Bond guru Bill Gross thinks investors need to “be careful in 2018” and cites six areas they need to watch as the calendar is set to turn.
In his monthly newsletter to clients, Gross frets over debt, liquidity and even bitcoin. The warnings come in a year when the portfolio manager at Janus Henderson expressed disdain for both stocks and bonds and advised owning real assets instead.
Of course, stocks have been on fire while bonds have been flat. Gross’ $2.2 billion Janus Henderson Global Unconstrained Bond Fund has been a laggard, returning just 2.74 percent year to date and in the bottom third of its class, according to Morningstar rankings.
His cautious approach to investing remains, and he outlined a half-dozen reasons why:
The Federal Reserve and its global counterparts have begun the first steps of policy normalization but have kept interest rates low.
While providing a backstop for the economy and markets, it also has given central banks less room to move in the future. Gross sees that as a problem because investors have less “insurance,” in the form of central bank maneuverability, for bad times ahead.
“Should a crisis arise because of policy mistakes, geopolitical crises, or other currently unforeseen risks, the ability to protect principal will be impaired relative to history,” he wrote. “That in turn argues for a more cautious and easier Fed than otherwise assumed.”
Gross cites economist Hyman Minksy who warned about how long periods of financial stability actually could create instability. A “Minksy moment” in market parlance refers to a point where asset prices crash due to a sudden shift in debt or currency stability.
The surge in leverage since the financial crisis has been a concern for Gross and others, including Fed Chair Janet Yellen, who recently warned that the surge in government debt should “keep people awake at night.”
Minksky “alerted economists to the fact that an economy is a delicate balance between production and finance. Both must be balanced internally and then the interplay between them balanced as well,” Gross said.
Credit and asset prices
Capitalism in the current sense depends on credit creation that leads to asset price growth which ultimately generates business investment, Gross said.
However, it’s a delicate ecosystem that can break down.
“This model, however, is leverage dependent and – 1) debt levels, 2) the availability, and 3) cost of that leverage are critical variables upon which its success depends,” he wrote. “When one or more of these factors deteriorates, the probability of the model’s success and stability go down.”
Cost of carry
“Carry” refers to the price investors pay to hold assets on their balance sheets.
Professional investors need to be mindful of that cost and how it compares to whatever benchmark it is they are trying to beat. When the carry equation doesn’t work anymore, investors have to move on.
“Timing that exit is obviously difficult and perilous, but critical for surviving in a new epoch. We may be approaching such a turning point, so invest more cautiously,” Gross said.
The question of ‘money’
Gross discusses the difference between cash and credit. When too many investors turned to cash and equivalents over credit, that can create a liquidity breakdown in the system.
“When the possibility of default increases and/or the real return on credit or liquidity decreases and persuades creditors to hold classical ‘money’ (cash, gold, bitcoin), then the financial system as we know it can be at risk (insurance companies, banks, mutual funds, etc.) as credit shrinks
and “money” increases, creating liquidity concerns,” he said.
The Fed and inflation
The Fed and Treasury always have an interconnected relationship, but particularly so over the past decade as the central bank’s holdings of government debt has surged.
At present the Fed is holding nearly $2.5 trillion of Treasurys on its $4.5 trillion balance sheet. However, the Fed is allowing a capped level of government debt to run off each month. Essentially, what the Fed has been doing is allowing the government to borrow money and pay a low level of interest on its debt.
“Money for nothing – The Treasury issuing debt for free. No need to pay down debt unless it creates inflation,” Gross wrote. “For now, it is not. Probably later.”