When the world's most prominent bond manager maps out the collapse of the developed world credit system it can't be dismissed out of hand.
Pacific Investment Management Co. (Pimco) co-founder Bill Gross manages the world's largest non-government bond portfolio, which stands at well over $250-billion (U.S.). In the latest of his widely-read monthly commentaries , Mr. Gross posits that "money may be running out of time" as it becomes steadily more devalued by credit growth:
"Each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result."
The economic implications of this theory are profound. Since the Second World War the expansion of credit, notably mortgages and credit cards, has been a central feature of developed market economic growth. The majority of economists believe that more private or public debt will be followed immediately by more consumer demand and higher levels of growth.
Mr. Gross suggests that this will no longer be the case. We are approaching the point where the interest payments on funds borrowed for investment will not be covered by the profits on the investment. Peking University economics professor Michael Pettis, among others, has already made a compelling argument that this process is well under way in China, where bad debt is piling up much faster than corporate profits.
Mr. Gross highlights three symptoms of this decline in credit-driven capitalism. One, low long-term bond yields that do not compensate investors for the risk of holding them; two, credit spreads lower than default risk merits; and three, price-to-earnings ratios too high relative to earnings growth.
These symptoms are already evident in global markets. Few investors are interested in holding long-term Treasuries for 30 years at the current yield of 3.2 per cent. Credit spreads – highlighted by the remarkable rally in junk bond and emerging market debt yields – have narrowed considerably in the past 18 months (although they remain above the dangerous pre-crisis levels in 2007).
As for price-to-earnings, the current S&P 500 level is 15 times, yet U.S. gross domestic product is contracting and global growth for 2013 is predicted at a relatively anemic 3.5 per cent. Thankfully, U.S. profit growth has remained strong, but this will become harder to maintain if economic growth remains sluggish. Also, earnings growth has been boosted in part by shedding employees, a process that will be self-defeating over the long term as companies fire their potential customers.
The Pimco outlook is an excellent example of why economics is known as the dismal science, and we can hope that Mr. Gross is as mistakenly pessimistic as Thomas Malthus . But, while Mr. Gross himself admits the end is not yet nigh, unlike astrologers and the Mayans he has a long and successful track record of predicting the global economy. As uncomfortable as it is, Canadians should take his predictions seriously.
Scott Barlow