Bill Gross – The New Normal

Normally whenever I hear some version of why something is different this time over I become a skeptic and start tuning out the person.However I am drawn to the idea of ‘The New Normal’  propounded by the Bond King-Bill Gross of PIMCO and Mohamed El-Erian his Co CIO.This is because they are not so much telling us that economic cycles are bunk but that we are blind to the larger economic cycles.

Bill’s message is anything but easily palatable for a lot of people.It is also true that his timing has been wrong in the past. I won’t go so far as to say every minor detail of what he describes as the ‘New Normal’ will come true but I believe he has gotten the big picture right.I fear that we are in for an extended period when equities might not on an average give the high rates of returns they did in the recent past.Bonds might outperform stocks in this period  and investors will have to re-examine their beliefs.Assumed rates of return on various long term savings might have to be revised. The most successful investors during this period will probably be those with common sense and importantly the powers of intuition, observation, and the willingness to accept uncertain outcomes. And all the talk of countries like India escaping the international turmoil unscathed will be wishful thinking.

According to Gross a half-century of global economic prosperity has ended, and investors must gird themselves for muted returns from the capital markets.Framing the history of the current crisis with an extended biblical analogy, Gross traces the “Genesis” of the global boom to the fall of the gold standard in 1971, which ushered in an era of central banks printing money, a shift that in turn sparked financial innovation. As he puts it “The combination of easy check-writing for central bankers and securitization made money cheap to the public.”

The central phase of the boom began in 1980 with the ‘Great Moderation’, a period of relatively low volatility and high returns in the capital markets, while inflation was well-controlled.  But financial innovation took over, and as the Shadow Banking System evolved, it exposed weaknesses in the markets.  Leverage ballooned and consumption grew until it was exaggerated to extreme proportions, eventually leading to the “expulsion from the Garden of Eden” – and the end of the Great Moderation.

Regulators have been piecing together a Noah’s Ark of solutions,as  Gross puts it , including the TARP, TALF, PPIP, stimulus spending, and quantitative easing.  These programs, however, will not avert what he calls the “New Normal” – slow economic growth, high unemployment, and accelerating inflation.“The New Normal will be an inherent part of our economy for years to come,” he says.Gross offers specific forecasts f0r the intermediate term in the developed economies– economic growth of 1-2%, unemployment of 7-8%, and inflation kicking in over the next three to five years.

The New Normal ,according to him ,will replace the previous paradigm, which he describes as the “Child of the Bull Market.”  Under that paradigm, investors could rely on historically generous rates of return, and whenever returns lagged they would reliably revert to the mean.  Barton Biggs, who Gross calls the poet laureate of the investment industry, encapsulated this line of thinking when he said that markets were good “because whenever they and the economy have gone down, they’ve gone back up to higher levels.”This sort of thinking could be dangerous an example of which is to be found here .

To quote BillStocks, long the volatile vamp of investor optimism, have not yet adjusted to the New Normal of half-size economic growth induced by deleveraging, reregulation, and deglobalization and have low single digit prospects as well. Yet, what has seemed obvious to those of us collectively at PIMCO for several years now is less than standard fare in the trading rooms of institutional money managers. While the phrase “New Normal” has been welcomed into the lexicon of reporters and commentators alike, the willingness of investors to accept its realities is fog-ridden and whispered, or perhaps softly whistled, much like midnight passersby at a graveyard.

Perhaps the enigma arises from a multi-generational acceptance of debt as common scrip, available for the asking and seemingly forever productive in boosting living standards – until, that is, liabilities became so large that the interest burden and probability of repayment overwhelmed borrower and lender alike in near unison. To understand why debt may have become a burden instead of a boon it is instructive as Philip Coggan points out in a recent Economist article, to ask why people, companies and countries borrow in the first place.

They do so, he intelligently argues, to boost their standard of living, to bring consumption forward instead of languishing in the present. How could almost any of us have afforded a home without a mortgage? By the time we would have saved enough money we’d have been close to retirement with the kids grown and facing a similar predicament. And so we turned to the wizardry of borrowing on time to be able to purchase and then repay in full. Crucially, since debt is a handshake between at least two parties, the lender had to believe that it would be repaid, and that belief or “credere,” was based on several rather rational expectations when observed on a macro level from 30,000 feet.

First of all, capitalistic innovation fostered productivity, and an increasing standard of living through technology and innovation. Debts could be paid back via profits and higher wages if only because of rising prosperity itself. Secondly, the 20th century, which fathered the debt supercycle, was a time of global population growth despite its interruption by tragic world wars and periodic pandemics. Prior debts could be spread over an ever-increasing number of people, lessening the burden and making it possible to assume even more debt in a seemingly endless cycle which brought consumption forward – anticipating that future generations could do the same.

But while technological innovation – much like Moore’s law – seems to have endless promise, population growth in numerous parts of the developed world is approaching a dead end. Not only will it become more difficult to transfer high existing debt burdens onto the smaller shoulders of future generations, but the overlevered, aging “global boomers” themselves will demand a disproportionate piece of stunted future goods and services – without, it seems, the ability to pay for it. Creditors, sensing the predicament, hold back as they recently have in Greece and other southern European peripherals, or in the U.S. itself, as lenders demand larger down payments on new home mortgages, and other debt extensions.

Aging and population change of course are just part of the nemesis. We could have “saved” for this moment much like squirrels in wintertime but humanity’s free will is infected with greed, avarice and in a majority of instances, hope as opposed to commonsense. We overdid a good thing and now the financial reaper is at the door, scythe and financial bill in one hand, with the other knocking on door after door of previously unsuspecting households and sovereigns to initiate a “standard of living” death sentence.

What is harder to understand in this demographic/psychological/sociological explanation of the crisis is why it should morph into a global phenomenon. There are 6.5 billion people in the world and will soon be 1 billion more. Many of them are debt-free and have never used a credit card or assumed a home mortgage. Why can’t lenders like PIMCO lend to them, allowing developing nations to bring their consumption forward, developed nations to supply the goods and services, and the world to resume its ‘Old Normal’ path toward future profits, prosperity and increasing standard of living? To a certain extent that is what should gradually happen, promoting more rapid growth in the emerging nations and a subdued semblance of it in the G-7 – a ‘New Normal.’

But they – the developing nations – are not growing fast enough, at least internally, to return global growth to its old standards. Their financial systems are immature and reminiscent of a spindly-legged baby giraffe, having lots of upward potential but still striving for balance after a series of missteps, the most recent of which was the Asian crisis over a decade ago. And so they produce for export, not internal consumption, and in the process leave a gaping hole in what is known as global aggregate demand. Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above.

It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem, which only economists with names beginning in R seem to understand (there is no R in PIMCO no matter how much I want to extend the metaphor, and yes, Paul _Rugman fits the description as well!). If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.

Even if your last name doesn’t begin with R, the preceding explanation is all you need to know to explain what is happening to the markets, the global economy, and perhaps your own wobbly-legged standard of living in recent years. Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a ‘New Normal’ where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. Stop whispering (and start shouting) the words “New Normal” or perhaps begin to pronounce your last name with an RRRRRRRRRRRR. Our global economy, our use of debt, and our financial markets have changed – not our alphabet or dictionary.”

Here is my list of the implications of the “New Normal” :-

  • The extent and duration of quantitative easing, term financing and fiscal stimulation efforts will be the keys to future investment returns across a multitude of asset categories, both in the Western World and globally.Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.Cheap money created by various governments will continue to flood the developing world.Join the crowd and borrow from these countries if you can.
  • Asia and Asian-connected economies (Australia,Brazil) will dominate future global growth.Money will flow into and out of them in anticipation of the news adding to asset price volatility in these countries. Inflation is a huge possibility.Buy inflation adjusted assets in these countries if possible.
  • Near zero interest rates combined with uncertainty will drive investments into bullion the developed world.So expect their prices to rise.
  • There will be a flight to quality bonds.Everyone will be trying to find  the least dirty shirt. And the U.S. looks like the least dirty shirt to a lot of people.So despite the downgrade expect a flight to US treasuries.This will act as a further depressant to the already low interest rates in the US. The best idea might be to trade in US bonds.
  • Investing in emerging country bonds from countries like Brazil  who have low debt and high rates is a good idea .Locals ought to lap up these issues but it will be a bit more of a challenge for foreign individuals to do the same as the infrastructure to do so is not well developed.But where there is a will there is a way.Locals need to watch government action on allowing foreign fund flows into debt to guard against falls in interest rates.
  • The” New Normal” in the developed economies where economic growth will be  slower, profit margins narrower, and asset returns  smaller than in decades past will reduce stock market returns.In the developing world inflation and high interest rates combined with lower exports will also reduce stock market returns.Stock market returns both in the developed and developing countries thus may not be high enough during this period to make the risk of investing in equities seem worthwhile compared to investing in bonds.So investors should stress secure income offered by justly priced bonds and stable dividend-paying equities.
  • For those who are already wealthy and those serious about becoming wealthy and committed to investing in value stocks, it will be time to reach for a bucket instead of a thimble as Warren Buffett puts it.Just remember that his holding period is forever and personally I feel that the patience of stock holders everywhere will be very severely tested.There will also be be better opportunities in other asset classes and passing them up in favour of stocks will be hard.
  • Combinations of equity and debt products will reappear.Now is the time to stock up on them to get the best of both worlds.
  • If you are banking on structured savings products like retirement plans,insurance plans etc. to secure your life goals check the assumptions in your calculations. Unfortunately time is a luxury few can afford and below par returns over a decade might compromise the achievement of these goals.Don’t assume that optimistic projections will play out in the near future.

About Keerthika Singaravel

2 Responses to Bill Gross – The New Normal

  1. Patrick says:

    Hello! This post could not be written any better! Reading through this post reminds me of my old room mate! He always kept chatting about stuff like this. I will forward this page to him. Fairly certain he will have a good read. Thank you for sharing!

  2. Anonymous says:

    Man I’m impressed with this informative blog.You have a genius mind.Keep up the good work.This is really nice info.Thanks for such a wonderful post.

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