Legendary bond investor Bill Gross just released his latest investment outlook on the PIMCO website. According to Gross, investors should expect Fed funds policy rates to stay low, and 4-5% returns, for an extended period of time. Here are some notable excerpts from the piece:

Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.

To some this might seem like a chicken and egg conundrum because they naturally move together. For the most part they do – and should…

What has happened is that our “paper asset” economy has driven not only stock prices, but all asset prices higher than the economic growth required to justify them.

PIMCO’s founder and co-chief investment officer added that policymakers in Washington are already aware of this relationship. Gross wrote:

This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms…

At the center of U.S. policy support, however, rests the “extraordinarily low” or 0% policy rate. How long the Fed remains there is dependent on the pace of the recovery of nominal GDP as well as the mix of that nominal rate between real growth and inflation. My sense is that nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to risk raising rates. The current embedded cost of U.S. debt markets is close to 6% and nominal GDP must grow within reach of that level if policymakers are to avoid continuing debt deflation in corporate and household balance sheets. While the U.S. economy will likely approach 4% nominal growth in 2009’s second half, the ability to sustain those levels once inventory rebalancing and fiscal pump-priming effects wear off is debatable. The Fed will likely require 12–18 months of 4%+ nominal growth before abandoning the 0% benchmark.

Gross concludes:

This somewhat detailed analysis on Fed funds policy rates should return us to my beginning thesis as to why they need to stay low: Asset appreciation in U.S. and other G-7 economies has been artificially elevated for years. In order to prevent prices sinking even lower than recent downtrends averaging 30% for stocks, homes, commercial real estate, and certain high yield bonds, central banks must keep policy rates historically low for an extended period of time. If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point. Investors must recognize that if assets appreciate with nominal GDP, a 4–5% return is about all they can expect even with abnormally low policy rates. Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets – while still continuously supported by Fed and Treasury policymakers – is likely at its pinnacle.

You can read the entire investment outlook here.

Source:

“Midnight Candles”
Bill Gross
PIMCO, October 2009

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