Bill Gross: "Credit creation or credit destruction is really the fundamental force that changes P/Es, risk premiums, natural interest rates, etc."

Bill Gross, Co-CIO of PIMCO, wrote how the expansion or contraction of credit and its velocity affects asset prices and economic growth in his February 2014 Investment Outlook titled "Most ‘Medieval’". Basically, unless the private sector can stimulate credit growth in the system, he's worried that the declining budget deficit and Fed tapering will put pressure on credit growth, asset prices, and economic growth. Pulling credit (or credit growth) and liquidity from the economy and financial system is deflationary in nature, and doing so would also affect the private sector leverage, allocations, and euphoria propping up asset prices (1, 2, 3Reflexivity?) And we already know that money supply (M2) growth hasn't translated into much GDP growth since the government bailouts in 2008 (velocity of money).

But, the Congressional Budget Office (CBO) disagrees with Bill Gross. According to AFP, "The United States is expected to post solid economic growth of more than 3.0 percent through 2016, accompanied by a shrinking deficit, a government agency said Tuesday." So maybe there's a chance.

Here is selected text from Bill Gross's February 2014 Investment Outlook at PIMCO.com. Read his full note there.
But lost in this rather complex maze of why is the function of credit and credit expansion in a modern, financial-based economy that it dominates. Asset prices are dependent on credit expansion or in some cases credit contraction, and as credit goes, so go the markets, one might legitimately say, and I do most emphatically say that! What exactly do I mean by “credit?” Well, money in all its multiple forms. Cash is a form of credit in my definition because you can use it to buy things. Bonds are credit. Stocks are credit. Houses and real estate can be considered credit when they are securitized and sold to investors in mortgage pools. In our modern financial economy, credit is anything that can be transferred on a wire or a computer from one account to another and ultimately be used as the basis for spending money on things such as groceries or airplane tickets.

And so when an investor tries to think about “prices” for these various forms of credit, it is necessary to get behind the winds of credit itself, to see what causes credit to behave like a mild South Seas breeze or a destructive typhoon in the China Sea. Credit creation or credit destruction is really the fundamental force that changes P/Es, risk premiums, natural interest rates, etc. For most investors that may be hard to understand, but that is where the little piggies come in.

Imagine you are on that South Sea island with only two people. Each of you owns half of the island, grows your own food and has four little piggies for bacon and chops and all of the good stuff that people like to eat. Things are copasetic; the local “economy” is doing fine, but one day your other buddy figures out a way to make a new crop that you don’t have. She’s the island’s entrepreneur, so to speak. Well, being jealous and perhaps a tad greedy, your previous buddy refuses to share the secret. But she will offer you a future share of her harvest for one of your little pigs – there being no money, credit or anything of the sort on the island. You love that bacon, but the lady is living higher on the hog, so to speak, with that new “crop,” so you agree on a deal – one pig for one year’s harvest of her future “crop.” Despite the lack of a “stock market,” “crops” are now trading at a P/E of 1 X pigs. One pig equals one future year’s worth of your ex-buddy’s bountiful harvest. Well the months roll by and one thing leads to another, and for some reason you want some more of your neighbor’s “crop.” Maybe it’s marijuana and the island has just legalized it for medicinal purposes. Let’s just say. And let’s say you’re willing to part with another pig for another share of medicinal “weed.” Neighbor, sensing enthusiasm, says, “No, it’ll cost you three pigs,” which is all you have, but you’re feeling high and certainly very hungry so you say OK. This funny smelling “grass” now sells at 3 X pigs, or a pigs-to-“grass” P/E ratio of 3/1 and everybody’s happy. Until … well … to get back to the real world, those piggies have really been credit or cash substitutes all along, and now in order to keep this system going you need more pigs or more credit in order to continue. But you’re out of pigs. A funny thing now happens in this capitalistic South Sea island and mainly to the price of marijuana. It traded last year at 3 pigs to 1, but since you’re out of pigs and credit, the price collapses. Grass goes to zero because there is no more credit; you have no more pigs to pay for it.

So for those of you who don’t live in Washington State or Colorado or others who are a little miffed at this example, let’s just put it this way. P/Es of 3 or P/Es of 15 or P/Es of 0 are intimately connected to the amount of available credit. So are interest rates. If there was only one dollar to lend and someone was desperate to have it, the interest rate would be usurious. If there was one trillion dollars of credit and no one was eager to borrow for some reason or another, then the rate would be .01% like it is today and for the past five years in my personal money market account. The amount of credit and its growth rate are critical to asset prices, and of course asset prices in our modern economy are critical to growth and job creation and future prospects for investment. We have a fiat/credit/debt-based economy that depends on the continuous creation of more and more credit in order to thrive and some would say – even survive. We need those pigs and more of them. And they need to circulate and be traded – what some would call “velocity” – in order to keep the economy growing. Our South Sea island economy never did change until the new crop was discovered, but concurrently, not until the pigs started to be traded for it.

Bill Gross then ended his note with a warning and a quick summary:
So our PIMCO word of the month is to be “careful.” Bull markets are either caused by or accompanied by credit expansion. With credit growth slowing due in part to lower government deficits, and QE now tapering which will slow velocity, the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume. Perhaps the whisper word of “deflation” at Davos these past few weeks was a reflection of that. If so, high quality bonds will continue to be well bid and risk assets may lose some luster. In any case, don’t be a pig in today’s or any day’s future asset markets. The days of getting rich quickly are over, and the days of getting rich slowly may be as well. Most medieval, perhaps.
Most ‘Medieval’ Speed Read

1) Asset prices depend on credit creation and expansion.

2) The U.S. and other countries create less credit from the public standpoint as their deficits decline.

3) 3–4% credit expansion in the U.S. may not be enough to maintain 3% growth, especially if asset prices go down and velocity is affected.

4) Don’t be a pig in a highly levered global marketplace.

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