Investment Line: Buy selectively in US and core Europe, avoid UK

Bill Gross believes individual countries can escape a debt crisis by creating even more debt, but only if they meet certain key conditions.

In his latest letter to investors, the Pimco chief outlines the three key tests he is applying:

1. Can a country issue its own currency and is it acceptable in global commerce?
2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?
3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

'These three important conditions render an immediate negative answer when viewed from an investor’s lens focused on Greece for instance,' he says.

First, he says, Greece can’t issue debt in its own currency; secondly its initial conditions and demographics are abominable; and third its central bank – the ECB – believes in positive, not negative, real interest rates.

'Greece therefore must extend a beggar’s bowl to the European Union or the IMF because the private market vigilantes have simply had enough,' he says.

Gross, manager of the world's largest bond fund, Pimco Total Return, advocates a strategy based around selective investment in core Europe, Germany, the US and Brazil. However the UK is still on his 'must avoid' list.

'The reason is that the debt the UK will increasingly issue in the future should lead to inflationary conditions and a depreciating currency relative to other countries, ultimately lowering the realised return on its bonds,' he says. 'If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap. For now though, “crisis” does not describe their current predicament, yet that bed of nitroglycerine must be delicately handled. Avoid the UK – there are more attractive choices.'

Overall, he says, investment strategies should begin to reflect a 'preservation of capital principal by positioning bond portfolios 'on front-ends of selected sovereign yield curves subject to successful reflation (US, Brazil) and longer ends of yield curves that can withstand potential debt deflation (Germany, Core Europe).'

'In addition, as increasing debt loads add impetus to higher real interest rates worldwide, a more “unicredit” bond market argues for high quality corporate spread risk as opposed to duration extension. In plain English, that means that a unit of quality credit spread will do better than a unit of duration. Rates face a future bear market as central banks eventually normalise QE policies and 0% yields if global reflation is successful. Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead. '

You can read Bill Gross's latest investor letter in full on the Pimco website.