Curious Capitalist

Is There a Reckoning Coming Thanks to Quantitative Easing?

Bond trader PIMCO believes the Federal Reserve's quantitative easing will have dire long-term effects on the ecoomy

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Bloomberg via Getty Images

Bill Gross, co-chief investment officer of Pacific Investment Management Co., doubts the economic viability of QE3.

Federal Reserve rune reading is serious business for a lot of big name investors. So I was interested to note that yesterday, when the minutes of the last Federal Reserve meeting held on October 23 and 24 came out, it pointed to yet more money injections into the economy, as part of a process that’s known as “quantitative easing.” QE has made anyone who owns stocks richer in the last year, buoying the market and helping hike up consumer confidence. If we’re reading the runes correctly, it looks like Ben Bernanke and his team are going to keep buying bonds well into next year in an effort to keep that good feeling going.

The news coincides nicely with my new feature in the latest issue of Time magazine on the oracles at the world’s largest bond trader PIMCO — Bill “the Bond King” Gross and his heir apparent Mohamed El-Erian, both of whom are very, very worried about the effects of this Fed-induced market sugar high, and what it might do to the economy in lieu of real economic growth. To put it simply, if quantitative easing is a big wave that investors ride, two of the best surfers in the business are saying, “get out of the water.”

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To understand why, you have to understand how PIMCO, like everyone else in the market over the past few years, has been riding the crest of money funneled into the economy by the Federal Reserve, which has, through its three rounds of quantitative easing, been buying vast quantities of U.S. bonds and, more recently, mortgage-backed securities. That’s one reason the stock market took off earlier this year, as the Fed’s moves pushed buyers into riskier assets like equities. PIMCO, which manages nearly $2 trillion, has surfed this money wave well: its flagship Total Return Fund has trounced its category over the last 5 years, returning 9.7 percent alone this year, nearly 3 percentage points more than comparable funds.

Yet PIMCO has grown wary of the wave—and maybe you should be too. Gross recently stunned the markets by calling equities a Ponzi scheme and warning investors they will never see 6% real returns again and would be lucky to get 3%. Gross and El-Erian believe there will ultimately be a price to pay for the Fed’s money infusion in the form of return-eroding inflation and other economic distortions. When that happens, real growth (already sluggish) will stagnate further, borrowing costs will skyrocket, stocks will swoon, real estate will struggle and consumers will hunker down. It will be like the 1970s but withless room for productivity gains. All this is compounded by the fact that finance as a fuel for capitalism is tapped out. Growth-killing inequality is growing. The rich aren’t paying enough taxes, especially in an era when lower returns will change retirement plans for millions. Without major policy changes, Gross and El-Erian believe, the U.S. won’t have the mojo to grow beyond a 2% economy anytime soon.

But we all have to put our money somewhere. So, given this downer of a forecast, how are we supposed to invest? Keep it real, says the PIMCO team. “What we try to do is tell clients, `Almost anything that we do in the future won’t be as high-returning as what you are used to,’ says Gross. “The double-digit returns, which are the result of both credit expansion and the wave of [globalization and growth] since the 1970s are in the past. And everything — whether it’s a stock or real estate and certainly bonds — is going to be lower returning, simply because it’s all been brought forward by zero interest rates and the Fed. So, how do we navigate in that environment? We look for the cleanest dirty shirts.”

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And what are they, you might ask? Pick up the latest issue of Time magazine to find out, and check out my PIMCO feature, along with Bill Gross’ investment picks and pans.