PIMCO is the worlds’ largest bond holder with almost US$2 trillion in funds under management. At the head of the organisation are two titans of the bond world – Bill Gross and Mohamed A. El-Erian – Co-Chief Investment Officers (CIO). It is not overstating things to say when they speak, markets move. Bill Gross, more often the public face of PIMCO, is the equivalent of Warren Buffett to the bond world.
Like Buffett, Gross has built his reputation on being right and sticking to his convictions. At the onset of the GFC, Bill Gross and his CIO partner coined the phrase ‘the new normal’ for what they saw as a prolonged period of slow growth on the back of government and household deleveraging. Despite initial resistance to the idea in some quarters, the ‘new normal’ gained traction as it played out exactly as predicted – and continues to play out. This wasn’t their first good call, and it won’t be their last.
Each year Warren Buffett produces the Berkshire Hathaway Shareholder Letter – widely read for his insights into the equity markets. Likewise, Bill Gross and Mohamed A. El-Erian provide an annual insight to the key themes they see playing out for bond markets in the coming years through their secular outlook. Here we will look at the key themes of this years’ outlook, and how SMSF investors can apply these themes to their own funds.
The key theme coming out of the PIMCO secular outlook was that market commentators and forecasters continue to over-estimate the rate of recovery. They note that actual performance in the economy has consistently fallen short of expectations leaving little upside in asset prices, with plenty of downside risk - the actual recovery is slower than the growth which equity markets have priced in. If markets fail to meet the growth rates currently assumed, as he believes they will, markets will have no choice but to re-price; downwards.
This key theme drives his outlook for all markets and underpins his views on how he will be investing the world’s largest bond fund in the coming year. With this key theme in mind, Gross suggested three positions he would be taking and SMSF investors can apply these same positions to their own holdings:
- Remove call risk – he’s selling bonds and hybrids with call risk. His view is that call risk is not being priced in, so it is better to take your money off the table until such time that it is. Like PIMCO, SMSF investors are not being appropriately rewarded for taking call risk and investors should consider following his lead and lightening call risk from their portfolios.
- Move from medium term exposure to short term exposure – this is due to his view that investors are not being rewarded for investing for longer periods.* Here Gross is referencing the US yield curve; Australian SMSF investors ARE being rewarded better than their US counterparts for medium term risk and should stick to exposures in the 5-7 year timeframe. Investors with short dated bonds nearing maturity, should consider selling (especially those trading above par) and moving into bonds with maturities in the 5-7 year timeframe.
- Take inflation protection for longer term exposures – whilst he sees scenarios where inflation remains benign in the longer term, he is still protecting his portfolio through inflation linked bonds. This in particular is interesting, even though he does not see much inflation risk on the horizon in the US context, he is still protecting his holdings against the risk of any inflation break-out in the long term. Australia is at higher risk of inflation than the US – with the possibility of converging growth (inflation) drivers of mining and property coming back on stream at the same time in the medium term, investors should follow Gross’ lead and look to protect against inflation by adding inflation linked bonds to their investment portfolio.
When Bill Gross speaks, fixed income markets listen. There is a lot SMSF investors can learn from the best investors around the globe, whether they be equity, property or fixed income focussed. Gross’ outlook for this year made some clear calls to action which SMSF investors should consider applying to their own portfolios.
*Investors should note that he is speaking with a US centric view where yield curves are flat. As I have covered previously, in Australia we have seen a dramatic steepening of the yield curve over recent months and as such I remain comfortable, that in the Australian context, it is appropriate to remain exposed to medium term maturities. This is something investors should keep in mind when reading Buffett’s commentary (or any US investor commentary) as well – when Buffett speaks about markets - he is in most cases talking about the US. Not everything which is applicable in the US is directly relevant to Australia.