Bill Gross | June 2012
Wall Street Food Chain
- Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors.
- Both the lower quality and lower yields of such previously sacrosanct debt represent a potential breaking point in our now 40-year-old global monetary system.
- Bond investors should favor quality and “clean dirty shirt” sovereigns (U.S., Mexico and Brazil), for example, as well as emphasize intermediate maturities that gradually shorten over the next few years. Equity investors should likewise favor stable cash flow global companies and ones exposed to high growth markets.
Yet while the whales have no immediate worries about extinction, their environment is changing – and changing for the worse. The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes, which lie on a visible horizon, may not be so beneficial for our ocean’s oversized creatures.
The balance between financial whales and plankton – powerful creditors and much smaller debtors – is significantly dependent on the successful functioning of our global monetary system. What is a global monetary system? It is basically how the world conducts and pays for commerce. Historically, several different systems have been employed but basically they have either been commodity-based systems – gold and silver primarily – or a fiat system – paper money. After rejecting the gold standard at Bretton Woods in 1945, developed nations accepted a hybrid based on dollar convertibility and the fixing of the greenback at $35.00 per ounce. When that was overwhelmed by U.S. fiscal deficits and dollar printing in the late 1960s, President Nixon ushered in a new, rather loosely defined system that was still dollar dependent for trade and monetary transactions but relied on the consolidated “good behavior” of G-7 central banks to print money parsimoniously and to target inflation close to 2%. Heartened by Paul Volcker in 1979, markets and economies gradually accepted this implicit promise and global credit markets and their economies grew like baby whales, swallowing up tons of debt-related plankton as they matured. The global monetary system seemed to be working smoothly, and instead of Shamu, it was labeled the “great moderation.” The laws of natural selection and modern day finance seemed to be functioning as anticipated, and the whales were ascendant.
Functioning yes, but perhaps not so moderately or smoothly – especially since 2008. Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core. Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors. QEs and LTROs totaling trillions have been publically spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea when compared to 2–3% inflation now commonplace in developed economies.
This transition continues to point towards higher global inflation as a solution to overextended debt-ladened balance sheets – be they public or private. Bond investors therefore should favor quality and “clean dirty shirt” sovereigns (U.S., Mexico and Brazil), for example, as well as emphasize intermediate maturities that gradually shorten over the next few years. Equity investors should likewise favor stable cash flow global companies and ones exposed to high growth markets. Investors in general, however, will be hard pressed to repeat the rather right-tailed performance of the past 30 years, a whale rather than plankton-dominated era based on excessive credit expansion. Deleveraging economies and financial markets present a different and lower returning kettle of fish than did recent credit-dominated decades.
The world’s financial markets currently seem obsessed with daily monetary and fiscal policy evolutions in Euroland which form the basis for risk on/risk off days in the marketplace and the overall successful deployment of carry and risk strategies so important to asset market total returns. Euroland is just a localized tumor however. The developing credit cancer may be metastasized, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields, produced by the debt crisis and policy responses to it. The great white whale lies waiting on the horizon. Investors should sail carefully and the Wall Street 1% should put on their life vests if they expect to weather the inevitable storm that may threaten the first-class cabins they have come to enjoy.
William H. Gross
PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
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Sydney, NSW 2000
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