking matter - whether 3.2 t or 32 t or 132 trillion it just sits.

new game's picture

all i'm saying is they might just be in control and fonz sees it and i'm starting to understand, that as long as everyone is forced to play their game of money and they make the rules and can constantly change the field to their advantage we must obligue...

max2205's picture

Bill..what should keep you up at night is the ugly guy with the beard you are sleeping with....soon to be followed by the ugly midget with gray hair.....keep one eye open

LawsofPhysics's picture

Bill is doing just fine, he is a Fed insider, has been all along.  A long, long, time ago I use to live a block away from Bill's current home in Corona Del Mar, right next to Dr. Beckman (a true success story).  This time around the world is experiencing a crisis of confidence on a global scale.  All those deflationists out there ignore the 7+ billion (and growing) we they say there is "no demand".  With 7+ billion all competing for a better standard of living (and the calories that make that possible), there is plenty of demand and "deflation" is a myth.  No money?  During the great depression, you could still live off the land, now, not so much.

fonzannoon's picture

Laws you are right in that Bill is, and will be just fine. But here is a prediction for you. PIMCO won't be here in a decade. They will be gone within 5-10 years. They are a casualty of the fed and Bill knows it well. He has hemorrhaged a massive amount of assets this year alone.

LawsofPhysics's picture

His corporate bond funds have done pretty well, sure the government bond market, in fact I 'd say the entire sorvereign bond market is a sham, but many have seen this coming as the entire planet is really insolvent (if we marked things to market).

 

Meh, life is good in my neck of the woods.

BandGap's picture

Bought two acres on a lake last year. Cleared this fall, hopefully ready by spring for planting.

Watch for the big rats leaving the ship, I think it will be weeks, not months.

Boston's picture

I think it will be weeks, not months.

 

Careful. I've read similar pronouncements pretty much every week here on ZH for the last four.......years.

FreeNewEnergy's picture

LawofPhysics, I have to object to your contention that 7+ billion are "competing for a better standard of living (and calories)."

Some of those 7+ (and expanding, correct) billion would just like to maintain their standards of living, i.e., preserve wealth, and that is occurring on a massive scale as the world population ages.

As for the calories, global raw material prices have dropped like stones this year, with PMs (sadly) and grains leading the way. Corn hit a 52-week low a few weeks ago and has since surpassed that to the downside.

Deflation (here we go) increases purchasing power, so, technically, one can improve one's condition with the same amount of money as before (buy more or the same amount of goods for less). The remainder is either savings or investment, which, if my Baby Boomer friends are correct, is now going mostly to savings.

Also, the contention that it's now more difficult to live off the land (apropos if one lives in an apartment complex), the vast majority of single-family homes have back yards large enough to provide 40-50% of a family of four's nutrition (oftentimes more) using sound land management and some basic principles of organic farming.

It's not just perception that drives the economy - individually and in aggregate - but action, and, forced by the Fed and the government to take action against financial and civil repression, the masses, to a large extent, act in their own best interests.

I'm an optimist. A recent drive from upstate NY to the uplands of SC restored my faith in America, especially while driving through the wilds of West Virginia. There's still lots and lots of land available for farming and enjoyment. It's just a matter of price and willingness, now.

The more the government tries to oppress rights, the more the public (or, at least a portion of them) will withdraw and fend for themselves.

Standards of living are mostly perception, as in, "I'll take my 3 1/2 acres of raw land with a cabin over a penthouse suite with modern technical do-dads all day long." My standards are different, as, I'm sure, are yours.

LawsofPhysics's picture

"Also, the contention that it's now more difficult to live off the land (apropos if one lives in an apartment complex), the vast majority of single-family homes have back yards large enough to provide 40-50% of a family of four's nutrition (oftentimes more) using sound land management and some basic principles of organic farming."

Some very smart people at MIT and CAL Tech have published their findings on exactl what you propose and even if the weather didn't fuck you over (and we farm 35,000+ acres), which it often does, they calculated that the carrying capcity of the earth was 14 billion (so one doubling away), but this was assuming we could still perform the Haber Bosch process to make fertilizer for at least another 50-100 years while making the transition.  I suggest you do a little homework on how much energy this currently requires.  The laws of thermodynamics, physics and Nature are what they are.  I'll bet on them over any ivy league "economic law" bullshit any day.  We have some nice properties in many nice cities with lots of nice electronic do-dads, but those are not the locations I would like to be when the power grid goes down.  I'll be in my private plane flying somewhere else, thank you very much.  Life is dynamic, always has been.  Adapt or die. location, location, location, location, etc.

Mediocritas's picture

14 billion? What the hell were they smoking? Maybe if we all turn vegetarian, miraculously acquire the skills of John Jeavons, all share water resources without gouging, or still have access to industrial fertilisers, herbicides and pesticides despite a collapsing world economy.

Like you alluded to, "optimal" calculations are total bullshit because nature is a cold hard bitch. We're already in overshoot as I see it and a dieoff is coming.

FreeNewEnergy's picture

OK, LOP, I'll grant you that you have a better understanding of agriculture than do I, but, we largely agree. I want to be on acreage rather than in a city when the power flops. Actually, I prefer the country to the city 98% of the time. we may not be able to feed everyone, so, let's agree to feed ourselves first. The rest of them, well, they'll have to find their own ways, and I pity most of them, because they're lost.

I have a hard time with zoning laws. Why is a McMansion preferable to a farmhouse, or, a mobile home on one or two good acres of arable land. Local governments are sorely misguided and they will be fodder when manure meets propellor.

LawsofPhysics's picture

"laws", like modern "currencies" are no longer about fair trade and justice, they are all about maintaining power and control over real resources (including the human kind). 

 

Hedge accordingly.

Eahudimac's picture

So true. Get out of the city. There is more open land out there than you think.