bill gross investment outlook may_03

8/14/2019 Bill Gross Investment Outlook May_03

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InvestmentOutlook BillGross

May/June 20

Is That All There Is To A Fire?

Attention K-Martshoppers and theprivate sector ev-erywhere! You have

morphed into a wetlog. Uncle Sam,Uncle Alan, and as-sorted global kin aretrying to light your

re again, but so fartheres been mainlysmoke and very littleheat. Wet logs dont burn very well.

OK, now that Ive got your attention,what could that possibly mean? Well,PIMCOs Secular Forum which meetsannually for three days in May to dis-cuss the fate of the world and the globalmarkets over the next few years, spentmuch of the time talking about rewoodand the use of newspaper, kindling, oreven a blowtorch to get it burning. Thiswas our approach to conceptualizing theplight of policymakers as they confronta post-bubble, debt laden, Americancentric/savings short, nancial imbal-anced, demographically challengedglobal economy. Could government, weasked, re ate the world when the privatesector was hung over, cranky, irritable,and ill disposed to do what it used to do best spend money?

We answered thiscritical secular ques-tion with a meta-phorical response

in rewood termi-nology: Yes, theycould, but wet logsdont burn very well.Sure, policy makerscould keep on ap-plying the kindling low interest rates,increasing scal

de cits, and perhaps even a Bernanke

blowtorch if need be but thats not aself-sustaining re. If anything it leadsto more bubbles and new instabilities.For a re to keep on burning late intothe night you need the logs to catch, andthe worlds economic rewood has longsince been soaked by oversupply andfeeble demand now exacerbated by apost-bubble psychology discouragingrisk taking. Wet logs in economic termsimply slow growth, relatively benign in-

ation, and near historically low interestrates in which carry and roll-down become fundamental to returns and out-performance, TIPS do especially well.It is a world in which stock returns doa slow burn along with everything elseand institutional and individual inves-tors eventually resign themselves to lessheat, and making do with a cup of coffee


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Investment Outlook

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or hot chocolate. Corporations and theirinvestors have for several years now beenmaking like Jim Morrison and implor-ing policymakers to light their re andrestore pricing power. They will, but at

our secular horizons end, Morrison mayin turn change his sex and morph into amellow version of Peggy Lee, wailing Isthat all there is to a re? To nd outwhy, cuddle up with any blankets youcan nd and listen to our following pyro-technical discussion of a global economywhose fate is still in the balance.

Historical Secular Review

To start at the beginning folks, let me justsay that this re starting stuff is prettycomplicated. For three days, over 100Secular Forum participants along withguest presenters economist MartinFeldstein, PBGCs Executive DirectorSteven Kandarian, Strategist Rob Arnott,and authors William Greider and KevinPhillips went back and forth on budgetde cits, currency devals, various esti-mates of real interest rates, trade de cits,post 9/11 syndrome, SARS, Iraq, and theappropriate value of the Renminbi. Justpronouncing Renminbi (RMB) is hardenough when youre 59 like yours truly.Thank goodness we were well stockedwith some cosmopolitan, currency-savvy MBA draft picks to show a few of uswhere the matches were stored.

In any case, let me attempt to outline assimply as possible the global economysprimary problem: It suffers from a lack of aggregate demand and too much sup-ply. Because of globalization and Chi-nese overproduction; because of high

debt levels and its suffocating impacton business investment and personalspending; because of a creeping, almostimperceptible demographic muting of consumption in aging societies such as

Japan, Germany, and Italy; because of market bubble popping and the nega-tives of receding wealth; because of thedragnet of post 9/11 and now SARS, be-cause of all of that and more we live ina world where we have too much rela-tive to what we can afford to, or want tospend.

Current Outlook

If you accept this PIMCO economic axiom, then certain private sector behavior becomes more understandable. In orderto get out from under the 16-ton sledge-hammer of debt, companies use cash

ow to build reserves or retire bonds they dont invest. Consumers beginto put away money instead of spend,which was the pattern of the late 90s.And the combination induces a negativespiral or vicious cycle of even more conservative behavior including job layoffswhich leads to muted growth in person-al income. In combination, this privatesector response to a high debt, reducedwealth, increased risk laden economicenvironment can produce a slowdownor even a recession Japan off and onfor years now, the U.S. in 2001/2002,Europe in 2003. This sometimes volun-

tary, sometimes imposed economic dietis graphically displayed in the chart onthe following page.

As the U.S. private sector retrenches toa more normal historic average level of


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total savings, it necessarily acts as aneconomic drag it throws more wateron the logs. Were we to return to typi-cal peaks of the past 30 years near 4% of GDP, then real growth will be reduced by 1% annually over our 3-5 year secu-lar time frame, relative to what it wouldotherwise have been.

This self-imposed, squirrel-like behav-ior, which retrains the savings center inour societal brains, may be exacerbated by enforced changes in governmentre-regulation typi ed in the pension ac-counting area. Britains new accountingstandard, FRS17, seems likely to becomemore of a global norm, compellingcompanies to value their pension assetsat current market prices. In additionnew more conservative future returnassumptions may ush global corporatepension funds out into the open, show-ing underfunding at levels such as theU.K.s displayed on the following page,or even worse.

Steven Kandarian, our guest speakerfrom the PBGC, estimates the U.S.private pension system is under water by over $300 billion. Public sector plantotals make the number much worse.So expect tens of billions of future cash

ow to be diverted into bonds andnot productive plant and equipment

payback time wet logs for the nextfew years, although long term, healthypension plans and corporate balancesheets are the foundations for eventualrecoveries.

Then there is the problem of our grow-ing current account de cit, a mysteri-ous chicken and egg conundrum thatstirs intense debate but little commonsense or logic. The fact is that we areoverspending by nearly 6% of GDP thats what a trade de cit means. To acertain extent, that number is re ectedin Chart 1, but heres the point. Movingtowards trade account balance/return-ing to a private sector savings mode can

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1947 Q1 1954 Q3 1962 Q1 1969 Q3 1977 Q1 1984 Q3 1992 Q1 1999 Q3 2007 Q1

U.S. Private Sector Financial Balance 1947-2007, % of GDP

Source: US Flow of Funds data, NIPA tables, LSR calculations for period 2002 Q4 to 2007 Q4Lombard Street Research Monthly International Review 125

Chart 1


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Investment Outlook

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be either voluntary or forced. If we dontgo there on our own, eventually theworld via a depreciating dollar, a saleof our widely foreign owned stocks and bonds, or both, will impose an in ation-ary tax or a negative wealth effect thatwill mandate the savings via reducedconsumption. The U.S. over the next 3-5years may still be the strongest non-Asian economy in the world but it will by no means be a locomotive.

That negative might be mitigated of course if some able and willing globalcompetitor would step up to the plateand lead some country or sector withdry rewood undrenched by highdebt, slowing demographics, and over-powering regulation. There are fewcontestants. Euroland is plagued by anaging work force, regulatory webs of

unfathomable complexity, ounderingnancial institutions, a straightjacket

called the Stability Pact, and a cen-tral bank obsessed with the rear viewmirror mirage called in ation. Japanis a basket case whose only investmentopportunity might be to buy its stockswhose prices cant go much lower. Chi-na is advanced by some as the GreatAsian Hope, but it is still more of aproducer than a consumer. As noted inlast years review, China is a signi cantde ationary in uence. It (and India)makes the logs in the U.S., the U.K., andEuroland even wetter by hollowing outour manufacturing and services indus-tries, leaving us less and less to exportexcept for our paper assets.

The entire globe of course is shrouded by geopolitical veils emanating from 9/11.

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Short On Promises

Estimated UK pension funding level for FTSE 100 companies, %

2001 2002 2003

Source: UBS Warburg, The Economist

Chart 2


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Consumer and business con dence isperiodically exposed to terrorist shocks,or unilateral U.S. decisions as to currentor future evil doer national behaviorand our self-imposed remedies. Preludes

to war seem to be far more con denceinhibiting than the short afterglow of their conclusion. One signi cant ter-rorist attack in future months or yearscould be economically calamitous. Andairline travel/tourism, already affectedfor 20 months by fear and securitymeasures surrounding the World TradeCenter attacks is now doubly vulnerableto the perceived plague of SARS. This

is not the normal world we once knewand believed in at the turn of the mil-lennium. Drying these logs will take anextended period of sunshine or perhapsgovernment sector kindling of bon remagnitude.

That bon re, of course, has been burn-ing for some time now. Last yearsSecular Outlook, and summaries (en-

treaties) by PIMCOs Paul McCulley inthe past 12 months have aptly describedthe transition of in uence (and power)that takes place during periods of pri-vate sector malaise. Budget surplusesare turned into de cits with the tap of alegislative wand. Short-term real inter-est rates drop to 0% levels or below.While all central banks are not createdor conceived equally, its fair to say thatmonetary gasoline is being poured onthe global economys wet logs in signi -cant quantities. Greenspan has peggedthe Fed Funds rate at 1 %. That is anominal rate, which when adjusted forcurrent in ation of about 2 % convertsto a negative real fed funds rate of -1%.

Similarly, the ECB is at 2 % nominalor about 0% in real terms. The Japanesecentral bank is, of course, nominally if not absolutely UNREAL. Add to all of this the vow by the Feds Bernanke and

now Greenspan to defeat de ation atany cost with any means and you geta sense as to the re power at theircommand.

Fiscal policy is proactive too, althoughheld back in Euroland by the (3% maxde cit) Stability Pact and in the U.S. byClintonian advocacy of a decade past,which ascribed the miracle of the New

Age Economy to balanced budgets. Japan has its limits as well, less theyrisk a rating agency downgrade close to junk bond status. But we expect more

scal gasoline in future years from eachof these burdened economic societies.$500 billion+ will be the U.S. standard; asee no evil fudge of the Stability Pactwill be Europes. For Japan, changes arealways out there somewhere.

So government is ghting back, and before we morph from Jim Morrison toPeggy Lee, we must critically ask whatkind of re will this be a few yearshence? Standard cyclical economistsand restarters answer that it will bea pretty hot one Greenspan certainlytalks that way as he points to a NewAge Economic revival. We are less op-timistic for all of the reasons cited thathave provided and will maintain wetlogs. We see 2-3% in ation in the U.S.and 2-3% max real growth over the next3-5 years; 1-2% in ation in Eurolandand 1-2% max real growth, barelyabove the line in Japan. Not much of


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a re. Some emerging market econo-mies may do relatively better as lowerreal interest rates and more aggressivereforms lead to increased reserves anda greater sense of stability. Nonethe-

less, it will be a Peggy Lee world, butthe mellowness of the in ation and realgrowth will mask the potential vola-tility engendered by a levered worlddependent upon nance for its warmth.A system built on the basis of a free

ow of capital can be severely damaged by volatility within the system itself.Peggy Lee never lived in Butler Creek (PIMCOs phrase in the mid-90s for

a placid economy and nancial mar-kets). Our perceived economy may atthe average appear to be an eddy, butthere are rapids on either side. This will be a global economy fraught with risk.Unregulated hedge funds, collateralizeddebt obligations, and poorly structuredderivatives of all kinds that redistributerisk but do not eliminate it portend thelikelihood of another LTCM debacle

at some point. Greenspan is clearly off base in his support of derivatives andtheir medicinal hedging qualities.Leverage cannot ultimately be hedgedin a nance dominated global economywhen interest rates rise. There will be apiper to pay when the restarters runout of fuel.

Investment Policy

So where should you put, how mightwe invest your money in this globaleconomy with insuf cient heat, but morethan enough volatility? With governmentyields at near record lows, we remainconvinced that Treasury bonds salad

days are over no more capital gains but that a bear market may be yearsaway. As critical a question to ask in ad-dition to Is that all there is to a re?is, How long does the Fed (and the ECB

stay low and what is a sustainable realinterest rate in this new environment?Answer that and you have a big pieceof the futures investment puzzle. Ourcurrent supposition is that they stay lowfor several years at least and that a realinterest rate of 1% after that, instead of the historic 2-3% level, may become thestandard. A debt laden, levered globaleconomy cannot stand much in the way

of interest rate hikes. The past few yearsreductions have barely kept us abovewater mortgage re s and all. Just thinkof what happens to housing and hous-ing equalization when the cycle reverses.Economy GONZO.

Bond investors should not be shocked bythis 1% real rate assumption. The charton the following page points out that it

was only during the post-1980 period thashort-term real interest rates were abnor-mally high on a global basis. Periods of disin ation (and certainly de ation) tendto produce high real rates because central banks are squeezing in ation out of thesystem. All other periods including re a-tionary ones have much lower real rates,averaging believe it or not a negative.7% globally for the rst 80 years of the20th century.

This 1% real rate assumption in the U.S.,and even lower elsewhere, is critical because if true, it allows bond portfoliomanagers to pro t not only from thecarry of higher yields of longer duration


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instruments but from what is known asroll-down the mild appreciation of price as a 5-year note matures into a 4-year note at lower yields rising in pricesimply by surviving for 12 more months.This little trick of alchemy that requiresof course a rebalancing and reextension

of maturities at the appropriate periodsend, essentially adds 1% to total Treasuryreturns. In combination with appropriateslightly longer than market durations, anannual return of nearly 5% from Treasur-ies is not out of the question as long asthe Fed stays low and 1% real becomesthe norm. So 5-15 year Treasuries withyield and roll downs are not as bad asthey appear on their yield surface. Thedays of eating salad may be over, but 5%is ample sustenance in a low in ation-ary environment. This secular horizonshould also be an attractive relativeperiod for holding TIPS. Their currentprices depend upon low real interest

rates staying close to existing levels yetthey guard against in ationary excess.

The roll down of risk assets can be cap-tured as well of course, but their wider bid-ask spreads and reduced liquidityforce an analysis of their attractiveness

more on a yield standard as well as theirability to narrow the basis spread toTreasuries. The past few months remark-able rally in credit product, includinghigh yield and emerging market debtmake us more cautious in this area thanwe were 12 months ago when opportunitywas just opening up. Besides, if anotherLTCM or terrorist attack is out theresomewhere in our future, risk assets willhave a good chance of living up to theirname. U.S. stocks in our opinion remainmore than fully valued using dividendyield, Tobins Q, and price to book stan-dards of more rational periods. Europeanmarkets where dividend yields nearly

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Fra Jap Bel Ger AVG Aus Spa Neth UK SAf US Ire Can Swi Swe Den

Real Interest Rates Internationally Pre- and Post- 1980

Percent Per Year

Source: Triumph of the Optimists, Princeton University Press

Before 1980

1980 - 2000

Chart 3


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840 Newport Center D

Newport Beach, CA 9

949.720

match 10-year bond rates (U.K., France)are far more appealing as are many of those in Asia including that of Japan!

Non-U.S. bond markets may still have a

little salad left on the table. The ECB haslagged the Fed and will undoubtedlyhave more rewood to chop in orderto hold their economies above the 0%growth rate line, especially in light of thesuper strong Euro which is a de ationaryin uence on the continent. We are notsigni cant currency investors but despitethe dollars weakness in recent months,there may be more ahead in future years

in order to redress our current account balance. In addition, Euroland and Asiamay not always support our lifestyle andmilitary supremacy that is re ected inthe trade de cit. A further dollar debaclefrom here based on politics and the saleof U.S. nancial assets is a possibility.What that implies about an uncom-petitive European manufacturing baseis a chapter for Alice in Wonderland it

probably means the ECB will come closerto mimicking Japanese interest rates thanwe will but only the monetary restart-ers can determine the timing.

Individual investors who read this Outlook and have stuck with this lengthy sum-mary to this point can take advantage of these low short term interest rate trends/forecasts by purchasing municipal closed-end bond funds that take advantage of mild leverage and borrowing costs near1% to offer yields in excess of 6% in thecase of tax-free municipals. Research is

important, but a broad list of existingpublicly traded funds can be viewed inBarrons , The Wall Street Journalor The NewYork Timeson a weekly basis. PIMCO, of course, has numerous municipal bond

funds that are listed on the NYSE.

Farewell

Well weve gone on long enough now talking about res and pop-singers asif we know a lot about both. We knowsome things though. We know that alook at the secular investment horizoneliminates some emotion and inducesat least a modicum of critical analysison the valuation of xed income andother securities. We know that were notperfect at it, that we make mistakes andthat in the process there are opportunitycosts and a few absolute black hole losses.We know that we have a responsibility,to our clients in the primary instance but to economic society as well in orderto distribute capital rationally and pro-ductively over time. We are not restart-ers, nor even re extinguishers, but remarshals in the investment world. Therewill be much to marshal and monitor inthe years ahead.

William H. GrossManaging Director


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bill gross investment outlook may_03

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