Bob Carlson

Don’t mistake leverage for genius. That’s an old saying in the investment business, but it’s especially true today. As Bill Gross of PIMCO says in his latest monthly essay, you could make money by leveraging almost any financial asset until 2008. While the period since then is described as a deleveraging, it really isn’t. Households in the U.S. and some other places are slowly reducing debt. But governments and central banks are balancing that with increased debt. Count it all up, and leverage is expanding but more slowly than before the crisis.

We’re now in a period of financial repression. Interest rates generally will be negative, and growth will be slow. Soon, a mild releveraging will begin, and that means rising rates and credit spreads. Gross says the question for investors today is make The Great Escape from this period of volatility and low returns, even negative real returns.

As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.

That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.

Gross suggests a narrow range of investment options going forward. (He emphasizes that you shouldn’t abandon PIMCO or its bond strategies.)

In plain speak –

For bond markets: favor higher quality, shorter duration and inflation protected assets.

For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks.

For commodities: favor inflation sensitive, supply constrained products.

And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.

With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”