I pick up Bill Gross where I left him on Friday. He said in his monthly newsletter that the Fed is going to keep interest rates at zero percent through 2010. But, he is not willing to stick his neck out in a liquidity seeking return kind of way even though this is what reflation is all about. He advises lower risk assets over higher risk ones cognizant that this could mean under-performance.
What I found interesting is that Gross highlighted only two bits in his piece. That should lead you to believe these are the most important points he makes. The first bit is the rationale behind why he thinks the Fed is on hold through 2010:
The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until.
This is what’s called an asset-based recovery and is exactly the same model we followed in 1992 and 2002. the Federal reserve lowers rates so much that the cash in your pocket burns a hole in it. Grandma may be stuffing her dollars in a mattress, but investors judged against an investment benchmark get fired if they don’t seek returns. how did Chuck Prince put it: When the music’s playing…
If you are an insurance company, you have a ton of money invested expecting 6-7% nominal returns. But, in a deflationary environment you have to be smoking something if you think you’ll get that return in low risk assets. So everyone is running the liquidity-seeking-return play.
The Wall Street Journal mentioned this today:
Though insurers continue to buy bonds, the rally does “make it challenging in terms of getting yield,” Steven Kandarian, chief investment officer at MetLife Inc., told analysts in an Oct. 30 earnings call.
Life insurers have long been one of the nation’s biggest bond buyers, currently holding about $1.78 trillion in corporate debt, or 16% of the total outstanding, according to industry group American Council of Life Insurers.
Their frustrations in finding investment opportunities signal how far and fast the bond market has recovered from the dark days when markets were frozen and insurers were diverting almost all incoming premiums and investment income into cash accounts.
But, it sounds like Gross is having none of this. He asks a rhetorical question about overpriced assets in nearly every asset class:
Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis?
Answering his own question is the only other part he highlights in his essay – one doubting the elevated price of risk assets. He says:
In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity.
Gross goes on to recommend high dividend safe stocks like utilities. But, I did get the sense he was talking out of both sides of his mouth. For months now, Gross has been advocating reflation as an economic policy. He has advocated massive deficit spending too. Back in June of 2008, he was the first one I knew who was talking about deficits in the trillions. Yet, here he is cautioning us about inflated asset prices. Well, zero rates and inflated asset prices go hand in hand. And I’m sure Bill Gross knows this.
Originally published at Credit Writedowns and reproduced here with the author’s permission.