The « new normal » characterisation of post-Lehman financial markets by Mohamed El-Erian, PIMCO CEO, is of most interest. He suggests that the markets will be moved according to the life cycle of bubble fueled by excessive monetary policies. What does it concretely mean for our portfolio allocation ?
William H. Gross‘ last investment outlook gave food for thought. Since he co-founded PIMCO, the 1 trillion bonds funds, it might be worth the time.
First of all, let’s stop the false wonders about the relative interest of mutual funds like PIMCO and ETF promoters like Vanguard. The question is less about the risk / return couple than about the alpha / fee ratio.
Our view is quite simple when correlation between securities rises towards one, there is no point paying the mutual funds management fee as there is no opportunity for them to pick securities. In case of flight-to-quality, fearful markets, like in 2008 or at the beginning of a bull market, like until 2013, smart-beta allocation using ETF are, by far, smarter investing. It is the now « classic » discussion about risk-on/risk-off.
The « new normal » characterisation of post-Lehman financial markets by Mohamed El-Erian is of most interest. He suggests that the markets will be moved according to the life cycle of bubble, fueled by excessive monetary policies. Nobody could argue, except on the timing. When does a monetary policy begin to be excessive ? We do not believe in desperate gamble to promote growth, but rather in « total war » against « economical suicide » : deflation. In that case, the fight against deflation might be worth artificially low interest rates. Interest rates might be too low, the monetary base (M3) is not growing. Quantitative Easing is only the counterpart of the new banking regulations limiting the leverage.
This being said, even we could disagree on the causes of the loose monetary policy, all the assets contain artificially low interest rate in their price. Besides they are also incorporating high GDP growth expectations. Considering those factors, we’ve shown that equities were even rather cheap . The question left unanswered being whether this growth expectations were sensible and the artificially low interest rates, sustainable.
America is sending, ISM after Non Farm Pay Rolls, signs of a strong recovery. Last but not least, anyone who think that the FED will increase their interest rates with inflation at 1% is a fool. QE might be tapered, 10Y is only at 2.85%, with the whole curve being very steep, meaning short term interest rates will stay at historical lows.
As a conclusion, we share his defensive view on front-end treasury. Investor will move away duration to avoid the consequences of QE tapering (long term interest rates increase) to move towards short term (short terms interst rates will have to stay low as the last weapon against deflation). In case of QE-tapering, it would mean recovery is full and complete. As a consequence, credit should benefit from it. It is even easier to believe when noticing that on the contrary to the interest rates, credit spreads are far from their lows. By the way, PIMCO is said to massively sell CDS (CDX NA IG).
The only question remaining concerns, equities. Even in case of steepening of the yield curve, the 5 year, the most relevant maturity for equities, is not likely to increase a lot. Again, because of deflation risk. As a conclusion, as long as inflation is below 2%, don’t try to fight the FED and remain long equities.