Fortune Telling IV
Bill Gross from PIMCO feels that cream may turn into skim milk… or that credit spreads are disquietingly approaching their lower profit limit.
Here’s a morsel to wet your appetite on his comments:
I, and I’m sure you as
well, am always amazed at the pundits who claim that certain just
released information is already priced in to the markets. How do they
know and who did they ask? Even if they did, would a 54% OJ majority
opinion be proof that it was so? I suspect not and that is why
investment management is partially art, partially science, and at least
a small part BS. But there are certain points in more definable, less BS-able asset markets that approach certainty if only because they
are more mathematically based.
To make a long story short, in his Reality Check post, Bill makes the case that credit spreads from already highly leveraged hedge fund products, such as CPDOs (constant proportion debt obligations), have reached a limit of decreased returns (200 bp at 8 times leverage, with each portfolio asset at 50 bp risk premium and 250 bp volatility). In other words, what used to be a safe (AAA) and comfortable investment with a healthy 2% return has reached the point where 2 or 3 more bp will degrade the rating of these instruments.
So Bill concludes…
And so? No gloom and doom
message here. I’ve already endorsed the rudiments of our new age
financial marketplace subject to one off and normal cyclical
corrections. But we are approaching limits. And just as distortions of
mass and time enter physicist’s equations as objects approach the speed
of light, so too can cream mutate if its price or spread morphs from
old world to new world to unworldly levels. I can’t guarantee this
reality – OJ lurks, it seems even in the financial markets. But I have
a strong sense that the ability to lever any or all asset returns via
increasing leverage is reaching a climax and therefore, that CPDO,
corporate credit spreads, and more importantly, sophomoric assumptions
of future assets returns in all markets may require some future
compromise, as the current masquerade of high asset returns gradually
morphs from cream to skim milk.
…And, I’ll be keeping in the back of my head… a potential volatility trade: could it be that the risk premium is about to spring from its long history of compression?