Saturday, April 9, 2016

Barron's Cover--"Bill Gross: Why Interest Rates Must Rise"

Yesterday the Federal Reserve Bank of Atlanta's Center for Quantitative Economic Research's GDPNow product pegged first quarter growth as: 
Latest forecast: 0.1 percent — April 8, 2016
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.1 percent on April 8, down from 0.4 percent on April 5. After this morning's wholesale trade report from the U.S. Bureau of the Census, the forecast for the contribution of inventory investment to first-quarter real GDP growth fell from –0.4 percentage points to –0.7 percentage points....
Combined with inflation rising just by virtue of commodities, especially oil and metals, not falling, a phenomena both Fed Chair Yellen and Vice-Chair Fischer mentioned in speeches last month, we are set up for a bit of minor stagflation.
Here's today's addition to the puzzle from Barron's:

The renowned bond investor argues that the Fed must normalize interest rates in coming years to keep the economy functioning properly.
Home, they say, is where you make it. For Bill Gross, 71, manager of the Janus Global Unconstrained Bond fund, home these days is a small suite in an office tower in Newport Beach, Calif., down the road from Pacific Investment Management, or Pimco, the asset-management firm he co-founded in 1971 and ran until leaving abruptly in 2014, following a few years of poor investment results and an ugly management spat.
At Pimco, with which he is still feuding, Gross oversaw what was once the world’s largest mutual fund, Pimco Total Return (ticker: PTTAX) with assets of $293 billion at its peak, and built an outstanding investment record. At Janus Capital, a Denver-based firm with assets of $192.3 billion, he runs a $1.3 billion fund (JUCAX), seeded in part with his own money, that performed dismally in 2015, losing 0.72%. This year, however, it appears to have turned the corner; it was up 2.04% in the first quarter, placing in the top 15% of nontraditional bond funds tracked by Morningstar. 

If Gross’ digs, portfolio, and results are humbler today than for most of his career, his ambition seems undimmed—to go out a winner, delivering substantial gains for investors even in a business that offers diminishing returns, now that interest rates in much of the world are close to zero, or less. He doesn’t think much of the central-bank policies that have repressed rates, punished savers, and failed to ignite economic growth, and says the Fed must begin to raise rates in coming years to keep the economy on track.
As of Feb. 29, Gross’ fund held a broad mix of assets, including agency, corporate, and high-yield debt; options on interest-rate volatility; and riskier credit-default swaps sold on Brazilian and Mexican debt. The swaps sales reflect his view that investors “tend to overpay for protection” against defaults by certain issuers, in this case two countries dependent on energy-sector receipts.

In a recent interview in his office, Gross was candid about the pros and cons of his transition to Janus. “On the plus side, it is easier to manage $1.5 billion than $1.5 trillion [Pimco’s assets at year-end 2014],” he says. “One of the negatives is that the smallness is isolating at times. It’s not that I enjoyed daily investment-committee meetings at Pimco, but at some level, they were fun and engaging.”
The Fed has to “normalize interest rates over a period of two, three, four years or the 
domestic and global economy won’t function.“ —Bill Gross Photo: Sam Comen
It is too soon to tell whether the onetime bond king will build a successful record at Janus—or win the breach-of-contract lawsuit he filed last fall against his former Pimco colleagues, charging that a “cabal” of executives wrongly had sought to oust him, to take his share of the firm’s profits. Last week, Pimco filed its own claim in connection with the suit, saying that Gross had quit without notice, leaving a handwritten resignation letter on his desk in the middle of the night, and that he was aware he would be giving up his bonus by leaving the firm before a certain date. Gross didn’t respond to queries about the latest developments in the suit.

Even as the case plays out, two things are clear: Gross is thrilled to still be in the competitive investment game, and remains one of the smartest market observers around.

Barron’s: How would you grade your performance at Janus so far?
Gross: Since I began managing the fund on Oct. 6, 2014, the I-class shares [JUCIX] are up 1.17% cumulatively through the first quarter, in the 22nd percentile of Morningstar’s universe of nontraditional bond funds. I’ll take it. We had some ups and downs early on, but things have turned around in the past few months. You have to follow the same strategy as a golfer who is down one, with two holes to play. You can’t panic; you just have to play your game. Sometimes, over short periods, it doesn’t work; it didn’t work for the first six months or so after I got here. But things have improved, and this year, returns have turned positive. I’d like to be 4% or 5% positive, but markets haven’t allowed for that.

Fund flows are improving, as well. Is that a validation of the improvement in your performance?
Fund flows are a function of two things. One is performance. The other is interest in the asset class—in this case, the interest of the public in mutual funds, exchange-traded funds, or alternative types of assets. Mutual funds are on the bottom rung at the moment, having been displaced to some extent by lower-cost ETFs. Also, the unconstrained-fund universe has disappointed investors as an asset class. It hasn’t been profitable in the past 15 months. Still, I’m glad that fund flows have turned positive. The object wasn’t to build this into a $1 trillion company or fund, but every manager wants his or her fund to be popular.

Was it difficult to take charge of an unconstrained bond fund after running a portfolio of mostly U.S. Treasuries and corporate bonds?
It is challenging. A manager of an unconstrained fund not only has more choices, but has to accept more risk. The unconstrained universe was born six or seven years ago from the idea that interest rates would bottom at some point, and bonds no longer would provide a decent return; in fact, returns might be negative. From conception, these funds were relatively neutral, duration-wise. To the extent that duration is minimized, a greater emphasis must be put on other elements of return, including credit, volatility, currency, and liquidity.

What do you emphasize in Janus Unconstrained?
I begin with the premise that money returns nothing at the moment. There’s an old song that goes “Nothing from nothing…
“…leaves nothing.”
That’s right. The song is about a relationship, not money, but the fund is positioned with that in mind. If you start at zero and aim to deliver a 4% or 5% annual return, you’ve got to lever your assets to some extent. The positions in the fund are primarily volatility-related, because volatility has the lowest amount of risk, relative to return, of the elements I mentioned. 

Years of easing by central banks mean that interest rates in most of the developed world will fluctuate narrowly. That offers an opportunity to sell volatility to create return. If you bought a 10-year Treasury bond today and nothing changed, you would get a 1.9% yield. If you bought a seven-year German Bund, you’d get zero. If, however, you sold a three-month call or three-month put on that same Treasury with a 20-basis-point [hundredths of a percentage point] variation—in other words, the yield stayed in the range of 1.7%-2.1% for three months—the trade would produce an annual return of 6%, as opposed to 1.9%.

The risk is that interest rates will go up or down by more than 20 basis points over a three-month period. But my premise is that central bankers will do anything possible to contain interest-rate fluctuations. The sale of volatility is producing the predominant amount of return in my fund.

How is the fund structured?
If you make a pie, you have the crust and the filling. The crust in a $1.3 billion fund is 12- to 18-month corporate bonds and notes, triple-B rated—hopefully, with no credit sinkholes—that yield about 2%. That’s where all the cash goes. If you start your pie with a 2% yield, you aim to get to 5% with a derivatives-based filling, much like the options I just discussed. You do it by assuming credit risk or selling credit risk, buying or selling volatility, taking mild currency positions, or buying or selling liquidity.

The Securities and Exchange Commission is seeking to regulate the use of derivatives in mutual funds. Wouldn’t that pose a risk for you?
The SEC is challenging mutual funds in a number of areas. Leverage in Janus Unconstrained has averaged about 150%. As I understand it, that is within regulators’ potential guidelines, but we’ll see.

You have taken central bankers to task for impotence and ignorance, among other sins. In particular, you have written that Fed Chair Janet Yellen and others are ignorant of the harm done by their policies “to a classical economic model that has driven prosperity.” Just what did you mean, and what sorts of dangers do we face?
The Federal Reserve was created in 1913. President Nixon took the U.S. off the gold standard in 1971. For the past 40-plus years, central banks have been able to print as much money as they wanted, and they have. When I started at Pimco in 1971, the amount of credit outstanding in the U.S., including mortgages, business debt, and government debt, was $1 trillion. Now it’s $58 trillion. Credit growth, at least in its earlier stages, can be very productive. For all the faults of Fannie Mae and Freddie Mac, the securitization of mortgages lowered interest rates and enabled people to buy homes. But when credit reaches the point of satiation, it doesn’t do what it did before.

Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a “wafer-thin mint.” He swallows it and explodes. It’s pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we’re to the point where every bite is less and less fulfilling. Even though credit isn’t being created as rapidly as in the past, it doesn’t do what it did before.

Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn’t the case.

So where does that leave our economy?
In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.

To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany’s case, what happens? We’ve seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts.

Now consider mom and pop and other people who read Barron’s. They are saving for retirement and to put their kids through college. They might have depended on a historic 8%-like return from stocks and bonds. Well, sorry. When interest rates get to zero—and that isn’t the endpoint; they could go negative—savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth.

Are you suggesting a recession looms?
No. I see very slow growth. In the U.S., instead of 3% economic growth, we have 2%. In euroland, instead of 2%, growth is 1%-plus. In Japan, they hope for anything above zero.
What governments want, and what central banks are trying to do, is produce, in addition to minimal growth, a semblance of inflation. Inflating is one way to get out from under all the debt that has been accumulated. It isn’t working, because with interest rates at zero, companies and individual savers sense the futility of taking on risk. In this case, the mint eater doesn’t explode, but the system sort of grinds to a halt....MUCH MORE