Tuesday, March 27, 2012

"Bill Gross on Risk Seeking Return and Safe Carry"

I'll do a little advertising for Edward* Harrison.
From Credit Writedowns:
Bill Gross is out with his monthly commentary. Because his points are central to the discussion of policy and markets right now, I am going to write this weekly newsletter commentary outside the paywall.
Below are the key points as summarized at the outset of Gross’ column:
  • How do we deliver in this New Normal world that levers much more slowly in total and can delever sharply in select sectors and countries?
  • When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
  • In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
  • We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
What Gross is referring to here is what I call "risk seeking return". It is a direct consequence of the Fed moving out the curve and attempting to artificially suppress interest rates in order to reflate the economy through asset price inflation. Gross puts it this way:
The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
What he goes on to describe is the great secular leveraging. Gross remarks that, depending on your ideological world view, you could date this leveraging:
from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth.
I tend to date it from the end of Bretton Woods and the beginning of the nonconvertible, floating exchange rate fiat currency system. See "The Age of the Fiat Currency: A 38-year experiment in inflation" from April 2009. ...MORE
*Many years ago I was introduced to a cat named Calico King Æthelred the Unready and reading up on the good if unprepared King saw that he was the half-brother of King Eadweard which lead to an excursion into Saxon and Old English were we find that Ead is real property which at the time pretty much was the source and display of wealth and that Weard was keeper or guardian so Mr. Harrison's name apparently translates into Guardian of Wealth which is good enough for me.