01 Jan 2010, Rob Davies, Credit
In an interview with Credit, Pimco's chief investment officer says the UK is "stretching the limits" with its quantitative easing programme.
Since its formation in 1971, global investment firm Pimco, headquartered in Newport Beach, California, has built a reputation for identifying risks quicker than most and taking action to protect its own (and its clients') assets.
In the lead-up to the financial crisis, for example, Pimco warned of the bubble that was building in the US housing market early in 2006. The same year it also questioned the wisdom of rating agencies assigning triple-A ratings to, and investors then buying, highly leveraged structures such as constant proportion debt obligations.
So when Bill Gross, managing director, chief investment officer and one of the founding members of Pimco, says sovereign risk is a legitimate issue, as applicable to the UK and the US as to Greece and Dubai, it is worth taking those comments seriously.
For a fairly conservative fixed income investor such as Pimco, US Treasuries and UK gilts make up a sizeable chunk of its portfolio. But the full cost of the measures taken by the governments of both countries to stabilise the financial system and stimulate the economy are testing the limits of investors in Treasuries and gilts.
Gross says sovereign yields have been artificially compressed in the UK and US because of policies such as quantitative easing. "The UK is keeping on with QE and doesn't seem to want to stop with its programme; at least, it hasn't yet given a hint as to when it wants to stop. The trillions of dollars that have been applied to the medium and longer ends of the curve in both the UK and the US have caused significant compression over what would have been the case under more normal circumstances. We think they are compressed by as much as 50-100 basis points, and that puts the entire bond market at risk," says Gross.
"Sovereign risk is becoming a legitimate topic of discussion even among the big boys, meaning the US, the UK, Japan and selected European countries. The UK is stretching the limits and the US is coming close to that as well. The UK's budget deficit is a reflection of QE, but you can't run a deficit of 13.5%-14% in the longer term. At some point over the next year, sovereign risk and the effect that has on real interest rates and currencies will be an important factor and may dominate the headlines," he adds.
Although Gross does not suggest the UK or the US are heading toward default, he hints allocations to sovereigns will likely shift to countries with smaller deficits, such as Germany.
"The prize of investor funds ultimately goes to the most conservative and fiscally stable countries. Although Germany has a 6% budget deficit, it also has a constitutional amendment that mandates it must achieve fiscal balance within five years. There is nothing in the UK, the US or Japan that even approaches that. As long as investors have a liquid choice within the big four sovereigns, that applies a hammer lock to the other three," says Gross.
Such comments from one of the biggest investors in government bonds will make grim reading, particularly for the UK, which is scheduled to issue £225.1 billion of debt over the 2009/10 fiscal year. In his pre-budget speech in December, Chancellor of the Exchequer Alistair Darling also made reference to an additional of £178 billion in the pipeline. And it isn't just Pimco questioning whether gilts still offer value for money.
"There is expected to be a budget deficit of around 12% of GDP, which is likely to continue for a number of years," says Richard Batty, global investment strategist at Standard Life Investments. "What is worrying is the extent to which domestic and overseas investors will take up that supply. This is in light of the absence of any real change in fiscal policy by the current government. Already the gilt/Bund spread, which had been in the 20-40bp range, is now wider than 60bp. So the market is starting to price in some of these concerns."
The full interview with Bill Gross will appear in the February issue of Credit. Request a free trial before Friday 5th February to get this issue.