CNSNews.com) - Every business day since May 17, the U.S. Treasury has published a daily statement claiming that the federal debt subject to the limit set by Congress closed the day at $16,699,396,000,000—about $25 million below the legal limit.
Monday, the Columbus Day holiday, according to the Daily Treasury Statement released today, marked the 150th straight day that the Treasury has said the debt subject to limit was stuck at $16,699,396,000,000.
On May 17, the first day the debt closed the day at $16,699,396,000,000, Treasury Secretary Jacob Lew sent a letter to House Speaker John Boehner stating that since the Treasury was about to hit the debt limit he would begin to use “extraordinary measures” to prevent it from doing so. These included, among other things, suspending investment of the Civil Service Retirement and Disability Fund in U.S. Treasury securities, and redeeming securities already held by this fund.
“In total, the extraordinary measures currently available free up approximately $260 billion in headroom under the limit,” Lew wrote then.
But in that letter, Lew described the unpredictability of the Treasury’s flow of funds to explain why he could not predict exactly when the extraordinary measures would be exhausted.
“The effective duration of the extraordinary measures is subject to considerable uncertainty due to a variety of factors, including the unpredictability of tax receipts, changes in expenditure flows under the sequester, and the normal challenges of forecasting the payments and receipts of the U.S. government months into the future,” wrote Lew.
“Given the uncertainty described above, at this time, Treasury is not able to provide a specific estimate of how long the extraordinary measures will last,” wrote Lew.
“However, in view of the forthcoming Fannie Mae payment and the trend in other payment flows, it is now clear that the measures will not be exhausted until after Labor Day,” he wrote.
On Aug. 26, Lew wrote Boehner again. “Based on our latest estimates, extraordinary measures are projected to be exhausted in the middle of October,” he said. “At that point, the United States will have reached the limit of its borrowing authority, and the Treasury would be left to fund the government with only the cash we have on hand on any given day.”
On Sept. 25, Lew wrote Boehner again. “Treasury now estimates that extraordinary measures will be exhausted no later than October 17,” he said. “We estimate that, at that point, Treasury would have only approximately $30 billion to meet our country’s commitments.”
On Oct. 1, Lew wrote Boehner again, restating his estimation that the “extraordinary measures” preventing the debt from breeching the limit would be exhausted “no later than October 17.”
When Lew wrote each of these letters, as well as at the close of business yesterday, his Treasury reported that the debt subject to limit had closed the day at $16,699,396,000,000.
Showing posts with label PIMCO. Show all posts
Showing posts with label PIMCO. Show all posts
Wednesday, October 16, 2013
Tuesday, July 9, 2013
The Tipping Point July 2013
The Tipping Point
I’ve spun a few yarns in recent years about my days as a naval
officer; not, thank goodness, tales told by dead men, but certainly
echoes from the depths of Davy Jones’ Locker.
A few years ago I wrote about the time that our ship (on my watch) was
almost cut in half by an auto-piloted tanker at midnight, but never have
I divulged the day that the USS Diachenko came within one degree of
heeling over during a typhoon in the South China Sea. “Engage emergency
ballast,” the Captain roared at yours truly – the one and only chief
engineer. Little did he know that Ensign Gross had slept through his
classes at Philadelphia’s damage control school and had no idea what he
was talking about. I could hardly find the oil dipstick on my car back
in San Diego, let alone conceive of emergency ballast procedures in 50
foot seas. And so…the ship rolled to starboard, the ship rolled to port,
the ship heeled at the extreme to 36 degrees (within 1 degree, as I later
read in the ship’s manual, of the ultimate tipping point). One hundred
sailors at risk, because of one twenty-three-year-old mechanically
challenged officer, and a Captain who should have known better than to
trust him.
wikiHow: the how to manual you can edit
The Basics: Before Setting Sail
1. Understand the mechanics of a sinking ship. Water usually enters the lowest point of a ship first, the bilge area.
2. As more and more water enters the ship, it will start to heel significantly. From this point on, sinking will occur quickly. Abandon ship.
If Sinking is Imminent
1. Think about your sense of etiquette. What will you do if push comes to shove?
2. If you’re in charge of the sinking ship learn how to send a Mayday. Read “How to call Mayday from a marine vessel” on the attached internet link.
3. Stay calm and don’t panic.
4. If you see someone with fear, yell at them.
5. While still on deck, watch for catapulting objects coming your way. Large items can kill you.
Abandoning Ship
6. Find a lifeboat. The best scenario is to enter a lifeboat without getting wet.
7. If jumping off the ship, always look first.
8. If you survive, be ready for the reality that others may have perished. Seek counseling.
Counseling indeed! If only I knew then what I know now: wikiHow, not experience or damage control school, is the best teacher. So, should bond investors abandon ship? And who to believe? The captain of the Fed, the co-captains of the USS PIMCO, or just trust your instincts? Well there is no wikiHow moment to guide you in this case, although it’s true that yours truly, PIMCO, and the bond market have sailed some rough seas over the past few years. So has Chairman Bernanke. We’re all in this one together it seems.
Immediate analysis of the past 6 weeks’ market action would argue that in late April, both the Fed and PIMCO observed that bond markets were approaching a tipping point.
Yields were too low, prices too high, both for investors’ and the economy’s own good. The Fed’s Jeremy Stein had written a research paper outlining the risk. I, in fact, had written a March Investment Outlook outlining Governor Stein’s paper, and to be fair, PIMCO had been warning of high seas for what seems like an eternity. “Never,” I tweeted, “have investors reached so high for so little return. Never have investors stooped so low for so much risk.” True enough, history will likely record.
It will also record however, that the risk was not only in narrow credit spreads and emerging market debt/equity markets but at the heart of the credit system itself: U.S. Treasuries.
What supposedly old salts like yours truly didn’t suspect was that all bonds, and yes, equities too were at risk of heeling over based upon a rather perfect storm, one that forecasters everywhere found difficult to fathom.
The forecast for bad weather as I’ve mentioned was becoming more rational with every increase in asset prices. If all markets were being artificially supported as PIMCO claimed and the Fed confirmed, then someday, someday that support via quantitative easing would have to be withdrawn. But the dark clouds seemed to be far off on the horizon. Investors worldwide piled on the leverage – not just in high yield or equity space – but in Treasuries as well. If the Fed (and BOJ) were going to keep writing checks at one trillion per year, then these two central banks alone might be buying 70-80% of all developed market future supply. The fear was that there might not be enough for others, not that there was too much leverage.
Well, that started to change with the May 22nd taper talk and, of course, with the Fed’s June 19th statement and Chairman Bernanke’s press conference. In trying to be specific about which conditions would prompt a tapering of QE, the Fed tilted overrisked investors to one side of an overloaded and overlevered boat. Everyone was looking for lifeboats on the starboard side of the ship, and selling begat more selling, even in Treasuries. While the Fed’s move may ultimately be better understood or even praised, it no doubt induced market panic. Without the presence of a “Bernanke Put” or the promise of a continuing program of QE check writing, investors found the lifeboats dysfunctional. They could only sell to themselves and almost all of them had too much risk. A band somewhere on the upper deck began to play “Nearer, My God, to Thee.”
Well I go too far in my sinking ship metaphor, but you get the point, I hope. The U.S. economy is not sinking, nor are the majority of global economies. Their markets just had too much risk, and in PIMCO’s opinion, too much hope for a constant QE and for the growth that it would produce. In effect, the ship was top heavy with too little ballast. Guess I should have known, huh?
Well where does the ship go from here? Should you as a bond investor jump overboard and risk the cold money market Atlantic Ocean at near zero degrees? We don’t think so – and not because we want to keep you on board – we just don’t think so. Why not?
1) The Fed’s forecast of the economy which prompted tapering panic is far too optimistic.
If 7% unemployment is tapering’s final port of call, we simply think that we’re much further away than the Fed’s compass would suggest. We argue for structural headwinds – demographic, globalization, and technology influences – that have had and will continue to have dampening effects on domestic and global growth. The Fed, we would argue, is too cyclically oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1½% in the last six months and the average monthly check for a new home buyer is up by 20–25% as well, then as I tweeted several weeks ago, “Mr. Chairman are you serious?” Growth will be negatively influenced.
2) Inflation, according to the Fed’s own statistics is running close to a 1% pace.
The Fed has told us that they “target,” “ target” 2% and for the next 1–2 years are willing to accept even 2½% until they reverse engines. Fed Governor Bullard of the St. Louis Fed was in our opinion correct where he dissented from the majority decision several weeks ago, citing the distant shores of 2%+ inflation and the seeming inability to even move in that direction.
3) Yields have adjusted by too much.
While T.V. and the press focus on 10-year Treasuries at 2.55% as their guiding star, subjective stabs by yours truly or anyone else are difficult day to day. The technicals, as Mohamed has written, can dominate while the fundamentals are flushed to second page priorities. When analyzing the fundamentals though, I like to point to a “North Star” that is as permanent as possible within the context of current market instability. Tapering aside, if the Fed has consistently informed the market that its policy rate – Fed Funds at 25 basis points – will stay there for a substantial period of time even after the end of QE, then to my eye, Fed Funds will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth. But the beauty of this North Star Fed Funds sextant is that it can be rather directly observed in futures markets, either for Fed Funds or for Eurodollars, which are a close companion. Right now, Fed Funds futures markets are predicting a 75 basis point yield in 2015, and Eurodollars validating a similar conclusion. That would suggest a mispricing, despite the obvious caveat of professional observers that some of the 75 is a surcharge for potential volatility.
In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves – the 10-year Treasury – may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%.
So there you have it, fellow passengers and paying clients. Don’t jump ship now. We may have reached an inflection point of low
Treasury, mortgage and corporate yields in late April, but this is overdone.
Will there be smooth sailing tomorrow? “Red sky at night, sailors delight?” Hardly. Will you be able to replicate annualized returns in bonds and stocks for the past 20–30 years? Hardly.
Expect 3–5% for both. But sailors, don’t panic. And like wikiHow suggests, if you see someone that’s afraid, “yell at them!” Yell, “This ship’s going to make it to port,” Fed, PIMCO, and PIMCO co-captains willing. Those icy Atlantic money market waters are likely to be with us for a long, long time. Have a cocktail, tell the band to stop playing dirges, because you’re gonna be just fine with PIMCO at the helm.
Tipping Point Speed Read
1) Yields and risk spreads were far too low two months ago.
2) Global markets were too levered and now they are derisking.
3) The bond market ship is not sinking. Expect low but positive returns in future years.
4) Don’t panic. Yell at someone!
William H. Gross
Managing Director
Saturday, June 15, 2013
Money for Nothin', Writing Checks for Free - Jan 2013
Investment Outlook
Money for Nothin’
Writing Checks for Free
It was Milton Friedman, not Ben Bernanke, who first made reference to dropping money from helicopters in order to prevent deflation. Bernanke’s now famous “helicopter speech” in 2002, however, was no less enthusiastically supportive of the concept. In it, he boldly previewed the almost unimaginable policy solutions that would follow the black swan financial meltdown in 2008: policy rates at zero for an extended period of time; expanding the menu of assets that the Fed buys beyond Treasuries; and of course quantitative easing purchases of an almost unlimited amount should they be needed. These weren’t Bernanke innovations – nor was the term QE. Many of them had been applied by policy authorities in the late 1930s and ‘40s as well as Japan in recent years. Yet the then Fed Governor’s rather blatant support of monetary policy to come should have been a signal to investors that he would be willing to pilot a helicopter should the takeoff be necessary. “Like gold,” he said, “U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
Mr. Bernanke never provided additional clarity as to what he meant by “no cost.”
Perhaps he was referring to zero-bound interest rates, although at the
time in 2002, 10-year Treasuries were at 4%. Or perhaps he knew
something that American citizens, their political representatives, and
almost all investors still don’t know: that quantitative easing – the purchase of Treasury and Agency mortgage obligations from the private sector – IS
essentially costless in a number of ways. That might strike almost all
of us as rather incredible – writing checks for free – but that in
effect is what a central bank does. Yet if ordinary citizens and
corporations can’t overdraft their accounts without criminal liability,
how can the Fed or the European Central Bank or any central bank get
away with printing “electronic money” and distributing it via helicopter
flyovers in the trillions and trillions of dollars?
Well, the answer is sort of complicated but then it’s sort of
simple: They just make it up. When the Fed now writes $85 billion of
checks to buy Treasuries and mortgages every month, they really have
nothing in the “bank” to back them. Supposedly they own a few billion
dollars of “gold certificates” that represent a fairy-tale claim on Ft.
Knox’s secret stash, but there’s essentially nothing there but trust.
When a primary dealer such as J.P. Morgan or Bank of America sells its
Treasuries to the Fed, it gets a “credit” in its account with the Fed,
known as “reserves.” It can spend those reserves for something else, but
then another bank gets a credit for its reserves and so on and so on.
The Fed has told its member banks “Trust me, we will always honor your
reserves,” and so the banks do, and corporations and ordinary citizens
trust the banks, and “the beat goes on,” as Sonny and Cher sang. $54
trillion of credit in the U.S. financial system based upon trusting a
central bank with nothing in the vault to back it up. Amazing!
But the story doesn’t end here. What I have just described is a
rather routine textbook explanation of how central and fractional
reserve banking works its productive yet potentially destructive magic. What
Governor Bernanke may have been referring to with his “essentially
free” comment was the fact that the Fed and other central banks such as
the Bank of England (BOE) actually rebate the
interest they earn on the Treasuries and Gilts that they buy. They give
the interest back to the government, and in so doing, the Treasury
issues debt for free. Theoretically it’s the profits of the Fed that are returned to the Treasury, but the profits are
the interest on the $2.5 trillion worth of Treasuries and mortgages
that they have purchased from the market. The current annual remit
amounts to nearly $100 billion, an amount that permits the Treasury to
reduce its deficit by a like amount. When the Fed buys $1
trillion worth of Treasuries and mortgages annually, as it is now doing,
it effectively is financing 80% of the deficit for free.
The BOE and other central banks work in a similar fashion. British
Chancellor of the Exchequer (equivalent to our Treasury Secretary)
George Osborne wrote a letter to Mervyn King, Governor of the BOE
(equivalent to our Fed Chairman) in November. “Transferring the net
income from the APF [Asset Purchase Facility – Britain’s QE] will allow
the Government to manage its cash more efficiently, and should lead to
debt interest savings to central government in the short-term.” Savings
indeed! The Exchequer issues gilts, the BOE’s QE program buys them and
then remits the interest back to the Exchequer. As shown in Chart 1, the
world’s six largest central banks have collectively issued six trillion
dollars’ worth of checks since the beginning of 2009 in order to stem
private sector delevering. Treasury credit is being backed with central
bank credit with the interest then remitted to its issuer. Should
interest rates rise and losses accrue to the Fed’s portfolio, they
record it as an accounting liability owed to the Treasury, which need
never be paid back. This is about as good as it can get folks. Money for
nothing. Debt for free.
Investors and ordinary citizens might wonder then, why the fuss over the fiscal cliff and the increasing amount of debt/GDP that current deficits portend? Why the austerity push in the U.K., and why the possibly exaggerated concern by U.S. Republicans over spending and entitlements? If a country can issue debt, have its central bank buy it, and then return the interest, what’s to worry? Alfred E. Neuman for President (or House Speaker!).
Well ultimately government financing schemes such as today’s QE’s or England’s early 1700s South Sea Bubble end badly. At the time Sir Isaac Newton was asked about the apparent success of the government’s plan and he responded by saying that “I can calculate the movement of the stars but not the madness of men.” The madness he referred to was the rather blatant acceptance by government and its citizen investors, that they had discovered the key to perpetual prosperity: “essentially costless” debt financing. The plan’s originator, Scotsman John Law, could not have conceived of helicopters like Ben Bernanke did 300 years later, but the concept was the same: writing checks for free.
Yet the common sense of John Law – and likewise that of Ben Bernanke – must have known that only air comes for free and is “essentially costless.” The future price tag of printing six trillion dollars’ worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold. To date, central banks have been willing to accept that cost – nay – have even encouraged it. The Fed is now comfortable with 2.5% inflation for at least 1–2 years and the Bank of Japan seems willing to up their targeted objective to something above as opposed to below ground zero. But in the process, zero-bound yields and their QE check writing may have distorted market prices, and in the process the flow as well as the existing stock of credit. Capital vs. labor; bonds/stocks vs. cash; lenders vs. borrowers; surplus vs. deficit nations; rich vs. the poor: these are the secular anomalies and mismatches perpetuated by unlimited check writing that now threaten future stability.
Ben Bernanke has publically acknowledged these growing disparities. “We are quite aware,” he said in November 2011, “that very low interest rates, particularly for a protracted period, do have costs for a lot of people… I think the response is, though, that there is a greater good here, which is the health and recovery of the U.S. economy... I mean, ultimately, if you want to earn money on your investments, you have to invest in an economy which is growing.”
That growth now is to be measured each and every employment Friday via an unemployment rate thermostat set at 6.5%. We at PIMCO would not argue with that objective. Yet we would caution, as Bernanke himself has cautioned, that there are negative consequences and that when central banks enter the cave of quantitative easing and “essentially costless” electronic printing of money, there may be dragons.
Investment conclusions
Investors should be alert to the longterm inflationary thrust of such check writing. While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the “out” years towards which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies. In addition, be aware of PIMCO’s continued concerns about the increasing ineffectiveness of quantitative easing with regards to the real economy. Zero-bound interest rates, QE maneuvering, and “essentially costless” check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs. Purchases of “paper” shares as opposed to investments in tangible productive investment assets become the likely preferred corporate choice. Those purchases may be initially supportive of stock prices but ultimately constraining of true wealth creation and real economic growth. At some future point, risk assets – stocks, corporate and high yield bonds – must recognize the difference. Bernanke’s dreams of economic revival, which would then lead to the day that investors can earn higher returns, may be an unattainable theoretical hope, in contrast to a future reality. Japan we are not, nor is Euroland or the U.K. – just yet. But “costless” check writing does indeed have a cost and checks cannot perpetually be written for free.
William H. Gross
Managing Director
CreditSuper Nova - February 2013
Investment Outlook
Credit Supernova!
This is the way the world ends…
Not with a bang but a whimper.
T.S. Eliot
Not with a bang but a whimper.
T.S. Eliot
They say that time is money.* What they don’t say is that money may be running out of time.
There may be a natural evolution to our fractionally reserved
credit system which characterizes modern global finance. Much like the
universe, which began with a big bang nearly 14 billion years ago, but
is expanding so rapidly that scientists predict it will all end in a
“big freeze” trillions of years from now, our current monetary system
seems to require perpetual expansion to maintain its existence. And too,
the advancing entropy in the physical universe may in fact portend a
similar decline of “energy” and “heat” within the credit markets. If so,
then the legitimate response of creditors, debtors and investors
inextricably intertwined within it, should logically be to ask about the
economic and investment implications of its ongoing transition.
But before mimicking T.S. Eliot on the way our monetary system
might evolve, let me first describe the “big bang” beginning of credit
markets, so that you can more closely recognize its transition. The
creation of credit in our modern day fractional reserve banking system
began with a deposit and the profitable expansion of that deposit via
leverage. Banks and other lenders don’t always keep 100% of their
deposits in the “vault” at any one time – in fact they keep very little –
thus the term “fractional reserves.” That first deposit then, and the
explosion outward of 10x and more of levered lending, is modern day
finance’s equivalent of the big bang. When
it began is actually harder to determine than the birth of the physical
universe but it certainly accelerated with the invention of central
banking – the U.S. in 1913 – and with it the increased confidence that
these newly licensed lenders of last resort would provide support to
financial and real economies. Banking and central banks were and remain essential elements of a productive global economy.
But they carried within them an inherent instability that required
the perpetual creation of more and more credit to stay alive. Those
initial loans from that first deposit? They were made most certainly at
yields close to the rate of real growth and creation of real wealth in
the economy. Lenders demanded that yield because of their risk, and
borrowers were speculating that the profit on their fledgling
enterprises would exceed the interest expense on those loans. In many
cases, they succeeded. But the economy as a whole could not logically
grow faster than the real interest rates required to pay creditors, in
combination with the near double-digit returns that equity holders
demanded to support the initial leverage – unless – unless – it was
supplied with additional credit to pay the tab. In a sense this was a
“Sixteen Tons” metaphor: Another day older and deeper in debt, except
few within the credit system itself understood the implications.
Economist Hyman Minsky did. With credit now expanding, the
sophisticated economic model provided by Minsky was working its way
towards what he called Ponzi finance. First, he claimed the system would
borrow in low amounts and be relatively self-sustaining – what he
termed “Hedge” finance. Then the system would gain courage, lever more
into a “Speculative” finance mode which required more credit to pay back
previous borrowings at maturity. Finally, the end phase of “Ponzi”
finance would appear when additional credit would be required just to
cover increasingly burdensome interest payments, with accelerating
inflation the end result.
Minsky’s concept, developed nearly a half century ago shortly after
the explosive decoupling of the dollar from gold in 1971, was primarily
a cyclically contained model which acknowledged recession and then
rejuvenation once the system’s leverage had been reduced. That was then.
He perhaps could not have imagined the hyperbolic, as opposed to
linear, secular rise in U.S. credit creation that has occurred since as
shown in Chart 1. (Patterns for other developed economies are similar.)
While there has been cyclical delevering, it has always been mild – even
during the Volcker era of 1979-81. When Minsky formulated his theory in
the early 70s, credit outstanding in the U.S. totaled $3 trillion.†
Today, at $56 trillion and counting, it is a monster that requires
perpetually increasing amounts of fuel, a supernova star that expands
and expands, yet, in the process begins to consume itself. Each
additional dollar of credit seems to create less and less heat. In the
1980s, it took four dollars of new credit to generate $1 of real GDP.
Over the last decade, it has taken $10, and since 2006, $20 to produce
the same result. Minsky’s Ponzi finance at the 2013 stage goes
more and more to creditors and market speculators and less and less to
the real economy. This “Credit New Normal” is entropic much like the
physical universe and the “heat” or real growth that new credit now
generates becomes less and less each year: 2% real growth now instead of
an historical 3.5% over the past 50 years; likely even less as the
future unfolds.
Not only is more and more anemic credit created by lenders as its
“sixteen tons” becomes “thirty-two,” then “sixty-four,” but in the
process, today’s near zero bound interest rates cripple savers and
business models previously constructed on the basis of positive real
yields and wider margins for loans. Net interest margins at banks
compress; liabilities at insurance companies threaten their levered
equity; and underfunded pension plans require greater contributions from
their corporate funders unless regulatory agencies intervene. What has
followed has been a gradual erosion of real
growth as layoffs, bank branch closings and business consolidations
create less of a need for labor and physical plant expansion. In effect,
the initial magic of credit creation turns less magical, in some cases
even destructive and begins to consume credit markets at the margin as
well as portions of the real economy it has created. For readers
demanding a more model-driven, historical example of the negative impact
of zero based interest rates, they have only to witness the modern day
example of Japan. With interest rates close to zero for the last decade
or more, a sharply declining rate of investment in productive plants and
equipment, shown in Chart 2, is the best evidence. A Japanese credit
market supernova, exploding and then contracting onto itself. Money and
credit may be losing heat and running out of time in other developed
economies as well, including the U.S.
Investment Strategy
If so then the legitimate question is: how much time does
money/credit have left and what are the investment consequences between
now and then? Well, first I will admit that my supernova
metaphor is more instructive than literal. The end of the global
monetary system is not nigh. But the entropic characterization is most
illustrative. Credit is now funneled increasingly into market
speculation as opposed to productive innovation. Asset price
appreciation as opposed to simple yield or “carry” is now critical to
maintain the system’s momentum and longevity. Investment banking, which
only a decade ago promoted small business development and transition to
public markets, now is dominated by leveraged speculation and the Ponzi
finance Minsky once warned against.
So our credit-based financial markets and the economy it
supports are levered, fragile and increasingly entropic – it is running
out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.
REPEAT: THE COUNTDOWN BEGINS WHEN INVESTABLE ASSETS POSE TOO MUCH RISK FOR TOO LITTLE RETURN.
Visible first signs for creditors would logically be 1) long-term
bond yields too low relative to duration risk, 2) credit spreads too
tight relative to default risk and 3) PE ratios too high relative to
growth risks. Not immediately, but over time, credit is exchanged
figuratively or sometimes literally for cash in a mattress or conversely
for real assets (gold, diamonds) in a vault. It also may move to other
credit markets denominated in alternative currencies. As it does,
domestic systems delever as credit and its supernova heat is abandoned
for alternative assets. Unless central banks and credit
extending private banks can generate real or at second best, nominal
growth with their trillions of dollars, euros, and yen, then the risk of
credit market entropy will increase.
The element of time is critical because investors and
speculators that support the system may not necessarily fully
participate in it for perpetuity. We ask ourselves frequently
at PIMCO, what else could we do, what else could we invest in to avoid
the consequences of financial repression and negative real interest
rates approaching minus 2%? The choices are varied: cash to help protect
against an inflationary expansion or just the opposite – long
Treasuries to take advantage of a deflationary bust; real assets;
emerging market equities, etc. One of our Investment Committee members
swears he would buy land in New Zealand and set sail. Most of us can’t
do that, nor can you. The fact is that PIMCO and almost all professional
investors are in many cases index constrained, and thus duration and
risk constrained. We operate in a world that is primarily credit based
and as credit loses energy we and our clients should acknowledge its
entropy, which means accepting lower returns on bonds, stocks, real
estate and derivative strategies that likely will produce less than
double-digit returns.
Still, investors cannot simply surrender to their entropic
destiny. Time may be running out, but time is still money as the
original saying goes. How can you make some?
(1) Position for eventual inflation: the end stage of a supernova
credit explosion is likely to produce more inflation than growth, and
more chances of inflation as opposed to deflation. In bonds, buy
inflation protection via TIPS; shorten maturities and durations; don’t
fight central banks – anticipate them by buying what they buy first;
look as well for offshore sovereign bonds with positive real interest
rates (Mexico, Italy, Brazil, for example).
(2) Get used to slower real growth: QEs and zero-based interest
rates have negative consequences. Move money to currencies and asset
markets in countries with less debt and less hyperbolic credit systems.
Australia, Brazil, Mexico and Canada are candidates.
(3) Invest in global equities with stable cash flows that should provide historically lower but relatively attractive returns.
(4) Transition from financial to real assets if possible at the margin:
buy something you can sink your teeth into – gold, other commodities,
anything that can’t be reproduced as fast as credit. Think of PIMCO in
this transition. We hope to be “Your Global Investment Authority.” We have a product menu to assist.
(5) Be cognizant of property rights and confiscatory policies in all governments.
(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.
We may be running out of time, but time will always be money.
Speed Read for Credit Supernova
1) Why is our credit market running out of heat or fuel?
a) As it expands at a rate of trillions per year, real growth in the economy has failed to respond. More credit goes to pay interest than future investment.b) Zero-based interest rates, which are the result of QE and credit creation, have negative as well as positive effects. Historic business models may be negatively affected and investment spending may be dampened.c) Look to the Japanese historical example.
2) What options should an investor consider?
a) Seek inflation protection in credit market assets/ shorten durations.b) Increase real assets/commodities/stable cash flow equities at the margin.c) Accept lower future returns in portfolio planning.
William H. Gross
Managing Director
* The terms “money” and “credit” are used
interchangeably in this IO. Purists would dispute the usage and I would
agree with them, arguing for the usage for simplicity’s sake and the
evolving homogeneity of the two.
† Outstanding credit includes all
government debt as well as corporate, household and personal debt. Does
not include “shadow” debt estimated at $20-30 trillion.
Rational Temperance - March 2013
Investment Outlook
Rational Temperance
But how do we know when irrational exuberance has unduly escalated asset values?
– Alan Greenspan 1996
PIMCO’s dear friend and former counselor Alan Greenspan coined this
now famous phrase in the midst of what turned out to be a fairly
rationally priced stock market in late 1996. While the market was indeed
moving in the direction of “dot-com” fever three to four years later,
the Dow Jones Industrial Average at the time was a relatively anorexic
6,000, and the trailing P/E ratio was only 12x. For a central bank that
was then more concerned about economic growth and inflation as opposed
to stock prices, risk spreads, and artificially suppressed interest
rates, the Chairman’s query made global headlines, became a book title
for Professor Robert Shiller and a strategic beacon for portfolio
managers thereafter. Having experienced two and perhaps three bouts of
significant market irrationality since Greenspan’s speech (the 1998
Asian Crisis, 2000 Dot-Coms, and of course 2007’s subprime euphoria),
investors these days have their ears pressed to the ground and eyes
glued to the tape for any sign of renewed irrationality. If the game is
now musical chairs as opposed to Chuck Prince’s marathon dancing, it
pays to be close to a chair, even as the “can’t miss” euphoria
mesmerizes 2013 asset managers worldwide.
Into this academic but high-staked market fog has stepped another Fed
official, this time not a Chairman but a relatively new yet similarly
quizzical Governor. Jeremy Stein’s February 2013 speech has not gained
the attention that Chairman Greenspan’s did, but it is remarkably
similar in its intent and initial question: Governor Stein asks, “What
factors lead to overheating episodes in credit markets?... Why is it
that sometimes, things get out of balance?” Without mimicking Chairman
Greenspan’s phrase, Governor Stein renews the quest, asking nearly a
decade and a half later, “How do we know when irrational exuberance has
unduly escalated asset values?” I suppose it’s fair to criticize both queries on two grounds: 1) Although asked by Chairman Greenspan, it was never really answered in the 1996 speech. 2) If the Fed’s so smart, why are some of us still poor? Why did our 401(k)s become 201(k)s in 2009 before recovering to near peak levels currently? If they’re so smart, why the roller coaster ride, the 30% decline in home prices since 2006, and our current 7.9% unemployment rate?
Well to answer for the absent Chairman and the necessarily silent Governor Stein, the Fed incorrectly assumed that as long as inflation was benign, and future productivity prospects were near historical proportions, then asset price exuberance was an indirect and much less significant influence on economic growth. The Chairman admitted as much in a public “mea culpa” several years ago. We’re not that smart, he seemed to intone. Sometimes we make mistakes. I’m with you there, Mr. Chairman. Sometimes we all do.
So let’s approach this new paper with eyes wide open and pant bottoms close to those mythical musical chairs. Governor Stein’s speech reflects importantly on the answer to the question asked by a recent Wall Street Journal headline: “Is (the) Bull Sprint Becoming a Marathon?” Is there indeed “A Boom Time” in markets as the Financial Times queried on the heels of Dell, Virgin Media, and then HJ Heinz?
Governor Stein, as does PIMCO, suggests caution. On a scale of 1-10 measuring asset price “irrationality”, we are probably at a 6 and moving in an upward direction. Admittedly, Stein never ventures into the netherworld of stock market prices or leveraged buyouts. He appears to know better. What he does stake claim to however is a thesis for high yield spreads with the implication that other credit markets bear similar consequences. His initial starting point is that the pricing of credit is primarily an institutional as opposed to a household decision making process. Individuals may become unduly irrational when it comes to buying high yield ETFs or mutual funds, but it is the banks, insurance companies and pension funds, to name the most dominant, that influence the price of credit – high yield bonds – and by osmosis, investment grade corporates, municipals, and other non-Treasury risk credit assets. From this initial premise, he then points to recent research by Harvard’s Robin Greenwood and Samuel Hanson that suggests that while credit spreads are helpful future guides, that a non-price measure – the new issue volume (and perhaps quality) of high yield bonds – is a more trustworthy input. To quote: “When the high-yield share (of issuance) is elevated, future returns on corporate credit tend to be low.” And because of financial innovation and easier regulatory changes, institutional buyers such as banks, insurance companies and pension funds tend to match the mountains of issuance with an exuberance that eventually can be labeled irrational. Stein’s bottomline is that recent evidence suggests that we are seeing a “fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.” In fact, investors bought over $100 billion of high yield and levered loan paper last year, a record level even exceeding the ominous levels in 2006 and 2007. Shown below in Chart 1 is a history of CLO issuance, admittedly a subset of high yield, but one which illustrates the supply pattern Governor Stein is leery of.
But I would step now into the forbidden territory of equity pricing by presenting additional historical correlations compiled by Jim Bianco of Bianco Research – admittedly not a thickly populated academically staffed organization like the Fed, but a well-regarded one nonetheless. He points out in a recent daily release that high yield and corporate bonds are really just low beta equivalents of stocks. It appears that they are. The following charts show a rather commonsensical negative correlation of high yield spreads (and therefore future high yield returns) to stock prices.
PIMCO’s and Governor Stein’s “rational temperance,” in contrast to excessive historical bouts of “irrational exuberance,” simply counsels to lower return expectations, not to abandon ship. PIMCO is a global investment manager – not one with a perpetual frown or even an ever-present half empty glass – but one which hopes to provide alpha and above market returns while still standing tall in the aftermath of future irrational bouts of exuberance. We join with Governor Stein and perhaps Alan Greenspan in encouraging not an exit but a reduced expectation. Credit spreads nor interest rates cannot be artificially compressed forever, nor can stock prices rise perpetually on their coattails. Be rational, be optimistic if so inclined, but temper it with a commonsensical conclusion that we have seen something similar to this before, and that previous outcomes seldom matched the exuberance.
IO Speed read:
1) Chairman Greenspan’s “irrational exuberance” speech in 1996 posed an excellent question, and history provided the answer.
2) Fed Governor Jeremy Stein asks the same question in 2013 with a uni-dimensional but useful model.
3) Stein’s paper, accompanied by correlations from Bianco Research, suggests caution in today’s high yield market.
4) High yield bonds, stock prices and other risk spreads move in relative tandem.
5) PIMCO cautions “rational temperance”: be bullish if you want, but lower return expectations on all asset classes.
William H. Gross
Managing Director
Man in the Mirror - April 2013
Investment Outlook
Am I a great investor? No, not yet. To paraphrase Ernest Hemingway’s “Jake” in The Sun Also Rises, “wouldn’t it be pretty to think so?” But the thinking so and the reality are often miles apart. When looking in the mirror, the average human sees a six-plus or a seven reflection on a scale of one to ten. The big nose or weak chin is masked by brighter eyes or near picture perfect teeth. And when the public is consulted, the vocal compliments as opposed to the near silent/ whispered critiques are taken as a supermajority vote for good looks. So it is with investing, or any career that is exposed to the public eye. The brickbats come via the blogs and ambitious competitors, but the roses dominate one’s mental and even physical scrapbook. In addition to hope, it is how we survive day-to-day. We look at the man or woman in the mirror and see an image that is as distorted from reality as the one in a circus fun zone.
A Man in the Mirror
I’m starting with the man in the mirror
I’m asking him to change his ways
And no message could have been any clearer
If you wanna make the world a better place
Take a look at yourself, and then make a…
Chaaaaaaaange .....
— Michael Jackson
I’m asking him to change his ways
And no message could have been any clearer
If you wanna make the world a better place
Take a look at yourself, and then make a…
Chaaaaaaaange .....
— Michael Jackson
Am I a great investor? No, not yet. To paraphrase Ernest Hemingway’s “Jake” in The Sun Also Rises, “wouldn’t it be pretty to think so?” But the thinking so and the reality are often miles apart. When looking in the mirror, the average human sees a six-plus or a seven reflection on a scale of one to ten. The big nose or weak chin is masked by brighter eyes or near picture perfect teeth. And when the public is consulted, the vocal compliments as opposed to the near silent/ whispered critiques are taken as a supermajority vote for good looks. So it is with investing, or any career that is exposed to the public eye. The brickbats come via the blogs and ambitious competitors, but the roses dominate one’s mental and even physical scrapbook. In addition to hope, it is how we survive day-to-day. We look at the man or woman in the mirror and see an image that is as distorted from reality as the one in a circus fun zone.
Yet at first blush, there is a partial saving grace in the money
management business. We have numbers. Subjective perceptions aside, we
have total return and alpha histories that purport to show how much
better an individual or a firm has been than the competition, or if not,
what an excellent return relative to inflation, or if not, what a
generous amount of wealth creation over and above cash … the comparisons
are seemingly endless yet the conclusions nearly always positive,
rendering the “saving grace” almost meaningless: everyone in their own
mind is at least a six-plus or a seven, and if not for the most recent
year, then over the last three, five, or 10 years. Investors thrive on
the numbers and turn them in their favor when observing their
reflections. That first blush becomes a permanently rosy complexion with
Snow White cheeks.
The investing public is often similarly deceived. Consultants warn
against going with the flow, selecting a firm or an individual based
upon recent experience, but the reality is generally otherwise. Three
straight flips of the coin to “heads” produces a buzz in the crowd for
another “heads,” despite the obvious 50/50 probabilities, as do 13
straight years of outperforming the S&P 500 followed by … Well, you
get my point. The Financial Times just published a study
confirming that a significant majority of computer simulated monkeys
beat the stock market between 1968 and 2011 – good looking monkeys that
is.
In questioning initially whether I am a great investor, I open the
door to question whether other similarly esteemed public icons like Bill
Miller are as well. It seems, perhaps, that the longer and longer you
keep at it in this business the more and more time you have to expose
your Achilles heel – wherever and whatever that might be. Ex-Fidelity
mutual fund manager Peter Lynch was certainly brilliant in one respect:
he knew to get out when the gettin’ was good. How his “buy what you know
best” philosophy would have survived the dot-coms or the
Lehman/subprime bust is another question.
So time and longevity must be a critical consideration in
any objective confirmation of “greatness” in this business. 10 years, 20
years, 30 years? How many coins do you have to flip before a string of
heads begins to suggest that it must be a two-headed coin, loaded with
some philosophical/commonsensical bias that places the long-term odds
clearly in a firm’s or an individual’s favor? I must tell you,
after 40 rather successful years, I still don’t know if I or PIMCO
qualifies. I don’t know if anyone, including investing’s most esteemed
“oracle” Warren Buffett, does, and here’s why.
Investing and the success at it are predominately viewed on a
cyclical or even a secular basis, yet even that longer term time frame
may be too short. Whether a tops-down or bottoms-up investor in bonds,
stocks, or private equity, the standard analysis tends to judge an
investor or his firm on the basis of how the bullish or bearish aspects
of the cycle were managed. Go to cash at the right time? Buy growth
stocks at the bottom? Extend duration when yields were peaking? Buy
value stocks at the right price? Whatever. If the numbers exhibit rather
consistent alpha with lower than average risk and attractive
information ratios then the Investing Hall of Fame may be just around
the corner. Clearly the ability of the investor to adapt to the market’s
“four seasons” should be proof enough that there was something more
than luck involved? And if those four seasons span a number of bull/
bear cycles or even several decades, then a confirmation or coronation
should take place shortly thereafter! First a market maven, then a
wizard, and finally a King. Oh, to be a King.
But let me admit something. There is not a Bond King or a Stock
King or an Investor Sovereign alive that can claim title to a throne.
All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too,
have cut our teeth during perhaps a most advantageous period of time,
the most attractive epoch, that an investor could experience.
Since the early 1970s when the dollar was released from gold and credit
began its incredible, liquefying, total return journey to the present
day, an investor that took marginal risk, levered it wisely and was
conveniently sheltered from periodic bouts of deleveraging or asset
withdrawals could, and in some cases, was rewarded with the crown of
“greatness.” Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.
Authors Dimson, Marsh and Staunton would probably agree. In
fact, the title of their book “Triumph of the Optimists” rather cagily
describes an epochal 101 years of investment returns – one in which it
paid to be an optimist and a risk taker as opposed to a more
conservative Scrooge McDuck. Written in 2002, they perhaps
correctly surmised however, that the next 101 years were unlikely to be
as fortunate because of the unrealistic assumptions that many investors
had priced into their markets. And all of this before QE and 0% interest
rates! In any case, their point – and mine as well – is that different
epochs produce different returns and fresh coronations as well.
I have always been a marginal or what I would call a measured risk
taker; decently good at interest rate calls and perhaps decently better
at promoting that image,
but a risk taker at the margin. It didn’t work too well for a few
months in 2011, nor in selected years over the past four decades, but
because credit was almost always expanding, almost always fertilizing
capitalism with its risk-taking bias, then PIMCO prospered as well. On a
somewhat technical basis, my/our firm’s tendency to sell volatility and
earn “carry” in a number of forms – outright through options and
futures, in the mortgage market via prepayment risk, and on the curve
via bullets and roll down as opposed to barbells with substandard carry –
has been rewarded over long periods of time. When volatility has
increased measurably (1979-1981, 1998, 2008), we have been fortunate
enough to have either seen the future as it approached, or been just
marginally overweighted from a “carry” standpoint so that we survived
the dunking, whereas other firms did not.
My point is this: PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter
Lynch’s epoch, all occurred or have occurred within an epoch of credit
expansion – a period where those that reached for carry, that sold
volatility, that tilted towards yield and more credit risk, or that were
sheltered either structurally or reputationally from withdrawals and
delevering (Buffett) that clipped competitors at just the wrong time –
succeeded. Yet all of these epochs were perhaps just that – epochs. What
if an epoch changes? What if perpetual credit expansion and its
fertilization of asset prices and returns are substantially altered?
What if zero-bound interest rates define the end of a total return
epoch that began in the 1970s, accelerated in 1981 and has come to a
mathematical dead-end for bonds in 2012/2013 and commonsensically for
other conjoined asset classes as well? What if a future epoch favors
lower than index carry or continual bouts of 2008 Lehmanesque
volatility, or encompasses a period of global geopolitical confrontation
with a quest for scarce and scarcer resources such as oil, water, or
simply food as suggested by Jeremy Grantham? What if the effects of
global “climate change or perhaps aging demographics,” substantially
alter the rather fertile petri dish of capitalistic expansion and
endorsement? What if quantitative easing policies eventually collapse
instead of elevate asset prices? What if there is a future that demands
that an investor – a seemingly great investor – change course, or at
least learn new tricks? Ah, now, that would be a test of greatness: the ability to adapt to a new epoch.
The problem with the Buffetts, the Fusses, the Granthams, the Marks,
the Dalios, the Gabellis, the Coopermans, and the Grosses of the world
is that they’ll likely never find out. Epochs can and likely will
outlast them. But then one never knows what time has in store for each
of us, or what any of us will do in the spans of time.
What I do know, is that, like Michael Jackson sang in his
brilliant, but all too short lifetime, I am and will continue to look at
the man in the mirror. PIMCO, Gross, El-Erian? – yes, we’re lookin’
good – in this epoch. If there’s a different one coming though, to make
our and your world a better place, we might need to look in the mirror
and make a Chaaaaaaaange … Depends on what we see, I suppose. We will
keep you informed.
Man in the Mirror Speed Read
- Investors should be judged on their ability to adapt to different epochs, not cycles. An epoch may be 40-50 years in time, perhaps longer.
- Bill Miller may in fact be a great investor, but he’ll need 5 or 6 more straight “heads” in a future epoch to confirm it. Peter Lynch is a “party pooper.” Warren is the Oracle, but if an epoch changes will he and others like him be around to adapt to it?
- No matter how self-indulgent you think this IO is, I just looked in the mirror and saw at least a 7. You must be blind!
William H. Gross
Managing Director
Haircuts - May 2013
Investment Outlook
There Will Be Haircuts
Well, not being inebriated at that moment I immediately shifted focus to a more serious topic. What IS money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of “ready” cash at a friendly bank. Yet as technology and financial innovation have progressed over the past few decades, and as central banks have tenuously validated the liquidity and price of various forms of credit, it seems that the definition of money has been extended; not perhaps to a bottle of Twenty Grand Vodka, but at least to some other rather liquid forms of near currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Fed to trade at par over the next few years.
All of the above are close to serving as a “medium of exchange” because they presumably can be converted overnight at the holder’s whim without loss and then transferred to a savings or checking account. It has been the objective of the Fed over the past few years to make even more innovative forms of money by supporting stock and bond prices at cost on an ever ascending scale, thereby assuring holders via a “Bernanke put” that they might just as well own stocks as the cash in their purses. Gosh, a decade or so ago a house almost became a money substitute. MEW – or mortgage equity withdrawal – could be liquefied instantaneously based on a “never go down” housing market. You could equitize your home and go sailing off into the sunset on a new 28-foot skiff on any day but Sunday.
So as long as liquid assets can hold par/cost with an option to increase in price, then these new forms of credit or equity might be considered “money” or something better! They might therefore represent a “store of value” in addition to serving as a convertible medium of exchange. But then, that phrase “Good as Money” on the vodka bottle kept coming back to haunt me. Is all this newfangled money actually “money good?” Technology and Fed liquidity may have allowed them to serve as modern “mediums of exchange,” but are they legitimate “stores of value?” Well, the past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.
But let’s not go there and speak of a bubble popping. Let’s perhaps more immediately speak about current and future haircuts when we question the “goodness of money.” Carmen Reinhart has said with historical observation that we are in an environment where politicians and central bankers are reluctant to allow write-offs: limited entitlement cuts fiscally, no asset price sink holes monetarily. Yet if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced. Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs, in home mortgages in the U.S., for example, and sovereign debt in Greece. But the cost of these strategies, which avoid what I simplistically call “haircuts,” has been high, and their ability to reduce overall debt/GDP ratios is questionable. Chairman Bernanke has admitted that the cost of zero-bound interest rates, for instance, extracts a toll on pension funds and individual savers. Some of his Fed colleagues have spoken out about the negative aspects of QE and future difficulties of exit strategies should they ever take place. (They won’t!) So current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money” – shots of vodka notwithstanding.
But the point of this Outlook is that even IF… even IF QEs and near zero-bound yields are able to refloat global economies and generate a semblance of old normal real growth, they will do so utilizing historically tried and true “haircuts” that rather surreptitiously “trim” an asset holder’s money without them really knowing they had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor’s purchasing power as manipulated interest rates lag inflation. In the process, governments and their central banks theoretically reduce real debt levels as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”
Before drinking up, let’s examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name – I welcome your suggestions as well via e-mail reply: outlook@pimco.com
(1) Negative Real Interest Rates – “Trimming the Bangs”
During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions.
Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and
(-2%) real rate haircuts are not a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.” But at the cut’s conclusion, there’s a lot of hair left on the floor.
(2) Inflation / Currency Devaluation – the “Don Draper”
Inflation’s sort of like your everyday “Mad Men – Don Draper” type of haircut. It’s been around for a long time and we don’t really give it a second thought except when it’s on top of a handsome head like Jon Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s just like breathing air … you just gotta have it for a modern-day levered economy to survive. Sometimes, though, it gets out of control, and when it is unexpected, a decent size hit to your bond and stock portfolio is a possibility. If our TV idol Don Draper lives another decade or so on the airwaves, he’ll find out in the inflationary 70s. Such was the example as well in the Weimar Republic in the 1920s and in modern day Zimbabwe with its One Hundred Trillion Dollar bill shown below. As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way – historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be “good as the money” you might be banking on.
Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the U.S. can latch on to your money or capital. Back in the 1930s, FDR instituted a rather blatant form of expropriation shown above. All private ownership of gold was forbidden (and subject to a $10,000 fine and 10 years in prison!) if it wasn’t turned into the government. Today we have less obvious but similar forms of capital controls – currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargos of bank deposits (Cyprus). Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax. Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you’re not careful.
Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in honor of this 5-year bond issued in the 1920s with a beautiful gold seal and payable, in dollars or machine guns! Bond holders got neither and so it represents the historical example of the ultimate haircut – the buzz, the shaved head, the “Dobbins.” As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die. That is half figurative and half literal, because central banks are typically limited from purchasing bonds payable in machine guns or subprime mortgages (there have been exceptions and Bloomberg reported that nearly 25% of global central banks are now buying stocks believe it or not)! But by purchasing Treasuries and Agency mortgages they have rather successfully incented the private sector to do their bidding. This behavior reflects the admission that modern-day developed economies are asset-priced supported. Unless prices can continuously be floated upward, defaults and debt deflation may emerge. Don’t buy a Dobbins bond or a Dobbins-like asset or a bond from a country whose central bank is buying stocks. They probably aren’t “good as money!”
Investment Strategy
So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd!
Let’s acknowledge that possibility, along with the observation that all
of these haircuts imply lower-than-average future returns for bonds,
stocks, and other financial assets. If so, the rather mixed metaphor of
“money’s goodness” and “avoiding haircuts” is still the question of our
modern investment age. The easiest answer to the question of what to buy
is to simply take your ball and go home. If the rules aren’t fair,
don’t play. That endgame however, results in a Treasury bill rate of 10
basis points or a negative yield in Germany, France and Northern EU
markets. So a bond and equity investor can choose to play with
historically high risk to principal or quit the game and earn nothing.
PIMCO’s advice is to continue to participate in an obviously
central-bank-generated bubble but to gradually reduce risk positions in
2013 and perhaps beyond. While this Outlook has indeed claimed
that Treasuries are money good but not “good money,” they are better
than the alternative (cash) as long as central banks and dollar reserve
countries (China, Japan) continue to participate. The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sounds a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing, and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.
Quick Read
1) Central banks and policymakers are acting like barbers. They haircut your investments. 2) Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.
3) Gradually reduce duration, risk positions and “carry” as the year proceeds.
William H. Gross
Managing Director
Wounded Heart - JUNE 2013
Investment Outlook
Wounded Heart
Joseph Schumpeter, the originator of the phrase “creative destruction,” authored a less well-known corollary at some point in the 1930s. “Profit,” he wrote, “is temporary by nature: It will vanish in the subsequent process of competition and adaptation.”
And so it has, certainly at the micro level for which his remark was
obviously intended. Once proud, seemingly indestructible capitalistic
giants have seen their profits fall short of “everlasting” and exhibited
a far more ephemeral character. Kodak, Sears, Barnes & Noble, AOL
and countless others have been “competed” to near oblivion by advancing
technology, more focused management, or evolving business models that
had better ideas more “adaptable” to a new age.
Yet capitalism at a macro level must inherently be different than the micro individual businesses which comprise it. Profits in total
cannot be temporary or competed away if capitalism as we know it is to
survive. Granted, the profit share of annual GDP can increase or
decrease over time in its ongoing battle with labor and government for
market share. But capitalism without profits is like a beating heart
without blood. Not only is it profit’s role to stimulate and rationally
distribute new investment (blood) to the economic body, but the profit
heart in turn must be fed in order to survive. And just as profits are critical to the longevity of our capitalistic real economy so too is return or “carry” critical to our financial markets. Without the assumption of “carry,” or return over and above the fixed, if mercurial, yield on an economy’s policy rate (fed funds), then investors would be unwilling to risk financial capital and a capitalistic economy would die for lack of oxygen. The carry or return I speak to is most commonly assumed to be a credit or an equity risk “premium” involving some potential amount of gain or loss to an investor’s principal. Corporate and high yield bonds, stocks, private equity and emerging market investments are financial assets that immediately come to mind. If the “carry” or potential return on these asset classes were no more than the 25 basis points offered by today’s fed funds rate, then who would take the chance? Additionally, however, “carry” on an investor’s bond portfolio can be earned by extending duration and holding longer maturities. It can be collected by selling volatility via an asset’s optionality, or it can be earned by sacrificing liquidity and earning what is known as a liquidity premium. There are numerous ways then to earn “carry,” the combination of which for an entire market of investable assets constitutes a good portion of its “beta” or return relative to the “risk free” rate, all of which may be at risk due to artificial pricing.
This “carry” constitutes the beating heart of our financial markets and ultimately our real economy as well, since profits on paper assets are inextricably linked to profits in the real economy, which are inextricably linked to investment and employment. Without these, the wounded heart dies and shortly thereafter the body. But there comes a point when no matter how much blood is being pumped through the system as it is now, with zero-based policy rates and global quantitative easing programs, that the blood itself may become anemic, oxygen-starved, or even leukemic, with white blood cells destroying more productive red cell counterparts. Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions. Let me shift from the metaphorical to the specific to make my case.
If “carry” is the oxygen that feeds financial assets then it is clear to all – even to central banks with historical models – that there is a lot less of it now than there used to be. In the bond market – interest rates, risk spreads, volatility and liquidity premiums are all significantly less than they were five years ago during the financial crisis and, in many cases, less than they have ever been in history. Before 2009, the U.S. had never had a policy rate so low, and in the U.K. short-term rates at 50 basis points are now nearly 2% lower than they have ever been, which is a long, long time. Throughout periodic depressions, the Bank of England in the 20th, 19th and even 18th century never dropped short rates below 2%. Add to that of course the New Age chemotherapy called Quantitative Easing (QE) being employed everywhere (and now in double doses at the Bank of Japan,) and you have an “all in”, “whatever it takes” mentality that has successfully lowered longer-term interest rates, risk spreads, volatility and risk premiums to similar extremes. Granted, the astute observer might counter that corporate and high yield risk “spreads” have historically been lower – and they were in 2006/2007 – but never have corporate and high yield bond “yields” been lower. Never has your average B/BB company been able to issue debt at well below 5% and never – which is my point – never have investors received less for the risk they are taking. “Never (as I tweeted recently) have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.”
In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.
Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.
In addition, there are several other important coagulants that seem to block the financial system’s arteries at zero-bound interest rates and unacceptably narrow “carry” spreads:
Well, there is my still incomplete thesis which when summed up would be this: Low yields, low carry, future low expected returns have increasingly negative effects on the real economy. Granted, Chairman Bernanke has frequently admitted as much but cites the hopeful conclusion that once real growth has been restored to “old normal”, then the financial markets can return to those historical levels of yields, carry, volatility and liquidity premiums that investors yearn for. Sacrifice now, he lectures investors, in order to prosper later. Well it’s been five years Mr. Chairman and the real economy has not once over a 12-month period of time grown faster than 2.5%. Perhaps, in addition to a fiscally confused Washington, it’s your policies that may be now part of the problem rather than the solution. Perhaps the beating heart is pumping anemic, even destructively leukemic blood through the system. Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution. Perhaps when yields, carry and expected returns on financial and real assets become so low, then risk-taking investors turn inward and more conservative as opposed to outward and more risk seeking. Perhaps financial markets and real economic growth are more at risk than your calm demeanor would convey.
- Zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth.
- Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of “carry” compression, and then nationwide retail branches previously serving as depository magnets are closed one by one. In the U.K. for instance, Britain’s four biggest banks will have eliminated 189,000 jobs by the end of this year compared to peak staffing levels, reports Bloomberg News. Investment banking, insurance, indeed the entire financial industry is now similarly threatened, which is leading to layoffs and the obsolescence of real estate office structures as well which housed a surfeit of employees.
- Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living. Schumpeter would be shocked at this perversion of capitalism, which is allowing profits to be more than “temporary” at zombie institutions. Real growth is stunted in the process.
- Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury “repo.” Again, too complicated for a sidebar Investment Outlook discussion, but the ability of private credit markets to deliver oxygen to the real economy is being hampered because most new Treasuries wind up in the dungeon of the Fed’s balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth. I have previously suggested that the Fed (and other central banks) are where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy.
Wounded heart you cannot save … you from yourself. More and more debt cannot cure a debt crisis unless it generates real growth. Your beating heart is now arrhythmic and pumping deoxygenated blood. Investors should look for a pacemaker to follow a less risky, lower returning, but more life sustaining path.
The Wounded Heart Speed Read
1) Financial markets require “carry” to pump oxygen to the real economy. 2) Carry is compressed – yields, spreads and volatility are near or at
historical lows.
3) The Fed’s QE plan assumes higher asset prices will revigorate growth.
4) It doesn’t seem to be working.
5) Reduce risk/carry related assets.
William H. Gross
Managing Director
Bill Gross - June 2013
Which way for bonds?
Mapping a path forward
Q: Can you explain what is happening in markets now?
Gross: In 1980, the Federal Reserve, led by Paul Volcker, tightened the quantitative noose to tame double-digit inflation, fueling an unprecedented tailwind for bond prices. Thirty years later we find ourselves at the other extreme, as central banks print money in the trillions of dollars to stimulate economic growth, and inflation is abnormally low. While we are not likely to see a repeat of that type of bull market any time soon, we also do not believe we are at the beginning of a bear market for bonds. Rather, what we’re seeing is the continuation – and acceleration, in some respects – of the de-levering process, a key distinction that may be getting lost in some of the noise over the past few weeks. The Fed, the Bank of England, and now the Bank of Japan have all committed to holding their easing stance until growth targets are hit. We don’t see the Fed raising rates in a meaningful way for at least the next few years.
That said, we believe caution is warranted not just for fixed income investors, but for investors in all risk assets. Central banks have reached a critical inflection point in which the negatives of their aggressive policies may be outweighing the positives and in fact hampering growth. Where their monetary repression has succeeded, however, is in forcing investors to take increasing amounts of risk, but for lower yields and more volatile returns.
Gross: In 1980, the Federal Reserve, led by Paul Volcker, tightened the quantitative noose to tame double-digit inflation, fueling an unprecedented tailwind for bond prices. Thirty years later we find ourselves at the other extreme, as central banks print money in the trillions of dollars to stimulate economic growth, and inflation is abnormally low. While we are not likely to see a repeat of that type of bull market any time soon, we also do not believe we are at the beginning of a bear market for bonds. Rather, what we’re seeing is the continuation – and acceleration, in some respects – of the de-levering process, a key distinction that may be getting lost in some of the noise over the past few weeks. The Fed, the Bank of England, and now the Bank of Japan have all committed to holding their easing stance until growth targets are hit. We don’t see the Fed raising rates in a meaningful way for at least the next few years.
That said, we believe caution is warranted not just for fixed income investors, but for investors in all risk assets. Central banks have reached a critical inflection point in which the negatives of their aggressive policies may be outweighing the positives and in fact hampering growth. Where their monetary repression has succeeded, however, is in forcing investors to take increasing amounts of risk, but for lower yields and more volatile returns.
Q: When do you expect the Fed to begin to take its foot off the QE pedal? Are rising rates a concern?
Gross: The Federal Reserve has cited an unemployment rate of 6.5% as its threshold for pulling back on monetary policy. At the same time, Chairman Bernanke wants to avoid the mistake of premature tightening, as occurred disastrously in the 1930s. While we agree with this reasoning, we are concerned by the growing downside of zero-based money and QE policies – among them a worrisome distortion in asset pricing, the misallocation of capital and ultimately a dis-incentivizing of risk taking by corporations and investors. The Fed shares these concerns as well, which is why some members are considering a reduction or tapering of purchases. From a technical perspective, the Fed may also be forced to taper its purchases to match the shrinking U.S. budget deficit. But there’s a difference between a mild reduction and a decision by the Fed to materially scale back its bond purchase program. The economy has yet to achieve escape velocity, and unemployment is still stubbornly high and structural in nature. So while we may see some tapering, possibly by the end of the year, we do not expect the Fed to remove the trough for some time or for this to signal a dramatic increase in rates. Rates will fluctuate over the shorter term, of course, and it’s our job as active managers to effectively position our clients’ portfolio if that occurs. This is something we have done for our investors for decades.
Q: How are you positioning Total Return to navigate this environment?
Gross: While it’s natural to want to reach for higher returns, an investment strategy’s success depends on carefully weighing potential rewards against the long-term costs, using the insights you’ve gathered on the ground and on a macro level through rigorous analysis. Today, given the economic uncertainty and rich market valuations, we think that the fortitude to wait for more attractive opportunities is a valuable attribute. Our goal for the Total Return strategy is to enhance our dry powder, seek prudent alpha and reduce risk – not dramatically, but to average or slightly below-average levels. Fortunately, PIMCO has a wide array of tools at our disposal to accomplish that. So, among other things, we’re avoiding long durations, reducing credit risk away from economically vulnerable companies and sectors, managing volatility and increasing exposure to countries with higher-quality balance sheets such as the U.S., Brazil, Mexico and Australia. And we are seeking out and taking advantage of opportunities in the market. For example, we believe intermediate Treasuries are currently attractively priced at around 2%.
At the forefront, PIMCO’s first and most important objective is
preserving our clients’ capital, as it has been since Total Return was
launched more than a quarter-century ago. In a market environment such
as the one we’re currently navigating, this risk management priority
becomes even more essential. In the meantime, we believe our portfolios
are well positioned for future opportunities. If “traditional” bond beta
is likely to be subdued, as we are forecasting, there are still ways
for a resourceful and experienced investment manager to generate alpha
from less traditional sectors.
Q: With bond markets so uncertain, what steps can investors take to ensure they’re prudently pursuing their financial goals?
Gross: It’s important for investors to remember the reasons they own bonds in the first place – namely for the potential for the preservation of capital, income and growth, relative steadiness and typically low to negative correlations with equities. These needs – which will only become more urgent as millions of baby boomers head to retirement over the next decade and a half – are long term, regardless of what markets are doing today. So fixed income should always have a place in a portfolio. Still, there are ways to navigate challenging markets without feeling stuck. One is to expand your investment universe by going global. Here at PIMCO we like to say that there is no “bond market,” but rather “a market of bonds.” So, you should prize flexibility in your fixed income manager or core bond strategy.
Finally, be patient. Times are challenging, to be sure, but PIMCO
has been successfully investing through more than four decades of market
and economic cycles, which gives us some perspective, as well as the
confidence that we’re going to be around to fight for the next 40 years.
We certainly hope our clients take some comfort in that.
Q: With bond markets so uncertain, what steps can investors take to ensure they’re prudently pursuing their financial goals?
Gross: It’s important for investors to remember the reasons they own bonds in the first place – namely for the potential for the preservation of capital, income and growth, relative steadiness and typically low to negative correlations with equities. These needs – which will only become more urgent as millions of baby boomers head to retirement over the next decade and a half – are long term, regardless of what markets are doing today. So fixed income should always have a place in a portfolio. Still, there are ways to navigate challenging markets without feeling stuck. One is to expand your investment universe by going global. Here at PIMCO we like to say that there is no “bond market,” but rather “a market of bonds.” So, you should prize flexibility in your fixed income manager or core bond strategy.
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