bill gross investment outlook jul_04

8/14/2019 Bill Gross Investment Outlook Jul_04

1/5

InvestmentOutlookBillGross

July 2004

Back to the Garden

We are stardust

We are golden

We are billion-year-old carbon

And weve got to get ourselves

Back to the garden

Woodstock: Crosby, Stills and Nash

The Earth can be a cold orb, especiallywhen viewed from a scientists instead of atheologians eye. Copernicus, for example,squashed the concept of our planet as thecenter of the universe surrounded by Godsheavens, Darwin introduced doubt as tothe factual instead of the mythologicalconcept of Adam and Eve, and in the early70s, many academics were even proclaim-ing that God was dead admittedly ametaphor in itself, but cold and frighten-ing nonetheless. It is refreshing, thereforein this modern age of singularities, string

theory with its twelve dimensions, andquantum physics posing the now its there,now its not phantasm to read a bit of sci-ence that offers some hope as to life and thehereafter if only in an atomical sense.

Author Bill Bryson in his bookA ShortHistory of Nearly Everything illuminates well just about everything you everwanted to know about science. His chap-ter on the Mighty Atom speaks to the

reincarnation of the body, not in a Bud-dhist or even a Catholic sense of the bodytranscending to heaven, but from a purelyscientic perspective. We are all reincar-nations though short lived ones, he/thescientists claim. When we die our atomsdisassemble and move on to nd new useselsewhere as part of a leaf or other hu-man being or drop of dew We are eachso atomically numerous and so vigorously

recycled at death that a signicant numberof our atoms up to a billion for each of us,probably belonged once to Shakespeare.A billion more each came from GenghisKhan and Beethoven although to be fair,we are not yet one with Elvis leave that toour great grandsons and granddaughters.Turns out I guess that David Crosby in hislate 60s golden oldie cited above was rightafter all: We are stardust, we are golden,even if were not yet Elvis.

Still this realization, while fascinating,

leaves me as frozen as a molecule of H2Oin a Sub-Zero unless one takes the addi-tional leap from the cold hard scientic factto the metaphysical. Seems that Crosby,Stills & Nash did as well: in their songsnext line they proclaim that weve got toget ourselvesback to the Garr arr arr arrdeeeeen. (they stretched out the Gardenpart dear reader in case you forget thesong). My rst thought when contemplat-ing these words at 60 was one of sheer

envy. How did they gure it out in their20s and Im heading into my fourth scoreof years and just now getting a clue? But Idigress. What was it about the mythologi-cal Garden of Eden that they wanted to getback to and what does it have to do withstardust? Well, as American author andteacher Joseph Campbell points out, theGarden was a place of oneness, of unity,of no divisions in the nature of people or


2/5

Investment Outlook

July 2004

things. And as Bryson elaborates, were allmade from the same atoms Beethovens,Shakespeares, Alpha Centauris: stardust.Understanding that scientic fact can atleast point us in the direction of the Gar-den. By nding it again, perhaps we wouldexperience a oneness with nature andthings, and just as importantly, a onenesswith each other. How dare we beheadhostage after hostage in Iraq. How darewe kill ourselves in Jerusalem and Gazawith the Garden so tantalizingly nearby.How dare we suffer Somalia and Sudanwith hundreds of thousands of us deadfrom tribal genocide. How dare we

(ll in your own). We are allstardust, we are all golden, and weve gotto get ourselves back to the Garr arr arrarr deeeeen.

Well, I being you and you being me, Iguess we created quite a stir with ourinterview printed in the Financial Times afew weeks ago. Like the doomsayers weare, we stated that the global economy wasmore imbalanced than at anytime in thelast 25-30 years (the early 70s and the fallof Bretton Woods, the rise of OPEC, and

the slicing of the U.S. stock market in halfbeing the supercedent). That thought wasa direct offshoot from our May Secular Fo-rum and the Circus Game/wire walkingtheme in last months Investment Outlook.Still a little further elaboration might be inorder as we try to get ourselves back to theGarden of investing, searching for oneness,and the Holy Grail of the perfect portfolio.

It seems to a lot of economists/investors

that weve rarely been in a more balancedeconomy. GDP in the U.S. is growing at 4%;productivity is high; ination is low; jobgrowth is resuming. Well yes for now.But my comments were a precautionaryfoghorn on a sea with a seemingly clear

horizon, suggesting that if the weatherchanged then a nancial and economicshipwreck was a possibility. But forecast-ing Armageddon is a tricky business.Mankinds indominatably optimistic spirithas a habit of postponing foggy days untilthe gloomsters warnings and ultimatesanity is called into question. Crying wolfmust be done infrequently and with rela-tively precise timing to be effective. I shalltry to follow my own advice.

The debate I helped foster over a balancedvs. imbalanced global economy revolvesaround the fundamental propositionthat bad things can happen in a leveredeconomy. Think of two garages one withtwo cars and an immaculately swept oorand the other lled with boxes, newspa-pers, paint cans and numerous oily rags.Which one do you think has the betterchance of going up in ames if a match ora faulty electrical wire creates Fahrenheit451? That is an apt metaphor in economicterms when comparing a healthy non-debt ladened economy to one thriving onthe creation of paper and articially lowinterest rates. To be realistic, the possibility

of matches and faulty wiring is ever-pres-ent and in retrospect, historically obvious.Geopolitical events such as the rise ofOPEC in the 1970s, the Vietnam War, and9/11 have always served as inationaryand in some cases recessionary sparks inan economic context. And scal and mon-etary policy mistakes surrounding theseand other independent cyclical trends haveaccentuated the damage. No Fed Chair-man, or President intent upon reelection

has ever been immune to minor and insome cases grievous errors of judgment.Rates too high or too low for too long forinstance; decits or scal surpluses atexactly the wrong time in the businesscycle for another. But a geopolitical or


3/5

policy match can be thrown onto a spotlessgarage oor with little chance of a majorcalamity. With debt laden oily rags strewnthroughout, however, the probabilitieschange. The chart depicted below and asshown in previous Investment Outlooks,therefore, is our major sin and largeststumbling block in any attempt to get backto the Garden of economic prosperity andattractive investment returns.

The commonsensical explanation as towhy, revolves around the observation thatdebt as opposed to equity requires anobligation to pay principal at maturity,interest periodically and when theres toomuch of it the burden can be crushing ifyields rise for geopolitical, policy mistake,or other imaginable reasons one as sim-ple as higher ination for instance. In ad-dition, problems arise when the maturityor distribution of the debt becomes imbal-anced. Too much short-term as opposed tofunded long-term debt has caused many apersonal, corporate, and in some cases sov-

ereign bankruptcy. And debt in the handsof benevolent instead of self-interestedcreditors can be crucial. Americans used toplacate themselves with the adage that weowe it to ourselves when confronted withmounting public decits. Such was the case

in the 30s, the burden of which was ratheranemically molted away by subsequent in-ation in the midst of interest rate ceilingsimposed during WWII and its aftermath.But when over 50% of outstanding Federaldebt is held by foreign creditors, then therules of the game can change. Global cur-rent account imbalances reected in ourongoing 5% of GDP trade decit speak todollar depreciation as a legitimate responseto placate foreign creditors in need of a

higher currency adjusted returnon their investments. And if thatdollar depreciation is signicant,swift or both then economicand nancial repercussions canfollow a similar path.

The consequences of higher inter-est rates mentioned above can bedestabilizing as well. Its soberingto contemplate that not only hasour current cyclical prosperitybeen due to the productivity oflower interest rates in a nance-

based, debt-laden economy, but thatthe reversal of yields must be more thandelicately manipulated in order to prevent

reciprocal damage and global economicinstability. I use the term global in this con-text more than guratively. The reality isthat almost all the worlds signicant cen-tral banks save the ECB have begun or arein the process of monetary policy reversaland many do so within an environmentfraught with substantial debt and thereforerisk. Englands Monetary Policy Commit-tee is already on the march upward in aneffect to cool speculative housing apprecia-

tion. With home prices ultra-sensitive toshort-term rates, however, they could gotoo high or stay too low, with their domes-tic economy swaying in the balance. Japanis contemplating an exit from their ZRPor Zero Interest Rate Policy. Talk about a


4/5

840 Newport Center D

Newport Beach, CA 9

949.720.

foggy horizon! With so much governmentdebt held by so many domestics banksand insurance companies, their centralbank could technically bankrupt their ownnancial sector by too precipitous a movewhich would sink JGB prices and assetvaluations at these institutions. Japans newfriendly neighbor to the west China hasa pickle with their own short-term ratesand eventual revaluation of the RMB vs.the dollar. Chinas banks themselves havean excess of low quality loans supportedby a thin thread of mercurial equity. Andthen theres the Fed. Wednesdays interestrate hike is just the beginning of a journeyas to who knows where or when. Not onlyour housing market, but the nanced-based prots (40% of all prots as shownbelow) of American corporations are atrisk. This in turn speaks to the stock mar-ket, P/E ratios, and wealth/paper-basedprosperity, that depend on the continuedlow cost of excessive debt taken on inrecent years.

Because of these realities based on histori-cally high levels of debt issued during aperiod of supercially low interest rates,the global economy is indeed in my view,more vulnerable than it has been for thepast 25-30 years. The economic and in-vestment consequences appear to be asfollows: real short-term rates kept too lowwill create asset bubbles and accelerat-ing ination. Real yields raised too highwill pop existing asset bubbles and leadto economic recession. The Goldilocksyield is the only one that speaks to rela-tive stability, and the margin for error ismuch narrower than in prior decades. Ifbond investors are accepting of this thesis,they must acknowledge the uncertainty oftheir own portfolio structures. Accelerat-ing ination speaks to defensive durationsand a healthy dose of TIPS. But potentialrecession at some point speaks to extendeddurations and a reemphasis on deation-ary preventative interest rate policies simi-lar to the past 24 months. While Greenspan

speak points towards gradualand measured hikes to return to amore neutral interest rate policy,he as well as other global central

bank chieftains must acknowledgethat neutral in a levered globaleconomy is a yield shrouded by fogand fraught with uncertainty. TheGarr arr arr arr deeeeen of nan-cial and interest rate Eden is outthere somewhere but getting back toit may be almost as difcult as thereturn to our mythological one lledwith oneness, unity, and love for oneanother.

William H. GrossManaging Director

0%

4%

8%

12%

16%

20%

24%

28%

32%

36%

40%

44%

48%

Financial Sector Breakdown

Source: Bianco Research, L.L.C.

Ma

r-77

Jun-78

Sep-79

Dec-80

Ma

r-82

Jun-83

Sep-84

Dec-85

Ma

r-87

Jun-88

Sep-89

Dec-90

Ma

r-92

Jun-93

Sep-94

Dec-95

Ma

r-97

Jun-98

Sep-99

Dec-00

Jun-03

Ma

r-02

Sep-04

Financial Sector Profits As A Percentageof All Domestic Corporate Profits

Financial Sector Profits

Consists of credit intermediation and related activities;

securities, commodity contracts, and other financialinvestments and related activities; insurance carriersand related activities; funds, trusts, and other financialvehicles; and bank other holding companies.

Profits = Corporate profits with inventoryvaluation adjustment - excluding"Rest of World"

Source: National Income andProduct Accounts (NIPA)Table 6.16


5/5

Past performance is no guarantee of future results. The graphs portrayed are not indicative of the past or futureperformance of any PIMCO product. This article contains the current opinions of the author and such opinions are subjectto change without notice. This article has been distributed for educational purposes only and is not a recommendation oroffer of any particular security, strategy or investment product. Information contained herein has been obtained fromsources believed to be reliable, but not guaranteed.

The Standard & Poors 500 Composite Index (S&P 500) is an unmanaged index of U.S. companies with market capitalizationsin excess of $4 billion. It is generally representative of the U.S. stock market.

Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. Theguarantee on Treasuries and Government Bonds is to the timely repayment of principal and interest, shares of a portfolio are notguaranteed. Mortgage-backed securities and Corporate Bonds may be sensitive to interest rates. When interest rates rise, thevalue of xed income securities generally declines and there is no assurance that private guarantors or insurers will meet theirobligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-ratedbonds. Investing in non-U.S. securities may entail risk due to non-U.S. economic and political developments, which may beenhanced when investing in emerging markets. Ination-indexed bonds issued by the U.S. Government, also known as TIPS, arexed-income securities whose principal value is periodically adjusted according to the rate of ination. Repayment upon maturityof the original principal as adjusted for ination is guaranteed by the U.S. Government. Neither the current market value ofination-indexed bonds nor the value of shares of a portfolio that invests in ination-indexed bonds is guaranteed, and eitheror both may uctuate.

No part of this article may be reproduced in any form, or referred to in any other publication, without express written permissionof Pacic Investment Management Company LLC. 2004, PIMCO.

bill gross investment outlook jul_04

Documents