Bill Gross Plays Defense, but May Leave Himself Open for a Bomb

Bill Gross's monthly investment outlook letter to PIMCO's investors is interesting. He makes many of the same points I have been arguing in this blog. Here are his summary points:

• Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth.
• Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills.
• The PIMCO defensive strategy playbook: Recognize zero bound limits and systemic debt risk in global financial markets. Accept financial repression but avoid its impact when and where possible. Emphasize income we believe to be relatively reliable/safe; seek consistent alpha.

Mr. Gross and I are in complete agreement through much of his argument, until he reaches his final point. At the end of his argument he believes there is a zero bound limit for nominal interest rates that offer a negative real yield due to inflation. I believe his argument doesn't fully consider a deflationary environment as a possible outcome, potentially leaving his defensive strategy open "over the top."

Mr. Gross begins his argument by stating,

"the gradual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seemingly endless virtuous timeline."

I clearly agree that falling interest rates have enabled valuations on multiple asset classes to appreciate. Mr. Gross goes on by stating,

"Yet an instant replay of these past few decades would have shown that accelerating asset prices weren’t due to any particular wisdom on the part of academia or the investment community but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the singular mantra of central bankers ever since the departure of Paul Volcker, but there was no sense that the shampoo bottle filled with money would ever run dry. Well, it has."

I am still with him with the portion of my Sagflation theme that argues an overly aggressive monetary policy has been the primary driver of excessive growth in the economy. His main point is thus made as,

"Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age."

At this point I'm thinking that he will make the next step in my argument that deflation may take over as banks and other financial businesses begin to shut down lines of businesses that are unprofitable in this low rate environment.

"It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benefit more from lower yields. As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced."

Good, I'm thinking, he's highlighting deflationary pressure on Main Street as incomes fall from lower savings rates. But then he states,

"If these firms can’t cover inflation with historical real returns from their float, then they begin to downsize in order to stay profitable. The downsizing is just another way of describing a transition from offense to defense in a zero bound nominal interest rate world where almost any level of inflation produces negative real yields on investment."

At this point I pause. Okay, Mr. Gross is assuming aggressive monetary policies like quantitative easing likely continues to drive inflation, essentially pushing real interest rates negative. He then goes on to illustrate how negative real yields likely force financial firms to downsize. He further emphasizes the point by arguing investment strategy should be more defensive in this environment. But, I'm left with two questions in his argument, which are:

(1) For how long is a negative real yield environment sustainable? 
(2) What happens when this environment ends?

Mr. Gross's argument appears to set up a seemingly endless wicked timeline, or the opposite of virtuous. The central banks drive yields closer to zero and increasingly print money, raising inflation, destroying real yields. It is implied that this becomes a difficult investment environment. I'm with him there. 

But, the issue I have with the conclusion is its avoidance of a discussion of deflation. It stands to reason that fundamental forces take-over if the Fed runs out of room to encourage inflation through either interest rate manipulation or political willingness to print money. If we enter a clearly recognizable deflationary environment, in which the CPI does actually turn negative, real yields actually begin to rise for lenders and borrowers. The real yield on cash goes positive and many other pretty funky things begin to happen.

Mr. Gross makes his points with the help of football analogies. I believe a cosmic metaphor may be in order. Where does our universe end? And, what is on the other side?