Bill Gross Investment Outlook May_04

8/14/2019 Bill Gross Investment Outlook May_04

http://slidepdf.com/reader/full/bill-gross-investment-outlook-may04 1/8

InvestmentOutlook Bill

Gross

May/June 20

Circus GameI’m up on a tightwire

One side’s ice and one is reIt’s a circus game with you and me

“Tight Rope” by Leon Russell

Investing’s a circus youknow. Messrs. Barnum &Bailey probably wouldn’thave had a clue as to what

I’m talking about but themetaphor is more than apt.Every big top, you see, hasa ringmaster who blowshis whistle to begin or endthe show (Greenspan), aswell as its share of ferociouscarnivores (portfolio man-agers). Then there’re the jugglers (traders), clowns(those that buy at tops and sell at bot-toms), and the inevitable entourageof elephants holding each other’s tails(PIMCO’s surely one of those, althoughit’s hopefully the lead pachyderm – tailholding’s a pretty stinky job). But dur-ing our three-day Secular Forum held inearly May, PIMCO’s 100+ professionalsfrom around the globe took this circusmetaphor to the very top of the tent.“Cast your eyes ladies and gentlemanup to the high wire more than 100 feetabove the center ring. The death defy-

ing global economy will astound you bywalking the wire between ice (de ation)and re (in ation). It’ll rebalance itself over the next 3-5 years before your veryeyes, tiptoeing from a U.S.-centric globaleconomy to one including Euroland,China, and its Asian neighbors. Truly theGreatest Show On Earth!”

Well…ringmasters (and Fed Chairmen)can be great salesmen at times. The artof hyperbole is a requirement of the job.

Our Secular Forum par-ticipants, with perhapsa slightly more down toearth view, would readily

concede that investing’sa circus and even that theglobal economy is success-fully walking a high wire,for now. We’re just notas con dent of the healthof our global economicwalker’s inner ear – call ithis sense of balance – andwhether he might not tip

rst in one direction ( re/in ation) andthen another (ice/de ation) and eventu-ally crash to the ground. Read on, dearreader – let the circus begin.

Historical Secular Review

Last year’s Secular show, if you’ll recall,was dominated by a sense of a globaleconomy in recovery due to near his-toric amounts of scal and monetarystimulation. We alluded to our 3-5 yearoutlook, however, as a “wet log” re,recognizing the potency of 1% inter-est rates and $500 billion de cits in theU.S., but insisting nonetheless that inthe out years – 2006 and 2007 – thatthe world’s economy would revert to asimmering (not smoldering) relic of itsformer self as the stimulus wore off andthe primary macroeconomic problemreturned: a lack of aggregate demandand too much supply. Because of globalization and Chinese overproduction; because of private debt levels and theireventual suffocating impact on personal



Investment Outlook

May/June 2004

spending; because of a creeping almostimperceptible demographic muting of consumption in aging societies such as Japan, Germany, and Italy; because of market bubble popping; and becauseof post 9/11 syndrome and other terrorrelated in uences, we felt we were liv-ing in a world where we had too muchrelative to what we can afford to or wantto spend. Slow growth would dominate.In ation would be contained.

Current Outlook

Into this potentially tepid re steppeda brand new set of Forum guest pre-senters with a fresh set of observationson our developing secular scenario.

Economist/journalist Martin Wolf of theFinancial Times , author Amy Chua, Fo-rum veterans Stephen Roach and AndyXie from Morgan Stanley, and NiallFerguson of The Cash Nexus and Colos-sus renown, who seemed to know morehistory than his 40 years could possiblyhave allowed, reminded us that muchhad changed in the past 12 months, evenif our focus was on the next 3-5 years.The changes include:

1) A rapid disappearance of the U.S. s-cal peace dividend and an accompany-ing extended timeframe for the Iraq/U.S. war against terror.

2) Increasing imbalances of overseastrade and/or nancial surpluses.(Japanese and Chinese accumula-tion of Treasury paper).

3) A deteriorating global imageof the United States, which couldimpact the spread of the Americancapitalistic model to venues suchas trade talks and OPEC meetings.

4) Con rmation of a reactiveas opposed to a formerlyproactive Fed.

5) The inclusion of 10 new countries intothe European Union.

With the exception of #5, all of theabove changes fall squarely into thecorner of increased government controland a diminishing in uence of AdamSmith’s and capitalism’s invisible hand.PIMCO’s Paul McCulley has for somemonths argued that the iron st of government was becoming increasinglyprominent as the United States beginsto refocus on the democratic principle of one person/one vote as opposed to thecapitalistic principle of one dollar/onevote. We are in his and PIMCO’s opin-ion beginning an almost imperceptible

shift from making the economic pie bigger to deciding how to divvy up theproceeds. If so, that is to predict that taxrates are at their ebb, that scal de citsas opposed to the Clinton surpluses willdominate our future, and that labor/em-ployment will be our primary domesticeconomic focus in years to come. Ac-cordingly, we hypothesize with muchhistorical backing that while capitalismpromotes disin ation (1980-2000), de-mocracy promotes in ation (1960-1979).A chart provided by PIMCO’s Mark Kiesel points out as well, that as govern-ment spending increases as a % of GDP,interest rates move higher.

U.S. Government Net Outlays & UST 10-yr Yields

15

16

17

18

19

20

21

22

23

24

Outlays as a % of GDP (LHS)10-yr TSY Yield (RHS)

N e t O u t l a y s %

o f G D P

Source: PIMCO

53 57 61 65 69 73 77 81 85 89 93 97 01 05



The economic rationale for increas-ing government involvement is thatour capitalistic model is extended andhighly levered – much as it was in thelate 1920s –

and that following such periods it has been the accepted Keynesian model tosubstitute government demand/controlfor weakness in the private sector. Weapparently came close to the perilousrocks of de ation during the past 12months and so the printing pressesrolled out the hundred dollar bills in theform of 1% Fed Funds, and sound scal

policy gave way to a $500 billion de cit.In addition, a trend towards reregula-tion and away from the deregulation/disin ation of the past several decadeshas been apparent via the ongoinglitigation across the securitiesindustry, implementation of Sar- banes-Oxley over the entire publiccorporate sector, minor erosionsof free trade principles via imple-mentation of steel and lumbertariffs, and the marginal loss of personal freedoms due to terroristlegislation.

U.S. Government, then, inPIMCO’s view is in the ascen-dancy and will seek to redistribute

wealth in future years that will have anin ationary bias. We note that in Euro-land (in contrast to the U.K.), trends re-main pointed towards less and not moregovernment involvement although they

admittedly start from a muchhigher base. A potential solu-tion to our high wire global balancing act is for Eurolandto become more capitalisticand therefore more growthoriented. Their feeble trendstowards deregulation andtheir more sound (althoughstill high) scal de cits are anattempt to do so. Whether ornot they succeed is perhaps

guesswork at this point, but amore Euroland-centric eco-nomic push is de nitely one of

the requirements if the global economyis to successfully walk the wire.

Necessary as well will be the contin-ued stable climb of Asia/Japan. Mor-gan Stanley’s Roach and Xie are ratheradamant in their belief that a signi cantslowdown is underway there and willcontinue for at least 2004, although thelonger term looks better. China, saysRoach, is more highly levered than theU.S. economy – 200% debt to GDP bycrude estimates – and that leverage ismost prominently expressed via the

15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05

300

280

260

240

220

200

180

160

140

120

100

Source: Gabelli

270%

299%

P e r c e n t

Total Credit Market Debt (all sectors) as % of U.S. GDP

Domestic Credit (lhs)

Gross Fixed Capital Spending (rhs)

50%

45%

40%

35%

30%

25%1993 1995 1997 1999 2001 2003E

180%

160%

140%

120%

100%

80%

P e r c e n t a g e o

f G D P

GDP

Source: China Statistical Yearbook , CEIC Data Co. Ltd., and Lehman Brothers

China's Domestic Investment & Credit Outstanding,1993-2003E (% of GDP)



Investment Outlook

May/June 2004

property market. It is that, as well asthe unsustainable surge in investmentshown in the accompanying chart thatrepresents risk, with its bubble poppingrami cations.

While China still only accounts for 4%of global GDP, it consumes tremendousamounts of commodities and other na-tions’ exports at the margin – 20-30%of the world’s cement, nearly as muchsteel, coal, and iron ore, and 7% of allthe oil. Increasingly, as China goes, sogoes the rest of the world, especially itsAsian neighbors and Japan. Estimatesare that 40-50% of Japanese growth isChina-centric. A Chinese slowdown of

some magnitude will be a challengingdevelopment for the Land of the (recent-ly) Rising Sun.

Even if China stabilizes at a relativelyhigh growth rate following credit andinvestment controls, there remains aperplexing secular problem in Chinathat strikes at the heart of the globaleconomy’s attempt to balance produc-tion and consumption. That dilemmaafter all has been central to our argu-ment for “wet logs” in the past fewyears, and as we shift to a new meta-phor, it is apparent that China/Asiaholds a key to successful wire walkingas well. With Europe and the U.S. head-ing towards either a demographically or

nance induced savings mode, it would be hoped that the 1.2 billion potentialconsumers in China (and 1 billion inIndia) would pick up the slack. Problemis that the Chinese, Indians (and Japa-

nese) like to save not spend, and thattypically, private accumulated savingshas to approach 300% of GDP beforeany semblance of “shop ‘til you drop”takes hold. China is years from thatlevel. They also lack the nancial infra-structure to facilitate a consumer led

boom even if the spirit and body werewilling. Credit cards and adjustable ratemortgages are not yet part of the Chi-nese consumer ethic. While the aboveis an admittedly brief summary of oneof the global economy’s major secularimbalances, it describes a critical vari-able to any forward analysis: China’swire walking needs to proceed brisklyand with greater balance from internalconsumption as opposed to investment– expenditures which currently exacer- bate global supply.

Which brings us to the United Statesand its consumption excesses that haveyet to be recti ed. A savings rate at 2%

instead of a more historical 6-8%; per-sonal debt at near 80% of GDP as shownin the following chart; annual consump-tion trends that have moved from 61%to near 70% of GDP over the past fourdecades; the list goes on, much of whichis hotly debated by economists due tothe salutary effect of lower interest ratesand tempered debt service. Nonethelessas economic historian Niall Fergusonreminded us, the U.S. is an empire basedon consumption with the Hummer asits domestic symbol and the Humvee itsinternational military equivalent. Gunsand butter have been replaced by Hum-vees and Hummers as I wrote monthsago – on that Ferguson and I have fullagreement. The fact is that our abilityand inclination to consume has given usthe privilege (and presumed responsibil-ity) to dominate global growth. That isperversely the primary reason why theglobal economy has recovered as well

as it has these past two years – wet logsor no – but also the source of its greatestfuture risk as it walks the wire. An im-plosion in China – that is a risk for sure– but a cessation of consumption trendsin the U.S. is the greater one if only be-cause we are so dominant economically.



A U.S. consumer slowdown or evenreversal could come from a number of directions although the timing is obvi-ously uncertain. One has only to ask how we Americans have been able toget away with it for so long and youhave the potential villains in sight. Thekindness of strangers – a 5% annualtrade de cit amounting to $500 billion isone place to look. Either a dollar devalu-ation or a pullback in the purchase of U.S. Treasuries shown below could beprecipitating factors since the higherinterest rates would necessarily eat intoconsumer purchasing power.

To date, Chinese and Japanese“strangers” have been kind because it suits their ownagendas – employing cheapcurrencies to support eco-nomic growth. Geopoliticalshocks in China’s neighbor-hood particularly related toNorth Korea could changethat. And too, the seeminglyendless pursuit of terroristsin any and every part of theglobe, which is accompanied by security constraints ontravel and trade, may hampernot only consumer con dence

and spending attitudes, but the contin-

ued spread of globalization itself.More likely, however, to slow the in-domitable American consumer would be internal interest rate forces in the U.S.In a nanced-based economy, which theU.S. surely is, the only real way to keepan economy going is via cheap money,more and more tax cuts, and/or addi-tional leverage. With tax cuts politicallyunpalatable and recent yield movementsalong the curve making leverage lesspro table, the beginning of the end isin sight. The American consumer, NiallFerguson hypothesized, is the least

hedged of the three major U.S. economic players(corporations and govern-ment being the others). Itmay take a few years foradjustable rate mortgagesto adjust upward, and a fewmonths for 0% automobile

nancing to completelydisappear, but the trendsare inexorable. To ll theconsumer void will requireeither larger and largergovernment de cits or more

� ��

�

�

�

�

�

�

�

�

U.S. Household Sector Credit MarketDebt as a Percentage of GDP

�

�

�

Net Purchases of U.S. TSY's by Foreigners



Investment Outlook

May/June 2004

and more business investment, neitherof which is likely in light of domesticpolitics and China’s own magnetic at-traction for global entrepreneurs.

Our culminating and summarizingpoint about wire walking with its allu-sions to re/in ation and ice/de ationis that cheap money is primarily re-sponsible for today’s economic recoveryand accelerating in ation, not just inthe U.S. but worldwide. When it goesaway, however, we may tip the otherway, especially if central banks go toofar to the upside, pop too many bubbles(housing, stocks, bonds) and precipitatethe liquidity trap that Greenspan has

feared for years. PIMCO’s Mohamed El-Erian, avoiding the circus metaphor butputting the problem in a more academicperspective, labels this situation as an“unstable equilibrium.” All is well untilsomething tips the walker to one side of the wire or the other. Higher in ation,geopolitical crisis, and nancial marketvolatility all can tip the American con-sumer or the Chinese growth juggernautto the opposite side of the wire. In ationand de ation in this levered world coex-ist nearly side-by-side. Is it any wonderthat in the space of the last six monthswe have had headline speeches promot-ing the dangers of de ation only to befollowed by fears of accelerating in a-tion? “One side’s ice and one is re.” Wemust monitor the situation closely. Our best estimate is for an “equilibrium”centered around 2% U.S. real GDPgrowth and similar amounts in Europeand Japan over the next 3-5 years. Wet

logs redeux. What has changed thisyear in our 3-5 year forward economicforecast is that the conditions for in-stability have accelerated – more U.S.consumer leverage dependent on cheap

nancing; more Treasuries in foreigners’hands; more geopolitical instability; and

more risk of a slowdown/shock in Asia;all are potential sources for tipping ourwire walker in one direction or another.

Investment PolicySo after all this re and ice stuff, whereto put your money? The sum total is to bet on accelerating in ation ( re) due tothe iron st of government, but to watchout for global instability that could tipthe other way (ice). That, I must tell youis tricky – sort of like walking the wirewithout a net. Because from a bondinvestor’s standpoint, existing condi-tions argue for reduced durations toguard against accelerating in ation andcentral bank tightening, but there is a

chance (20-30%) that at some point, the balance and momentum swing the otherway and require greater than marketdurations. This may not be a secularenvironment, in other words, where youcan successfully ride the great and longlasting waves of in ation (1965-79) andthen disin ation (1980-2000) without aconcern as to reversals. PIMCO made itsfame and fortune partly on the basis of accurately forecasting those two pri-mary secular trends. The future may not be so simple.

In addition to global economic andgeopolitical forces cited in previousparagraphs, we will analyze mostimportantly the level of real short-terminterest rates for clues as to what to do.Last year we asked, “How long does theFed (and the ECB) stay low and whatis a sustainable real interest rate in thisnew (wet log) environment?” Although

it may seem obvious that the rst ques-tion will be answered at least in the U.S.within a period of a few short months,the real key to the “bond alpha” gener-ating kingdom will come with a recog-nition of the appropriate real interestrate that can produce a continuation of



global economic recovery for at least afew more years. As discussed last yearand in recent Outlooks and Fed Focuses ,we think it is a lot lower than the marketdoes. The following chart points out thatit was only during the post-1980 disin-

ationary period that short-term realinterest rates were abnormally high on aglobal basis.

Re ationary, government oriented peri-

ods have much lower real rates averag-ing – believe it or not – a negative 0.7%globally for the rst 80 years of the 20thcentury. We believe that 1% real shortrates are about all the U.S. and globaleconomy can take given its leverage andpotential for tipping into de ationaryice. If so, front end to intermediate termyields may be close to fair value givena future 3% Fed Funds level in the U.S.and a 2% rate in Euroland. Whether ornot we continue to stay here will de-pend on in ationary trends which fornow point upward. In general, therefore,we are mildly bearish on U.S. bonds,and more neutral towards global alter-natives. Due to our in ationary bias andthe necessity to keep short rates low,

we prefer the front ends of the curvefor now instead of long-term debt. Ourfocus on U.S. TIPS has been rewardedduring the past 12 months and despitetheir revaluation by the market, theyremain relatively cheap insurance for apossible in ationary surge.

The best secular strategy we have,

however, remains our focus on non-U.S.government paper especially that inEuroland. It only makes sense, for nowat least, while the globe is still success-fully balanced on the wire, to purchasedebt of governments that have the leastin ationary bias. At the moment those bonds are issued by Germany and as-sociated countries in Euroland. We arenot signi cant currency investors but believe that a continuation of the recent-ly interrupted dollar slide will persist infuture years. This will add to the attrac-tion of global debt via its in ationaryimplications in the U.S. and the reversein strong currency countries. Speakingof currencies, the ultimate revaluationof the Chinese RMB, although it now

-2

0

2

-8

-6

-4

4

6

8

Ita

-5.4

1.1

2.62.1

4.6

3.13.7 3.7

4.9

4.1

-0.1

0.1 0.20.4 0.4

0.9 0.91.3 1.7

4.5 4.5

3.22.8

4.8

1.5

4.7

7.2

-4.8

-3.1

-1.6 -1.5- 0. 7 -0 .7 -0.6

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



840 Newport Center D

Newport Beach, CA 9

949.720

Past performance is no guarantee of future results. All data is as of 5/18/04 unless otherwise indicated. The graphs por-trayed are not indicative of the past or future performance of any PIMCO product. This article contains the current opinionsof the author and such opinions are subject to change without notice. This article has been distributed for educational purposesonly and is not a recommendation or offer of any particular security, strategy or investment product. Information containedherein has been obtained from sources believed to be reliable, but not guaranteed.

Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. The

guarantee on Treasuries and Government Bonds is to the timely repayment of principal and interest, shares of a portfolio are not guaranteed. 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 their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rat-ed bonds. 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. In ation-indexed bonds issued by the U.S. Government, also known as TIPS,are xed-income securities whose principal value is periodically adjusted according to the rate of in ation. Repayment uponmaturity of the original principal as adjusted for in ation is guaranteed by the U.S. Government. Neither the current market value of in ation-indexed bonds nor the value of shares of a portfolio that invests in in ation-indexed bonds is guaranteed, andeither or both may uctuate. Duration is a measure of price sensitivity expressed in years. In an environment where interest rates may trend upward, rising rates will negatively impact the performance of most bond funds, and xed income securitiesheld by a fund are likely to decrease in value. Bond funds and individual bonds with a longer duration (a measure of the ex- pected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securitieswith shorter durations.

No part of this article may be reproduced in any form, or referred to in any other publication, without express written permis-

sion. ©2004, Paci c Investment Management Company LLC. IO026-051404

appears to be beyond 2004, will be a sig-ni cant re ationary event for the non-Asian economies and add to the bearish-ness of U.S. bonds in particular.

Individual investors who read thisOutlook and have stuck with this lengthysummary to this point can take advan-tage of our low real short rate forecast by purchasing mildly levered closed-end bond funds (especially municipal)at what are now substantial 10% or sodiscounts to true asset value. Purchasinga dollar for 90 cents is rarely a stupidstrategy. Because of our mildly bearishstance, however, and the now appar-ent upward trend of most central bank

short rates, investors should be aware of further price downside despite yields of 6-7% in municipals and 9-10% in manycorporate closed-end bond funds.

We would also caution those that haveinvested in levered assets that have bene ted immensely at the altar of 1%money. Although we believe short rateswill stay relatively low by necessity andhistorical precedent, there’s little doubtthat U.S. and U.K. housing prices areoverextended. The old saw about hous-ing never going down in price becauseyou don’t have to sell, is vulnerable if intermediate yields rise more than theirrecent 100 basis points or so and adjust-

able rate mortgages ultimately “adjust.”Homeowners at the margin may indeedhave to sell a few years hence if monthlypayments rise faster than wages andearned income.

FarewellWell, enough I suppose of circusesand things, cabbages and kings. We atPIMCO are convinced of the currentglobal recovery but have reservationsas to its stability and longevity. How itplays out will depend on interest rates,geopolitical and U.S. consumer proclivi-ties, as well as the continuation of theChinese economic miracle. For now, weare mildly bond bearish – later on we

could secularly reverse direction. Thatis the way of the wire, I suppose, domi-nated by the ever-present danger of tip-ping in one direction or another. For youour treasured clients, however, we shallendeavor to provide alpha generation of a stable and consistent nature. Elephantswalk on terra rma and are supposedlywise and ever loyal throughout theirmany years. We shall be content to belabeled a circus elephant, hopefully atthe front of the entourage, avoiding oth-ers’ tails.

William H. GrossManaging Director

Bill Gross Investment Outlook May_04

Documents

Transcript of Bill Gross Investment Outlook May_04