The world's largest bond fund is steering clear of gilts.
American bond giant PIMCO's Bill Gross attracted a lot of attention last week with his observation that UK government gilts 'are resting on a bed of nitroglycerine.'
Not pulling his punches, he described the UK as a 'must to avoid', underlining the words to make his point crystal clear.
And a telling chart compared the fortunes of sixteen of the world's major non-emerging economies, plotting public sector debt as a percentage of GDP against the public sector deficit as a percentage of GDP. The UK? Squarely in a cluster of 'red zone' economies dubbed by Gross 'the ring of fire'.
Cause for concern
All good knockabout stuff. But how worried should investors be?
They shouldn't be sanguine, that's for sure. PIMCO, founded by Gross in 1982, has this month seen its assets under management top $1 trillion. The firm's flagship Pimco Total Return fund, personally managed by Gross, is the world's largest, with assets of $202 billion. Not for nothing is Gross regarded as something of an investment guru.
And the analyses on which he bases his views are impressive in their own right -- some research by consultancy firm McKinsey into past patterns of post-financial crisis deleveraging, and Carmen Reinhart and Kenneth Rogoff's own recently-published study of past financial crises, 'This Time is Different'.
Lean times ahead
According to Gross, the McKinsey study makes three telling points.
- Deleveraging generally begins around two years after the beginning of a financial crisis, and lasts for six to seven years.
- Around half the time, deleveraging for such a prolonged period acts as significant drag on GDP growth.
- Economies with relatively low initial levels of public and private debt tend to cope better with a financial crisis.
For their part, three different aspects of Reinhart and Rogoff's work struck a chord with Gross.
- Banking crises tend to adversely impact employment: typically, unemployment spikes upward by seven percentage points, and stays high for five years.
- On average, a country's debt doubles within three years of a banking crisis.
- Once a country's public debt exceeds 90% of GDP, its economic growth rate slows by 1%.
For the avoidance of doubt, the present level of the UK's public sector debt -- as I wrote last week -- was 62% at the end of Q4.
Gross's conclusion? Steer clear of the UK, as well as other 'ring of fire' economies, and invest in emerging economies instead. Preferably emerging economies with a strong savings tradition: India, China, and Brazil, for example.
Plausible scenario
Am I worried? To some extent, yes. Gross has a good track record, and it would be stupid to ignore it.
It's also true that recovery has so far still felt a little 'too easy'. We've had a recession, to be sure, but not the Great Depression. All that debt has to work its way through the system somehow, and the scenario outlined by Gross is plausible to say the least.
That said, Gross is talking in the context of fixed income investment. Given the state of the government's finances, you don't have to be Einstein -- or Gross -- to foresee troubled times ahead for government gilts.
Other asset classes present a different proposition. Yes, UK shares reflect the fortunes of the UK economy -- but as Hargreaves-Lansdown's Mark Dampier points out this week, between two-thirds and three-quarters of the revenues of the FTSE 350 come from overseas. The FTSE 100 is even less dependent on the UK.
Avoiding the train wreck
For myself, I've found Gross' analysis helpful.
I won't be buying gilts -- even though the Stock Exchange has this week made them easier than ever to buy.
I will be buying more emerging economy stocks -- specifically India, via two funds that I'm exploring at the moment.
And I will be increasing my exposure to UK equities with strong foreign earnings.
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