Saturday, January 7, 2012


I read the 2012 outlook from Bill Gross this week and wanted to make it available and make some clarifications about his thoughts and also highlight how powerful it is that this controller of literally hundreds of billions of dollars has gone so negative on the outlook for the global economy.

Below is the link;

In this post, Bill Gross revisits the term "New Normal" that Mohamed El-Erian had made common place when referring to a low growth, stagnant global economy.

"The New Normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly delevering. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012."
Where Gross is really focusing on is this idea of a distribution curve where there are two really bad outcomes at each side of the distribution of events.  Unlike the unforeseen black swan eventst, Gross is suggesting that the probability of the worst outcomes is increasing and therefore he references the "fat tails". (In a normal distribution the tails are small).

Gross describes where we are as we enter 2012;
"The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust. Goodbye “Old Normal,” standby to redefine “New Normal,” and welcome to 2012’s “paranormal.   
Perhaps the first observation to be made is that most developed economies have not, in fact, delevered since 2008. Certain portions of them – yes: U.S. and Euroland households; southern peripheral Euroland countries. But credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QEs) in the U.S., U.K., and Japan. Now it seems a gigantic tidal wave of QE is being generated in Euroland, thinly disguised as an LTRO (three-year long term refinancing operation) which in effect can and will be used by banks to support sovereign bond issuance. Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another."
Not exactly mincing words is he?  Gross continues to state that in reality, global credit markets are actually EXPANDING mildly rather than what should be happening through normal events we've been through.  Extra normal intervention of central banks and politicians is having the effect to push credit expansion rather than contraction.  Gross explains that INFLATION is one side of the distribution; one of the "fat tails".

On the other side of the curve we have the following;

"At the other tail, however, is the potential for “implosion” and actual delevering. To the extent that most sovereign debt is now viewed as “credit” in addition to “interest rate” risk, then its integration into private markets cannot be assured. If only Italian banks buy Italian bonds, then Italian yields are artificially supported – even at 7%. If so, then private bond markets and non-peripheral banks in particular may refuse to play ball the way ball has been played since 1971– purchasing government debt, repoing the paper at their respective central banks and using the proceeds to aid and assist private economic expansion. Instead, fearing default from their sovereign holdings, any overnight or term financing begins to accumulate in the safe haven vaults of the ECB, Bank of England (BOE) and Federal Reserve. Sovereign credit risk reintroduces “liquidity trap” and “pushing on a string” fears that seemed to have been long buried and forgotten since the Great Depression in the 1930s."
Here, Gross suggests that the other side of inflation is the repudiation of ponzi debt and the notion that central banks efforts to stave off credit implosion through debt purchases could result in absolutely nothing meaningfully good, and ultimately tax-payers eating a lot of defaulted debt.

 Well, central bank efforts have worked previously, why not now?  I've discussed this reason many times, the Fed has worked itself into a box of zero interest rates now, and that amounts to them trapping themselves with little room to work.  If rates are 25bps how much farther can they go?  If the Fed dropped rates to zero and the ten year US Treasury fell to 1% through additional bond-buying activities (QE) does that buy them incrementally anything?  Does more liquidity available do anything at all when the world is swimming in USD?

NO, zero bound money makes yield investors freeze and these buyers state that all they would really desire to do is keep their money safe given that when they deploy it and invest, they are really taking significant risk adjusted risk for very little return.  Why is that?  When was the last time your broker told you that money markets could lose money?  When was the last time you thought about your brokerage firm freezing your money in accounts like an MF Global situation?  Situations like these make investors that rationally examine risk state that they will forego investing in anything to ensure the safety of their money.  Essentially, the desires of the central banks to stimulate asset demand ultimately can have a chilling effect on investing that is exactly opposite to what they intend.

So what does Bill Gross say the Fed will do about this growing conundrum?  He says that they will actually signal in their January meeting that they intend to hold interest rates low even longer, perhaps as long as 3 years!  

What does Mr. Gross say investors should do in response to the 2 potential outcome disaster scenarios?

Bond Investors -
1)  Extend out maturities and bond duration.  With a signal from the Fed it won't raise rates for even longer, essentially you are protected from rising rates and the losses on bonds this imposes.
2)  Invest in US Treasuries, not Europe.  Go 6 to 9 years out, not less because you get paid nothing.
3)  If you are buying long dated US Treasuries, they better be TIPS
4)  Corporate bond holdings should be in the higher grades of debt, not lower.  Again, he suggests some financials here and I think he is off his rocker.
5)  Munis could be a good opportunity --- PERSONALLY I THINK HE IS NUTS, but then again, Pimco has to invest in long maturity bonds, but I wouldn't touch them.
6)  No EU bonds.

Stock Investors -
1)  High yielding dividend payers is what he says to go after.  Look for companies with stable cash flows like utilities and big healthcare (pharma).
2)  Commodities - Gross is basically flipping a coin here saying it could go either way.

Currency -
He gives us no real insight, simply saying that in deleveraging the USD is awesome and in inflation, it sucks.

Finally, Gross puts it all in perspective with this last parting shot;

"For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. 2–5% for stocks, bonds and commodities are expected long term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable."

What?  Investors had better begin to expect 2% to 5% returns from all asset classes?  Is he serious?  I presume he is dead serious and this is the real issue.  I still have discussions with friends that expect 10% returns or 12% returns and I ask them where you plan to get that?  The reality is that yes, you can get those returns, but the amount of risk you take in the investing environment today is off the charts.

I will say it again, daily moves up and down 3% indicate that the market is having a death-rattle event, not that it is healthy and invigorated.  I am suggesting that the very underpinnings of the market itself is heaving and struggling and these are the last gasps and fits of life in this dying beast. It seems as though Bill Gross agrees.  Gross doesn't say it, but I think he is calling BS on all work of the Fed and realizing that they have gained us absolutely no material and meaningful improvement for lots and lots of bailouts and manipulation.  We are at the end of our rope and essentially the Fed has only bought us time over the last three years, not more rope.

In a way, I feel like the comments of Bill Gross echo the sentiments of a video interview Kyle Bass did a couple of months ago, where Bass lamented that we are in a "Binary Outcome" situation with the Euroland.  Bass described the Euro situation as a scenario that results in either the implosion and collapse of the financial system or they are saved.  While Bill Gross extends a bit more of the "curve" in between nasty outcomes, the thrust of the statement is the same, nothing is better, and the big one is coming.


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