If so then the legitimate question is: How much time does money/credit have left and what are the investment consequences between now and then? Well, first I will admit that my supernova metaphor is more instructive than literal. The end of the global monetary system is not nigh. But the entropic characterization is most illustrative. Credit is now funneled increasingly into market speculation as opposed to productive innovation. Asset price appreciation as opposed to simple yield or “carry” is now critical to maintain the system’s momentum and longevity. Investment banking, which only a decade ago promoted small business development and transition to public markets, now is dominated by leveraged speculation and the Ponzi finance Minsky once warned against.
So our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.
REPEAT: THE COUNTDOWN BEGINS WHEN INVESTABLE ASSETS POSE TOO MUCH RISK FOR TOO LITTLE RETURN.
Visible first signs for creditors would logically be 1) long-term bond yields too low relative to duration risk, 2) credit spreads too tight relative to default risk and 3) PE ratios too high relative to growth risks. Not immediately, but over time, credit is exchanged figuratively or sometimes literally for cash in a mattress or conversely for real assets (gold, diamonds) in a vault. It also may move to other credit markets denominated in alternative currencies. As it does, domestic systems delever as credit and its supernova heat is abandoned for alternative assets. Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase.
The element of time is critical because investors and speculators that support the system may not necessarily fully participate in it for perpetuity. We ask ourselves frequently at PIMCO, what else could we do, what else could we invest in to avoid the consequences of financial repression and negative real interest rates approaching minus 2%? The choices are varied: Cash to help protect against an inflationary expansion or just the opposite – long Treasuries to take advantage of a deflationary bust; real assets; emerging market equities, etc. One of our Investment Committee members swears he would buy land in New Zealand and set sail. Most of us can’t do that, nor can you. The fact is that PIMCO and almost all professional investors are in many cases index constrained, and thus duration and risk constrained. We operate in a world that is primarily credit based and as credit loses energy we and our clients should acknowledge its entropy, which means accepting lower returns on bonds, stocks, real estate and derivative strategies that likely will produce less than double-digit returns.