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Investment P IM :COOutlookFebnta ry

The Ring of FireInvestment management is a privilegedprofession - not just for being paid byX-times what you're really worth tosociety, but from the standpoint of longevity. If you're good, and you at leastgive the impression that you still havemost of your faculties, you can literallyhang around forever. James Carville,the well-meaning but evil-look in' guyfrom the Clinton Administration onceremarked that in his next life he'd liketo come back as a bond manager. Hehad part of it right - the influence, thewealth, and even fame - but there wasno need to imagine himself as somecryogenically preserved Wall Streetversion of Ted Williams - he was youngenough at the time to make the leapand still have a 20-year career ahead ofhim. Other professions do not affordsuch opportunities - the gold watchat 65 is not only symbolic, but a statement in most professions that says youare more or less washed up. Athleteshave at most 20 years and musicians

seem to have that brief window of creation as well. The Beatles, for instance,were done after a decade's time. Paul isstill writing songs, but the magic clearlydisappeared in the 70s and now hisconcerts are "garden parties" of remembrances as opposed to creation.

What I think is close to unique aboutinvestment management is that it'sreally about the stewardship of capitalmarkets, and that time weeds out theimpostors, leaving the aging survivorsto appear as wise and capable of guidingclients through the next crisis - whatever and whenever it might appear. Thatassumption has some logic behind it, butcritically depends on the investor trulyenjoying the game and - of course holding on to at least a few billion braincells that keeps him from being obviously senile or at least being accused ofhaving "lost it." An investment managerat 65 fears both. I remember havingmet John Templeton on the set of Wall


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Street Week nearly 20 years ago. I wasa young buck and he was - well - onthe downside of his career. About theonly thing he could tell Rukeyser, itseemed to me, was to cite the rule of 72and proclaim that stocks and the Dowwould be at 100,000 by 2030 or something like that. Now, approaching thatsame age, I'm a little more unders tanding and a little less young-buckish. Ifthat was his only lesson, then it was apretty good one I suppose - Dow 5,000and the New Normal notwithstanding.And despite the strikingly prematuredeparture of Peter Lynch and the transition of George Soros to philanthropicpursuits, there are some great examplesof longevity in this business. WarrenBuffett, of course, comes immediatelyto mind, as does Dan Fuss of LoomisSayles, who may wind up as the BearBryant or Adolph Rupp of the bondbusiness. Peter Bernstein, who passedaway but a few months ago, was a brilliant writer and commentator on theinvestment scene well into his 80s. Sothere's hope for you still, James Carville,and, I suppose, for me as well. It'squite a privilege to be a "steward of thecapital markets," to have done it well forso long and to still be able to walk up

to the plate and face a 95-mile-an-hourfastball. Or, is it a curve? Time will tell.

There have been numerous change-ups and curve balls in the financialmarkets over the past 15 months or so.Liquidation, reliquification, and the substituting of the government wallet forthe invisible hand of the private sectordescribe the events from 30,000 feet.Now that a semblance of stability hasbeen imparted to the economy and itsmarkets, the attempted detoxificationand deleveraging of the private sectoris underway. Having survived due toa steady two-triUion-dollar-plus doseof government "Red Bull," Adderall, orsimply st rong black coffee, the globalprivate sector is now expected by someto detox and resume a normal cyclicalschedule where animal spirits and thewillingness to take risk move front andcenter. But there is a problem. Whilecorporations may be heading in that direction due to steep yield curves andgovernment check writing that havepartially repaired their balance sheets,their consumer customers remain fullylevered and undercapitalized with little

.hope of escaping rehab as long as unemployment and underemployment remai

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at 10-20% levels worldwide. "Build it andthey will come" is an old saw more applicable to Kevin Costner's Field of Dreamsthan to today's economy. "Say's Law"proclaiming that supply creates its owndemand is hardly applicable to a modemday credit-oriented society where creditcards are maxed out, 25% of homeownersare underwater, and job and income creation are nearly invisible.

In this New Normal environment it isinstructive to observe that the operative word is "new" and that the use ofhistorical models and econometric forecasting based on the experience of thepast several decades may not only beuseless, but counterproductive. Whenleveraging and deregulating not onlyslow down, but move into reverse gearencompassing deleveraging and reregulating, then it pays to look at historicalexamples where those conditionshave prevailed. Two excellent studiesprovide assistance in that regard - thefirst, a study of eight centuries of fi-nancial crisis by Carmen Reinhart andKenneth Rogoff titled This Time isDij/,erent, and the second, a study bythe McKinsey Global Insti tute speaking to "Debt and deleveraging: The

global credit bubble and its economicconsequences."

The Reinhart/Rogoff book speaks primarily to public debt that balloons inresponse to financial crises. It is a voluminous, somewhat academic productionbut it has numerous critical conclusionsgleaned from an analysis of centuries ofcreditor/sovereign debt cycles. It states:

1) The true legacy of banking crisesis greater public indebtedness,far beyond the direct headlinecosts of bailout packages. Onaverage a country's outstandingdebt nearly doubles within threeyears following the crisis.

2) The aftermath of banking crisesis associated with an average increase of seven percentage pointsin the unemployment rate, whichremains elevated for five years.

3) Once a country's public debtexceeds 90% of GOp, its economic!l:0wth rate slows by 1%.

Their conclusions are eerily parallel to events of the past 12 months andsuggest that PIMCO's New Normal mayas well be described as the "time-tested

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for six to seven years.2) In about 50% of the cases the de

leveraging results in a prolongedperiod of belt-tightening exertinga significant drag on GDP growth.In the remainder, deleveragingresults in a base case of outrightcorporate and sovereign defaultsor accelerating inflation, all ofwhich are anathema to an investor.

3) Initial conditions are important.Currently the gross level of publicand private debt is shown in Chart 2.

Sixteen Ton2009Country Total Debt(% 01 GOP)

India 129Brazil 142China 159Canada 259Germany 285United States 300United Kingdom 466Japan 471

Source: McKinsey Global InStit uteChart 2

Initial conditions are important becausethe ability of a country to respond to afinancial crisis is related to the size ofits existing debt burden and becauseit points to future financing potential. Is it any wonder that in this NewNormal, China, India, Brazil and other

Who's Riskier?120 Government Debt as a % oJ GOP100

- 80 Ic: 60

40

20 -+-...........

Advanced CountriesOeveioptng Countries

o - - - . - - - . - - - - . - - - ~ - - _ . - - - - 200 6 2007 200 8 2009 20 10 20 14

Source: DB Gtobat Malkets Research, tMFChart 3

developing economies have fared farbetter than G-7 stalwarts? PIMCO'sNew Normal distinguishes betweenemerging and developed economicgrowth, forecasting a much betterfuture for the former as opposed to thea t t e r . Chart 3 displays a star tling recent

historical and IMF future forecast forgovernment debt levels of developedand developing countries. "Escalating"might be a conservative future description for advanced countries. "Stable"might now be more applicable to manyemerging sovereigns.

What then is an investor to do? If,instead of econometric models foundedon the past 30-40 years, an analysismust depend on centuries-old ex-amples of deleveraging economiesin the aftermath of a financial crisis,how does one select and then time an

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investment theme that can be expectedto generate outperformance, or whatprofessionals label "alpha?" Carefullyand cautiously with regard to timing, Isuppose, but rather aggressively in theselection process under the assumptionthat it's never "different this time" andthat history repeats as well as rhymes.Reinhart and Rogoff's book, if anything,points to the inescapable conclusionthat human nature is the one definingconstant in history and that the cyclesof greed, fear and their economic consequences paint an indelible landscapefor investors to observe. If so, then investors should focus on the following30,OOO-foot observations in the serectionof global assets:

1) Risk/growth-oriented assets (aswell as currencies) should bedirected towards Asian/developing countries less levered andless easily prone to bubbling andtherefore the negative deleveraging aspects of bubble popping.When the price is right, go wherethe growth is, where the consumer sector is still in its infancy,where national debt levels arelow, where reserves are high, and

where trade surpluses promiseto generate additional reservesfor years to come. Look, in otherwords, for a savings-orientedeconomy which should graduallevolve into a consumer-focusedeconomy. China, India, Braziland more miniature-sized examples of each would be excellentexamples. The old establishedG-7 and their lookalikes as theydelever have lost their position asdrivers of the global economy.

2) Invest less risky, fixed incomeassets in many of these samecountries if possible. Because oftheir reduced liquidity and lessdeveloped financial markets,however, most bond money muststill look to the "old" as opposedto the new world for returns. It istrue as well, that the "old" offer amore favorable environment fromthe standpoint of property rightsand "willingness" to make interepayments under duress. Thereforesee #3 below.

3) Interest rate trends in developed markets may not follow thesame historical conditions observed during the recent Great

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Moderation. The downward pathof yields for many G-7 economieswas remarkably similar over thepast several decades with exception for the West German/EastGerman amalgamation and theJapanese experience which stillplaces their yields in relative isolation. Should an investor expect asimilarly correlated upward wavein future years? Not as much. Notonly have credit default expectations begun to widen sovereignspreads, but initial conditiondebt levels as mentioned in theMcKinsey study will be important as they influence inflationand real interest rates in respective countries in future years.Each of several distinct developedeconomy bond markets presents interesting aspects that bearwatching: 1) Japan with its agingdemographics and need for external financing, 2) the US. withits large deficits and explodingentitlements, 3) Euroland with itsdisparate members - Germanythe extreme saver and productiveproducer, Spain and Greece withtheir excessive reliance on debt

and 4) the UK., with the highestdebt levels and a finance-orientedeconomy - exposed like Londonto the cold dark winter nightsof deleveraging.

Of all of the developed countries,three broad fixed-income observationsstand out: 1) given enough liquidityand current yields I would prefer toinvest money in Canada. Its conservative banks never did participate in thehousing crisis and it moved towardand stayed closer to fiscal balancethan any other country, 2) Germanyis the safest, most liquid sovereign alternative, although its leadership andthe EU's potentia l stance toward bailouts of Greece and Ireland must bewatched. Think AIG and GMAC andyou have a similar comparative pre-dicament, and 3) the UK. is a must toavoid. Its Gilts are resting on a bed ofnitroglycerine. High debt with the po-tential to devalue its currency presenthigh risks for bond investors. In addition, its interest rates are alreadyartificially influenced by accountingstandards that at one point last yearproduced long-term real interest ratesof 1/2 % and lower.

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The last decade - the "aughts" - wereremarkable in a number of areas: joblessrecoveries in major economies, negativeequity returns in U.S. and otherdeveloped markets, and of course thefinancial crisis and its aftermath. If aninvestment manager and an investmentmanagement firm proved to be goodstewards of capital markets during theturbulent but vapid "aughts," they maybe granted a license to navigate therapids of the "teens," a decade likelyto be fed by the melting snows of debtdeleveraging, offering life for unleveredemerging and developed economies,but risk and uncertainty for thoseoverfed on a diet of financed-basedconsumption. Beware the ring of fire! ...William H. GrossManaging Director

Ifr 'o

Past performance is not a guarantee or a reliable indicator of future resuits. Ill vestillg in tile bond market is subject to certaillrisks including market, illterest-rate. issuer, credit. alld int7ation risk; investmmts may be worth 1II0re or less thal1 the original costwi/ell redeemed. Investing ill foreign denom illated IIIld/or domiciled securit ies may illllolve heightened risk due 10 ClIrrellcy}1uctllLltions,alld ecollomic and politiCilI risks, which may be ellhall ced ill emerging markets.Tlris article conta ills the Cllrrellt Op illiollSof tire allthor bllt Ilot necessarily those of tile PIMCO Group . The author's opinion s are subjectto change wi t/lOut notice. This article is distributed for informational purposes ollly. Forecas ts, estimates, and certain illformationcontained hereill are ba sed uponl'roprit'lary research and sholiid not be considered as illvestment advice or a recoll1mendatioll ofllllYpartielliar secllrity, strategy or investment product . II rjonllation cOlltained herein has been obtained rom SO llrces believed fa be reliable,bllino t Xl/aranteed. No part of this article may be reproduced In any/orm, or referred to ill any other p"blication , Wit/lOllt expresswri tten permissioll of Pacific Investment A,flllragelllent Company LLC. 201O, PIMCO. 10091-012010.

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