Home ListingMay 13, 2014

PIMCO: The Age of ‘New Neutral’

PIMCO’s latest long-term view reflects slow economic growth, high leverage, the end of bull markets, and a lower neutral policy rate.

Reported by Featured Author

(May 13, 2014) — The age of the “New Normal” has ended, PIMCO has announced, and the next three to five years will be an era with a different outlook dubbed the “New Neutral.”

According to the bond shop’s 2014 secular outlook, the global economy, burdened with an all-time high of leverage, could be at risk of being “unable to grow and generate inflation at pre-crisis levels for many years to come.” Investors, in turn, could expect a period of sluggish growth in the economy that is likely to lead to continued low policy rates from central banks.

“Five years after the global financial crisis, average growth in the global economy is modest and the level of global GDP remains below potential,” said Richard Clarida, PIMCO’s global strategic advisor. “We will be operating in a multi-speed world with countries converging to historically modest trend rates of potential growth with low inflation.”

Such economic environment has had significant implications to current asset prices, PIMCO’s Founder and CIO Bill Gross argued.

Credit spreads remain narrow while equity prices are through the roof, reaching peaks in some countries, he said. Emerging market equities, on the other hand, have been underperforming due to slower than expected growth rates, while risk assets have been booming based on artificially raised asset prices.

“Investors wonder what’s left in the tank,” Gross said. “With yields so low, spreads so tight, and Shiller price-to-earnings ratios above historical norms, there appears to be more risk than reward on the horizon. Financial repression, as it continues for years to come, will almost ensure that outcome.”

He added that policy rates set by the US Federal Reserve are too high for neutral interest rate, a rate that neither stimulates nor decelerates economic growth. Currently the US market is looking for real policy rates to rise to 1% to 2% by the end of the decade, but PIMCO estimated the figure to be closer to 0%—the “New Neutral.”

Lowering neutral policy rates would help reduce risk and minimize bubbles, Gross argued, alleviating some fears in the market.

“If the future resembles those neutral policy rates, then the investment implications are striking: low returns yet less downside risk than investors currently expect; and end to bull markets as we’ve known them, but no perceptible growling from the bears,” he said.

However, the “New Neutral” would result in similarly low returns on risk assets, PIMCO’s leader predicted. Bonds would return around 3% and equities about 5%, most likely not enough to sustain investors with liability structures.

Instead, investors could look to earn alpha from assets with different risks and alternative strategies.

“PIMCO recognizes that the New Neutral may allow for the assumption of greater carry portfolios in order to attain [higher returns],” Gross said. “A sow’s ear can be turned into a silk purse even if 10-year treasuries are range-bound between 2.5% and 4% as we expect over our secular horizon.”

Since cash will be cheap to borrow, the bond man suggested, it could be leveraged to enhance returns or “swapped by corporations to reduce their interest rate expenses.”