Don’t worry until rates actually start to rise

Falcons in the gyre, or something. A second coming and how Pimco works

| 4 March 2014

Given that a certain Secretariat of the world’s biggest bond fund has attracted some attention of late, lets give the newest investment outlook from Pimco’s Bill Gross the once over.

That picture, along with a bit of Yeats is what first catches the eye. The poetry is there to fulfill the Grossian requirement for colourful metaphor, and is well chosen given that the power of William Butler Yeat’ Second Coming stems largely from its prophetic generalisation and vagueness, but it also serves as entendre: Gross is back in charge after chief executive Mohamed El Erian’s recent departure.

The circles are the thing, however. These have been drawn on Pimco whiteboards for years, safest assets in the middle of concentric circles of always green ink, for some reason, and what they show are process.

Yet there is more to our concentric circles of asset classes than meets the eye. If its only message were that risk and return were correlated, then we could simply write that on the whiteboard and be done with it. Instead, our visual schematic expresses a more complicated process of cause and effect that allows an investor to anticipate price changes instead of simply describing ex post returns and volatility. It provides the foundation for alpha generation, as opposed to simple beta summation, and therefore the potential to beat the market and outperform competitors.

You, Pimco investor, might have been starting to think that it is just the whirring of Mr Gross’ mind that keeps your billions safe. But no, there is a framework, debate, structure, bells, whistles, safeguards and a platform. How else can you stand straight in a mysterious world without a stable platform?

This conceptual “cause and effect” is what brings life to our concentric circles – it is what allows us – if done properly – to make profitable choices between asset classes at the appropriate time; it is the heart of our active management process and our YGIA “Your Global Investment Authority” platform.

Right, so standing on that Ygia platform, everything depends on the center – what the Federal Reserve et al do to interest rates. What next?

Yeats describes a falcon, which in this metaphorical context should be assumed to be the investor, “turning and turning in the widening gyre,” moving outward and outward in PIMCO’s concentric circles in search of higher and higher returns. The falconer of course, in our cause and effect model, is the global central banker, training the vulturous investor to swoop down and snatch attractively priced assets on command. But can the falcon hear the falconer? Does the investor have confidence in the word and efficacy of the falconer’s artificially priced policy rate? Can the center hold?

OK, we think that is sort of restating the fact that everything depends on low rates.

If the center holds, if global central bankers can convince investors that their abnormal policies can recreate a semblance of the old normal economy, then risk assets at the outer edges of our circle will have higher future returns than otherwise.

Which gets to the point where this falcon has its gloomy cake mouse and eats it as well.

As long as artificially low policy rates persist, then artificially high-priced risk assets are not necessarily mispriced. Low returning, yes, but mispriced? Not necessarily.

So be worried, but don’t be worried yet/until rates actually start to move. Which as Matt King at Citi has said for some time, is actually the fragile market consensus. Own risky assets that give you plenty of yield, but do so with one foot out the door/circle/falconer’s back yard.

Which leads to some strangely explicit cognitive dissonance.

In the short term, however, and to be specific for 2014, artificial prices will not be mispriced if circling falcons can be convinced of the efficacy of qualitative forward guidance. We believe that will be the case. Carry trades, then, in numerous forms should be profitable, although their information or Sharpe ratios may show that these positions provide historically low risk-adjusted returns once volatility is considered relative to lifeless cash.

Carry trades are bad, because of the dangers of volatility when things are upset, but assuming things won’t be upset just yet we advocate carry trades.

However that makes more sense read as a pitch for active management. Do what everybody else is doing, but realise its highly dangerous and so you better pay us to do it for you.

After all, they have a structure, and a platform, and a process.

Article from FTAlphaville

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