Investors are focused on daily events surrounding the European debt crisis, but the real challenge to the market is a much more powerful and far reaching crisis, says the world’s largest bond fund manager.
Bill Gross, managing director at Pacific Investment Management Co., says the lower quality of sovereign debt, coupled with the negative returns this debt now offers after factoring in inflation, threatens to undermine the global monetary system.
“The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits,” Mr. Gross writes in his monthly investment outlook.
The trillions of dollars that governments and central banks have pumped into the global monetary system since the crisis in 2008 have prevented a meltdown but also increased the risk and lowered the return of sovereign securities, he says.
“Both the lower quality and lower yields of previously sacrosanct debt represent a potential breaking point in our now 40-year-old global monetary system,” he says.
Mr. Gross' comments are particularly timely, as the yield on the benchmark U.S. 10-year Treasury note fell to a record low for the second day in a row. The yield sunk five basis points, to 1.58 per cent on Thursday afternoon.
Investors will reach a point where they decide that the 2 per cent negative real return rates they get don’t justify the benefits of holding sovereign debt. Instead of lending to governments, they will turn to hard assets such as land and gold, or simply sit on their cash.
Either the global monetary system becomes “stagnant, dysfunctional and ill-equipped to facilitate the process of productive investment,” or a new system emerges to replace the current one, Mr. Goss says.
“Together, there is the potential for both public and private market creditors [including China and PIMCO itself]to effect a change in how credit is funded and dispersed – our global monetary system. What that will look like is conjectural, but it is likely to be more hard money as opposed to fiat-based, or if still fiat-centric, less oriented to a dollar-based reserve currency. In either case, the transition is likely to be disruptive,” he writes.
Mr. Gross argues that higher global inflation is the likely solution to the overwhelming public and private debt loads. As a result, he says bond investors should therefore favour quality sovereigns, such as the U.S., Mexico and Brazil, and choose intermediate maturities that gradually shorten over the next few years. Equity investors should look for international companies with stable cash flow competing in high growth markets.