The next era of investment will be won by teams playing strong defense, Pimco’s Bill Gross says in his March investment letter.
Gross argues that we have come to the end of a 30-year long stretch in which “offensively minded” central bankers pushed down interest rates and created a false sense of wealth.
Investment managers during the 30 years of offense discovered that “the secret to getting rich since the early 1980s has been to borrow someone else’s money, throw some Hail Mary passes and spike the ball in the end zone,” Gross writes.
But with interest rates at the zero-boundary, the old strategies have stopped working.
“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,” Gross writes.
Gross includes an interesting chart illustrating the relative decline of personal interest income to personal debt payments. This demonstrates that declining interest rates have not produced a neutral outcome, with equal numbers of winners and losers.
Instead, “Main Street” has seen its savings decline while “Wall Street” got ever wealthier.
In order to repair the damage to their balance sheets, households must develerage. And, as the chart shows, there’s still a very wide gap between interest income and debt obligations.
As a result of the deleveraging of households and historically low yields, the business models of all sorts of financial firms have begun to break down. Insurance companies, pension funds, and banks find that they can no longer achieve the kind of market returns they once relied on. The ones that can begin to shrink: banks close retail branches, insurance companies shut down some business lines.
“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,” Gross writes.
Gross says that the appropriate defensive strategy is an emphasis on “reliable/safe” income, deemphasizing derivative structures, and picking investment carefully. Most importantly, acknowledge that nominal returns are likely to be lower than historical examples.
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