Pimco’s Gross: Time to lower return expectations in age of inflation

The Lending Lindy

Too little return Lender Chuck Prince’s figurative health, however, is not so obvious. Certainly bank balance sheets and creditors in general need to downsize assets, increase equity, or both. That by itself will be a disincentive for economic growth. But in addition there is the lender’s current precarious lack of return, yield, or call it “carry” that threatens additional credit extension in future years.

A lender will not easily lend money to an obese over-indebted borrower – that much is clear – but she will also not extend a check when the yield, carry and return on investment is so low that it cannot compensate for historic business model overheads. That is when Chuck Prince’s dancing turns from a quick step into a waltz. When yields are too low, and acceptable risk spreads so narrow that top line interest revenue is increasingly marginalized, then lending is at risk. Excessive historical overhead represented by rents, salaries, pension and health benefits, to name just a few, force financial and lending institutions to do one of two things: They lever up to cover those costs or they slow or shut lending down to preserve equity and the ultimate franchise. The levering up is indeed difficult given the 2008 financial crisis and the ensuing follow-through of intensified regulatory oversight. And so, what we are witnessing instead is the beginning of a waltz, a dance where financial institutions such as banks, insurance companies and investment management firms fail to reap the economies of scale so reminiscent of the prior era of fat as opposed to the present one of lean. In the process, they lay off, instead of hire new workers; close branch offices or even ATM machines by the thousands as did Bank of America recently; and yes, ultimately reduce the rate of lending or credit growth which propelled the global economy so effortlessly over the past century.

If the dancing has slowed down, then the reason is not just an overweight partner. It’s that the price of money (be it in the form of a real interest rate, a quality risk spread, or both) is too low. Our entire finance-based monetary system – led by banks but typified by insurance companies, investment management firms and hedge funds as well – is based on an acceptable level of carry and the expectation of earning it. When credit is priced such that carry is no longer as profitable at a customary amount of leverage/risk, then the system will stall, list, or perhaps even tip over.

For the current shipwreck perhaps we have the Fed and other central banks to blame. Zero bound interest rates according to their historical models should inevitably and inexorably lead to dynamic real economic recovery. Who wouldn’t borrow at near 0% yields – namely the banks – in order to relend at seemingly profitable spreads? Who wouldn’t borrow at 3.5% for a 30-year mortgage – namely homeowners – in order to match or even reduce current rent payments? Well, they haven’t. Not in the amounts they were supposed to in any case. Structured impediments such as regulatory risk standards for banks and fear of losing money for households have thrown a monkey wrench into those models. Central banks are agog in disbelief that the endless stream of QEs and LTROs have not produced the desired result. Wimpy and Chuck are waltzing, not quickstepping, even with a band playing in up tempo.

Strategy recommendations What then is an investor to do? In a New Normal economy where lenders dance to the Blue Danube instead of the Lindy, how should we move our own feet? Carefully, I suppose, and with recognition that historic returns are just that – historic. Last month’s “dying cult of equity” Investment Outlook elicited a lot of excitement, but somehow failed to impress readers with its main point: Returns from both stocks and bonds will be stunted. How could one argue otherwise on the bond side with investment grade bonds yielding only 1.75%? How could one argue otherwise for stocks under the assumption that bond and stock returns were at least in part mathematically conjoined at the hip? How could one argue otherwise when it is obvious that boomers and X’ers, Y’s and Z’ers are likely to be disenchanted for their own good reasons for years? How could one argue otherwise when it is apparent that stock market trading has been taken over by machines – that HAL rules the stock exchange roost and does a bad job of it at that? Well, some did and some will continue to argue the counterpoint. Chart 2, however graphically displays the mood of the public as opposed to the mood of the pundits. Only time will determine who was right and who was wrong, even if stocks outperform bonds as indeed I predicted.

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