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‘Be careful in 2018’: Bill Gross’s five themes to follow

Bond veteran’s monthly outlook returns with ominous overtones.

Bill is back

Outspoken fund manager Bill Gross has been relatively restrained as of late.

In his first investment outlook letter since July, Gross says investors should be careful in 2018 as risks abound.

The manager of the $2.2 billion Janus Henderson Global Unconstrained Bond fund cites low interest rates, high leverage and liquidity concerns as key risks that investors should pay attention to in 2018.

The legendary bond investor lays out out five themes for investors to ponder. Click through to see his top concerns. 

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1. Protection is a rare commodity

Gross said that previous market tops were countered by investors buying treasury bonds as a defensive measure. However, with interest rates so low, the benefits of this have waned and it means there are fewer predictable elements at play in risk assets.

‘Should a crisis arise because of policy mistakes, geopolitical crises, or other currently unforeseen risks, the ability to protect principal will be impaired relative to history,' he said. 'That in turn argues for a more cautious and easier Fed than otherwise assumed.’

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2. Leverage lessons not being learned

‘Credit creation begins at the central bank level, but in reality is predominantly expanded via fractional reserve banking and near zero reserved shadow banks,' Gross said. 'This model allows substantial leverage and can overprice AAA assets at the core then expand outward until it reaches the periphery of financial markets.'

Within this dynamic, credit usually leaks out into the real economy via purchases of real assets, plant and equipment, commodities and other factors of production, Gross explained. However, this is predicated on a heavy dependence on leverage in this system, which, Gross said, is no longer a fundamentally sound investment thesis.

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3. Carry on carrying on

Gross said the entire financial system is based upon carry and the ability to earn it. ‘When credit is priced such that carry can no longer be profitable – or at least grow profits – at an acceptable amount of leverage/risk, then the system will stall or perhaps even tip. Until that point, however, investors should stress an acceptable level of carry over and above their index bogies.’

While carry could be drawn from other areas – notably duration, curve, volatility or event currency – Gross said investors need to generate excess carry to outlast their target market. ‘Timing that exit is obviously difficult and perilous, but critical for surviving in a new epoch. We may be approaching such a turning point, so invest more cautiously.’

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4. Don’t confuse cash with credit

Gross said there is a big difference between cash and credit – a definition which is lost in some areas of the market. ‘High-quality credit can at times take the place of money when its liquidity, perceived return and safety of principal allow for its substitution.

‘When the possibility of default increases and/or the real return on credit or liquidity decreases and persuades creditors to hold classical “money” (cash, gold, bitcoin), then the financial system as we know it can be at risk (insurance companies, banks, mutual funds, etc.) as credit shrinks and “money” increases, creating liquidity concerns.’

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5. Fed refuses to pay

Working in extreme theoretical economics, Gross said he has been asked what would happen if the Federal Reserve simply told the Treasury it was ripping up $4 trillion worth of assets. Gross responded that the current situation is effectively just that.

‘“Just pay us the interest”, the Fed says, “and oh, by the way, we’ll remit all of that interest to you at the end of the year.” Money for nothing – the Treasury issuing debt for free. No need to pay down debt unless it creates inflation. For now, it is not. Probably later.’

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William H Gross
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29/102 in Bonds - US Dollar (Performance over 3 years) Average Total Return: 7.42%
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