Gross advises the Fed to use Ray Dalio’s brilliant model
In his September 18 interview with Bloomberg, legendary fund manager, Bill Gross discussed the Fed’s decision to delay the liftoff. He also advised the Fed to use Ray Dalio’s brilliant model instead of the Phillips curve and the Taylor rule that are usually used to measure economic data to serve as guidance for monetary policy action. In his Investment Outlook for October 2015, Gross comments that the Fed is “accustomed to Taylor Rules and Phillips Curves” and that “their commentary is almost obsessively focused on employment statistics and their ultimate impact on inflation.”
On the other hand, Gross has a different view of how the economic machine works. In his interview with Bloomberg, Gross stated his view that “every asset price is artificially elevated.”
Discounting at a lower rate leads to higher asset values
Let’s understand what Gross means by this. The value of an asset can be looked at as the sum of its expected future cash flows, discounted at investors’ acceptable rate of return—also known as the “IRR” (internal rate of return). Investors’ expectations of returns are lowered in a low-interest rate environment. This leads to a lower IRR. As a result, asset values soar when interest rates are low.
For example, an investor expects to generate a 10% return annually from his asset. If this return amounts to $100,000, all else constant, the asset would be valued at $1 million—100,000/0.10. Now, suppose that the investor’s required rate of return was 8%. The asset would now be worth 100,000/0.08—this is $1.25 million. Take a situation when the interest rates in the economy are zero-bound. The investor would still be optimistic to expect a 2% return. At this discount rate, the value of the asset immediately rises to $5 million.
With the US equity (SPY) (SPXL) (SPXS) (VOO) and real estate (IYR) (VNQ) markets doing well over the past five years, let’s move on to assess the situation in the US from Gross’ asset price elevation angle.