Bill Gross: Investment Outlook (May 2012)

Wednesday, May 2nd, 2012

Tues­day Never Comes

May 2012

by William H. Gross, Co-Chief, PIMCO

- The cur­rent accel­er­a­tion of credit via cen­tral bank poli­cies will likely pro­duce a pos­i­tive rate of real eco­nomic growth this year for most devel­oped coun­tries, but the struc­tural dis­tor­tions brought about by zero bound inter­est rates will limit that growth and induce seri­ous risks in future years.

- Not sud­denly, but over time, grad­u­ally higher rates of infla­tion should be the result of QE poli­cies and zero bound yields that will likely con­tinue for years to come.

- Focus on secu­ri­ties with shorter dura­tions – bonds with matu­ri­ties in the five-year range and stocks pay­ing div­i­dends that offer 3%–4% yields. In addi­tion, real assets/commodities should occupy an increas­ing per­cent­age of portfolios.

The global econ­omy is float­ing on an ocean of credit, and a good thing too as our car­toon friend Wimpy reminds us. With­out it, he would be a hun­gry puppy by next Tues­day and nearly seven bil­lion world cit­i­zens would be worse off if barter, and not credit, was the oil that lubri­cated trade. Unlike Wimpy, early soci­eties func­tioned with­out an exchange of (money) or the promise to pay it back in the future (credit). Growth was lim­ited, how­ever, because sav­ings or invest­ment could not be incented prop­erly. Those that wanted to save for a rainy day had no means to express that cau­tion; bet­ter to con­sume a banana or a ham­burger today than to watch it rot and become worth­less on Tues­day. But money changed all of that and the abil­ity to bor­row and exchange it for repay­ment at some future date was the eco­nomic elixir of the ages. Shake­speare, with his admo­ni­tion to “nei­ther a bor­rower nor a lender be,” might have won a 17th cen­tury Pulitzer, but def­i­nitely not a Nobel Prize for economics.

Still, the use of credit never really kicked into high gear until the dis­cov­ery of frac­tional reserve bank­ing and the ulti­mate for­ma­tion of cen­tral banks to facil­i­tate and pro­tect its dis­burse­ment. Pic­ture a Wild, Wild West Bank in Yuma, Ari­zona back in 1901. It had a big safe where min­ers left their gold nuggets for safe keep­ing, but in order to become more than a depos­i­tory, the bank needed to issue notes and let­ters of credit in an amount greater than the gold in its vault. The­o­ret­i­cally there was some of the owner’s gold dust in there too, but who was count­ing as long as gold came in and gold went out and Yuma’s cit­i­zens thought that the bank’s notes were backed by tan­gi­ble evi­dence of wealth. Frac­tional reserve bank­ing was aborn­ing in the 20th cen­tury, sharp­shoot­ers and all.

Prob­lem was that many of those local banks with their indi­vid­ual cur­ren­cies and drafts went out of busi­ness, lead­ing to pan­ics and mild depres­sions through­out the grow­ing states, and so in 1913 the dol­lar became our sin­gle cur­rency, and the Fed­eral Reserve our offi­cial cen­tral bank. The Fed, with a cer­tain amount of gold cer­tifi­cates, would then extend credit to its mem­ber banks, which would then extend credit to busi­nesses, which would mag­i­cally pro­mote sav­ings, invest­ment and eco­nomic growth. No left­over ham­burg­ers on Tues­day for Wimpy – his tummy was grum­bling and by god, or by Fed, he was gonna get it NOW.

This process of credit and its cre­ation pow­ered global economies for the next cen­tury. It ben­e­fited not only con­sumers who wanted their burg­ers now, but lenders and investors who were will­ing to go hun­gry on Fri­day for the ben­e­fit of get­ting their money back with inter­est on Tues­day. Both sides expe­ri­enced a win/win exchange as the real econ­omy charged ahead, cre­at­ing jobs, tech­no­log­i­cal advances and the erad­i­ca­tion of dis­ease. What was not to like about credit? Noth­ing really, except much as the absence of it hin­dered ancient soci­eties, the excess of it now hob­bles mod­ern economies. Credit is the foun­da­tion of the wealth cre­ation process, but it can also be the cause of finan­cial insta­bil­ity and poten­tial wealth destruc­tion. Like nuclear energy, “atomic” credit or debt must be con­trolled if it is to ben­e­fit, as opposed to destroy.

And so the job of modern-day cen­tral bankers – Bernanke, King, Draghi and their global coun­ter­parts – is to decide how to con­trol a ben­e­fi­cial chain reac­tion with­out it get­ting out of hand. In many ways they are like their Wild, Wild West coun­ter­parts, try­ing to con­vince skep­ti­cal depos­i­tors that the gold will always be there. Yet, since 1971, when Nixon cratered Bret­ton Woods, there has been no explicit or even implicit gold back­ing. The U.S. and there­fore the world’s finance-based economies have been backed by an increas­ing amount of IOUs, which are sim­ply paper promises to cre­ate more paper when there is an old-fashioned 20th cen­tury run on the banks, or incred­i­bly enough – even when there is not. Lack­ing a dis­ci­plined parental exam­ple, the banks, invest­ment banks, money man­agers and hedge funds piled paper on top of paper as well, cre­at­ing deriv­a­tives and seem­ingly end­less chains of repos and rehy­poth­e­ca­tion of repos to amass a total amount of credit that lit­er­ally can­not be counted. Esti­mates sug­gest global credit in the finan­cial sec­tor exceeds $200 tril­lion, with devel­oped economies’ cen­tral banks hold­ing only $15 tril­lion in reserves or fig­u­ra­tive “gold dust.” If so, then the global bank­ing sys­tem is lev­ered at least thir­teen times. These num­bers don’t even count the amount of side bets or credit default swaps, which can’t be used as burger pay­ments, but which total $700–$800 tril­lion alone. Wimpy has financed so many Whop­pers that Tues­day can never come. Judg­ment day must always be around the cor­ner or after the next week­end. Wimpy can­not pay the tab, except with more and more credit cre­ation, as Euroland coun­tries are dis­cov­er­ing first hand.

Yet how much credit is too much credit and how is a ded­i­cated cen­tral banker to know? Part of the prob­lem is in clearly defin­ing what does or doesn’t fit the def­i­n­i­tion. There are the fam­i­lies of M’s – M1, M2 and the dis­banded M3 in the U.S. – the for­mer two of which the Fed now loosely uses to mon­i­tor a growth rate so as not to bring credit cre­ation to a boil. 21st cen­tury pri­va­teers, how­ever, proved there can be no accu­rate gauge of credit growth as long as banks and the shadow banks can cre­ate their own money at will. CDOs, CLOs and secu­ri­tized lend­ing that man­aged to skirt reg­u­la­tory stan­dards for bank loans by apply­ing 1%, 2% and 5% “hair­cuts” to secu­ri­tized assets made a mock­ery of sound bank­ing and ulti­mately cre­ated great risk for cen­tral bankers and their abil­ity to tem­per the excess of credit cre­ation. In 2008, cen­tral bankers never really knew how much debt was out there, and to be hon­est, they don’t know now.

Aus­trian school econ­o­mists might say “no mat­ter, for­get the count­ing – all a cen­tral banker has to do is observe the inter­est rate, the price of credit, to know whether things have got­ten out of hand.” And they may have had a point – even after 1971 and up to the mid-1990s, but then economies and the credit that was dri­ving them mor­phed into a uni­verse that the con­ser­v­a­tive Aus­tri­ans would not have rec­og­nized. With the dot­coms, the sub­primes and now the reflex­ive delev­er­ing of our finan­cial sys­tem, it is prac­ti­cally impos­si­ble to know what inter­est rate is applic­a­ble. With the QEs and LTROs reduc­ing real yields far below absolute zero, a cen­tral banker must wan­der aim­lessly in pol­icy space, won­der­ing how much credit to cre­ate, how many Trea­suries to buy, and how firm a twist to give the yield curve in order to allow Wimpy the chance for another burger and a side order of fries.

What they should know – and what the fol­low­ing chart, pro­vided by the always obser­vant Jim Bianco, shows – is that when QEI and QEII lapsed in recent years, stock prices declined by 10%–15% until mag­i­cally they came back to live another day. The same stunt­ing effect can be observed in the bond mar­ket when mea­sured by real as opposed to nom­i­nal inter­est rates. They go down with QEs and up in their absence.

Admit­tedly, Chart 1 shows only two real data points, which are dif­fi­cult for a Fed Chair­man or his staff to rely on, but com­mon sense under­lies the his­tor­i­cal obser­va­tion as well. With the Fed buy­ing nearly 70% of all five– to 30-year Trea­suries dur­ing Oper­a­tion Twist, and sim­i­larly large per­cent­age amounts of Trea­sury and Agency mortgage-backed issuance since the begin­ning of QEI in Decem­ber 2008, who will buy them now, if the Fed doesn’t?

The Fed appears to have a the­ory that is some­what incom­pre­hen­si­ble to me, stress­ing the “stock” of Trea­suries as opposed to the “flow.” Future flows and annual sup­plies of $1 tril­lion and more, the the­ory argues, will be gob­bled up by the mar­ket even with­out the Fed’s help, at cur­rent arti­fi­cially sup­pressed yields because the pri­vate market’s “stock” of Trea­suries has been depleted. Much like a wine cel­lar, I sup­pose, that is now nearly empty because pol­i­cy­mak­ers have been drink­ing the rare vin­tages, wine lovers will now be forced to restock their cel­lars to get a his­tor­i­cally com­fort­able inven­tory. Hmmm, being a beer drinker myself, I might oth­er­wise assume that appetites might switch due to higher prices (and lower yields). And if wine or bonds were man­dated to fill the cel­lar, then why not a for­eign wine or a for­eign bond? And too, I’m sure the Chi­nese in addi­tion to PIMCO clients would be will­ing at the mar­gin to change their pref­er­ences to real as opposed to finan­cial assets. More con­ser­v­a­tive investors might migrate to cash as the pre­ferred alter­na­tive, because the price of bonds or burg­ers was too high. Wimpy, in other words, might just go vegan if burg­ers aren’t cooked to taste.Because of QEs, the asso­ci­ated Twist, and sim­i­lar check writ­ing by the BOE, BOJ and ECB, sev­eral tril­lion dol­lars of what is aca­d­e­m­i­cally referred to as “base money,” and what Main Street cit­i­zens would rec­og­nize as “gold dust,” has been added to global cen­tral bank vaults. Rather than dug out of the ground, this credit has been cre­ated at the stroke of a pen or a touch of the key­board in today’s elec­tronic mon­e­tary sys­tem. How that is done is a topic for another day, but since the early 1900s, and espe­cially since 1971, it has been done so often that prices of goods and ser­vices are 400% of what they were when Pres­i­dent Nixon decided to pro­pel cen­tral bank­ing to another orbit. “We are all Key­ne­sians now,” he said back then, but he should have replaced Mr. Keynes with Mr. Burns, Miller, Vol­cker, Greenspan and Bernanke. We are all cen­tral bankers now, at least from the stand­point of endors­ing stim­u­la­tive poli­cies that per­mit Wimpy and his seven bil­lion coun­ter­parts to keep on eat­ing burg­ers, and their lenders, by the way, to keep on coin­ing profits.

Part pro­duc­tive, but increas­ingly destruc­tive, the cur­rent accel­er­a­tion of credit via cen­tral bank poli­cies will likely pro­duce a pos­i­tive rate of real eco­nomic growth this year for most devel­oped coun­tries, but the struc­tural dis­tor­tions brought about by zero bound inter­est rates will limit that growth as argued in pre­vi­ous Out­looks, and induce seri­ous risks in future years. In addi­tion, infla­tion should creep higher. Do not be mel­lowed by the affir­ma­tion of a 2% tar­get rate of infla­tion here in the U.S. or as tar­geted in six of the G-7 nations. Not sud­denly, but over time, grad­u­ally higher rates of infla­tion should be the result of QE poli­cies and zero bound yields that were ini­ti­ated in late 2008 and which will likely con­tinue for years to come. We are hooked on cheap credit just as Wimpy was hooked on Friday’s burg­ers. As I high­lighted last month in “The Great Escape,” bond and equity investors should focus on secu­ri­ties with shorter dura­tions – bonds with matu­ri­ties in the five-year range and stocks pay­ing div­i­dends that offer 3%–4% yields. In addi­tion, real assets/commodities should occupy an increas­ing per­cent­age of port­fo­lios. Wimpy would not be pleased by this change of diet nor by the cost and risk of burg­ers for deliv­ery next Tues­day. But for him, and for cen­tral bankers, the hope is that Tues­day never comes.

William H. Gross
Man­ag­ing Director

Tags: Admonition, Bank Policies, Bill Gross, Central Banks, Disbursement, Distortions, Fractional Reserve Banking, Future Years, Global Economy, Gross Co, Gross Investment, Hungry Puppy, Investment Outlook, Maturities, Nobel Prize For Economics, Qe, Real Assets, William H Gross, Wimpy, World Citizens
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PIMCO's Bill Gross – No QE3 Right Away, but a Few Weak Employment Reports Brings It

Monday, April 30th, 2012

PIMCO's Bill Gross has a wide rang­ing inter­view on Bloomberg dis­cussing all sorts of top­ics from more QE, the Fed fol­low­ing the Bank of England's plan to ignore any infla­tion as 'tem­po­rary' so they can con­tinue ultra easy poli­cies, the dys­func­tion in Europe, the poten­tial for reces­sion, among other topics.

9 minute video – email read­ers will need to come to site to view

Tags: All Sorts, Bank Of England, Bill Gross, Bloomberg, Employment Reports, Europe, inflation, PIMCO, Qe, Qe3, Recession, Video Email
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PIMCO Takes Record MBS Position Even Higher, Dumps Treasurys

Thursday, April 12th, 2012

The trend con­tin­ues: as has pointed out here every month for the past five months, Pimco's Bill Gross con­tin­ues to layer into the "NEW QE" trade, only this time he is mak­ing it more clear than ever that he is cer­tain that the Fed will have no choice but to mon­e­tize Mort­gage Backed Secu­ri­ties. Indeed, in March the firm added another 100 bps in its MBS expo­sure, bring­ing the total to 54% of total, or a record $134 bil­lion of the fund's $253 bil­lion in AUM. And while before Gross would buy MBS and TSYs pari passu, that is no longer the case. In fact in March, Gross dumped the most Trea­surys since Feb­ru­ary 2011, cut­ting his net expo­sure from 38% to 32%, and likely is in part or whole respon­si­ble for the big bond dump in the mid­dle of March, now long for­got­ten (that or he merely pig­gy­backed on the neg­a­tive sen­ti­ment: April hold­ings will be indica­tive of that). Other notable shifts: Gross con­tin­ues to sell Euro­pean sov­er­eign expo­sure, with Non-US Devel­op­ment hold­ings down to 6%, the low­est since April 2011, and sur­pris­ingly even cut­ting Invest­ment Grade hold­ings to just 14%, the low­est since Octo­ber 2008: is Gross smelling a bond bub­ble (in both IG and HY) and is get­ting out while the get­ting is good? Sure looks like it.

And TRF's matu­rity and dura­tion dis­tri­b­u­tion over time.

Tags: Aum, Bill Gross, Bps, Case In Fact, Cutting, Dumps, Duration, Five Months, Hy, Ig, Maturity, Mortgage Backed Securities, Negative Sentiment, Pari Passu, Qe, S 253, Treasurys, Trend, Trf
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PIMCO's Gross: Market Has Bernanke in a Box, QE3 Still on the Way

Thursday, April 5th, 2012

Bond king Bill Gross is right along the same line of think­ing as I am on this sub­ject.  Unfor­tu­nately, moral haz­ard is now the name of the game, and rather than being dis­si­pated, it has been enhanced.  To that end the top head­line on CNBC is "Why Fed is likely to Inter­vene if Mar­ket Falls too far" – as if "stock mar­ket man­age­ment" is part of their Con­gres­sional man­dated duty.

Bernanke wants a wealth effect from equi­ties since he is unable to reblow a bub­ble into hous­ing, and the mar­ket knows it.  Hence the tem­per tantrums each time the mar­ket does not get what it wants.  Ben also sees how badly the mar­ket acted dur­ing peri­ods the Fed was not sup­port­ing it the past few years.  You can imag­ine they are watch­ing what has hap­pened since 2 PM yes­ter­day in hor­ror.   Gross pro­vides more color, and why the mar­ket over­re­acted to a few words yes­ter­day.  Again, what that means for the mar­ket in the next hour or days or weeks, who knows.

• The stock mar­ket is over­re­act­ing Wednes­day to what the Fed­eral Reserve didn't say about quan­ti­ta­tive eas­ing in the min­utes from its March meet­ing, bond king Bill Gross told CNBC. It's much ado about noth­ing or much ado about a lit­tle," the founder of Pimco said.
• "We should think of the Fed as like a chess game where some of the pieces are more impor­tant than oth­ers," liken­ing Fed Chair­man Ben Bernanke to the king, San Fran­cisco Fed gov­er­nor Janet Yellen to the queen and New York Fed chief William Dud­ley to the cas­tle, with the rest of the gov­er­nors the knights.  "You have a story when some of these major pieces, one of the three, basi­cally con­cedes and says, 'Check mate.' But we haven't seen that," Gross said. "Until that hap­pens this wordsmithing…is rel­a­tively unimportant."
• But Gross thinks the Fed is very cog­nizant of the state of the stock mar­ket, and if it falls too much it may have to act with some form of eas­ing. The Fed and other cen­tral banks have "got to keep going [with some form of stim­u­lus] if they expect equity mar­kets to continue…at this level," he said.
• "When QE1 has ended, when QE2 has ended, basi­cally the stock mar­ket has gone down by 1,500 points the next month or two," Bill Gross, co-CEO of bond giant Pimco, said in a CNBC inter­view. "Is the Fed trapped in this conun­drum of pro­vid­ing cheaper liq­uid­ity in order to pump up the stock mar­ket and risk mar­kets? I think they are. I won't argue…whether it's good pol­icy, but it's nec­es­sar­ily pol­icy based on where cen­tral banks have led us."

8 minute video

Tags: Bill Gross, Central Banks, Check Mate, Chess Game, Chief William, Cnbc, Fed Chairman, Fed Chief, Fed Governor, Gross Market, Market Management, Moral Hazard, Name Of The Game, New York Fed, PIMCO, S Gross, Temper Tantrums, Wealth Effect, William Dudley, Wordsmithing
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Bill Gross: Investment Outlook (April 2012)

Tuesday, March 27th, 2012

The Great Escape:
Deliv­er­ing in a Delev­er­ing World

by William H. Gross, PIMCO

April 2012

• When inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed, the momen­tum begins to shift, not nec­es­sar­ily sud­denly, but grad­u­ally – yields mov­ing mildly higher and spreads sta­bi­liz­ing or mov­ing slightly wider.
• In such a mildly reflat­ing world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Trea­sury bills, then you must take risk in some form.
• We favor high qual­ity, shorter dura­tion and inflation-protected bonds; div­i­dend pay­ing stocks with a pref­er­ence for devel­op­ing over devel­oped mar­kets; and inflation-sensitive, supply-constrained com­mod­ity products.

About six months ago, I only half in jest told Mohamed that my tomb­stone would read, “Bill Gross, RIP, He didn’t own ‘Trea­suries’.” Now, of course, the days are get­ting longer and as they say in golf, it is bet­ter to be above – as opposed to below – the grass. And it is bet­ter as well, to be deliv­er­ing alpha as opposed to delev­er­ing in the bond mar­ket or global econ­omy. The best way to visu­al­ize suc­cess­ful deliv­er­ing is to rec­og­nize that investors are locked up in a finan­cially repres­sive envi­ron­ment that reduces future returns for all finan­cial assets. Break­ing out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delev­er­ing implies a period of prior lever­age, and lever­age there has been. Whether you date it from the begin­ning of frac­tional reserve and cen­tral bank­ing in the early 20th cen­tury, the debase­ment of gold in the 1930s, or the ini­ti­a­tion of Bret­ton Woods and the coör­di­nated dol­lar and gold stan­dard that fol­lowed for nearly three decades after WWII, the trend towards finan­cial lever­age has been ever upward. The aban­don­ment of gold and embrace­ment of dol­lar based credit by Nixon in the early 1970s was cer­tainly a lever­ag­ing land­mark as was the dereg­u­la­tion of Glass-Steagall by a Demo­c­ra­tic Clin­ton admin­is­tra­tion in the late 1990s, and else­where glob­ally. And almost always, the pri­vate sec­tor was more than will­ing to play the game, invent­ing new forms of credit, loosely known as deriv­a­tives, which avoided the con­cept of con­ser­v­a­tive reserve bank­ing alto­gether. Although there were acci­dents along the way such as the S&L cri­sis, Con­ti­nen­tal Bank, LTCM, Mex­ico, Asia in the late 1990s, the Dot-coms, and ulti­mately global sub­prime own­er­ship, finan­cial insti­tu­tions and mar­ket par­tic­i­pants learned that pol­i­cy­mak­ers would sup­port the sys­tem, and most indi­vid­ual par­tic­i­pants, by extend­ing credit, low­er­ing inter­est rates, expand­ing deficits, and dereg­u­lat­ing in order to keep economies tick­ing. Impor­tantly, this com­bined fis­cal and mon­e­tary lever­age pro­duced out­sized returns that exceeded the abil­ity of real economies to cre­ate wealth. Stocks for the Long Run was the almost uni­ver­sally accepted mantra, but it was really a period – for most of the last half cen­tury – of “Finan­cial Assets for the Long Run” – and your house was included by the way in that cat­e­gory of finan­cial assets even though it was just a pile of sticks and stones. If it always went up in price and you could bor­row against it, it was a finan­cial asset. Secu­ri­ti­za­tion ruled supreme, if not subprime.

As nom­i­nal and real inter­est rates came down, down, down and credit spreads were com­pressed through pol­icy sup­port and secu­ri­ti­za­tion, then asset prices mag­i­cally ascended. PE ratios rose, bond prices for 30-year Trea­suries dou­bled, real estate thrived, and any­thing that could be lev­ered did well because the global econ­omy and its finan­cial mar­kets were being lev­ered and lev­ered consistently.

And then sud­denly in 2008, it stopped and reversed. Lever­age appeared to reach its lim­its with sub­primes, and then with banks and invest­ment banks, and then with coun­tries them­selves. The game as we all have known it appears to be over, or at least sub­stan­tially changed – mov­ing for the moment from pri­vate to pub­lic bal­ance sheets, but even there fac­ing investor and polit­i­cal lim­its. Actu­ally global finan­cial mar­kets are only selec­tively delev­er­ing. What delev­er­ing there is, is most vis­i­ble with house­hold bal­ance sheets in the U.S. and Euroland periph­eral sov­er­eigns like Greece. The delev­er­ing is also rel­a­tively hid­den in the recap­i­tal­iza­tion of banks and their looka­likes. Increas­ing cap­i­tal, in addi­tion to hair­cut­ting and defaults are a form of delever­ag­ing that is long term healthy, if short term growth restric­tive. On the whole, how­ever, because of mas­sive QEs and LTROS in the tril­lions of dol­lars, our credit based, lever­age depen­dent finan­cial sys­tem is actu­ally lever­age expand­ing, although only mildly and sys­tem­i­cally less threat­en­ing than before, at least from the stand­point of a growth rate. The total amount of debt how­ever is daunt­ing and con­tin­ued credit expan­sion will pro­duce accel­er­at­ing global infla­tion and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Nor­mal world that levers much more slowly in total, and can delever sharply in selec­tive sec­tors and coun­tries? Look at it this way rather sim­plis­ti­cally. Dur­ing the Great Lever­ag­ing of the past 30 years, it was finan­cial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more lev­ered those flows, then the bet­ter they did. That is because, as I’ve just his­tor­i­cally out­lined, future cash flows are dis­counted by an inter­est rate and a risk spread, and as yields came down and spreads com­pressed, the greater return came from the longest and most lev­ered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the abil­ity of global economies to con­sis­tently repli­cate them. Finan­cial assets rel­a­tive to real assets out­per­form in such a world as wealth is brought for­ward and stolen from future years if real growth can­not repli­cate his­tor­i­cal total returns.

To put it even more sim­ply, finan­cial assets with long inter­est rate and spread dura­tions were win­ners: long matu­rity bonds, stocks, real estate with rental streams and cap rates that could be com­pressed. Com­modi­ties were on the rel­a­tive los­ing end although infla­tion took them up as well. That’s not to say that an oil com­pany with reserves in the ground didn’t do well, but the oil for imme­di­ate deliv­ery that couldn’t ben­e­fit from an expan­sion of P/Es and a com­pres­sion of risk spreads – well, not so well. And so com­modi­ties lagged finan­cial asset returns. Our num­bers show 1, 5 and 20-year his­to­ries of finan­cial assets out­per­form­ing com­modi­ties by 15% for the most recent 12 months and 2% annu­ally for the past 20 years.

This out­per­for­mance by finan­cial as opposed to real assets is a result of the long jour­ney and ulti­mate des­ti­na­tion of credit expan­sion that I’ve just out­lined, result­ing in neg­a­tive real inter­est rates and nar­row credit and equity risk pre­mi­ums; a state of finan­cial repres­sion as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie star­ing Steve McQueen called The Great Escape where Amer­i­can pris­on­ers of war were con­fined to a POW camp inside Ger­many in 1943. The liv­ing con­di­tions were OK, much like today’s finan­cial mar­kets, but cer­tainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and Amer­i­can offi­cers to try to escape and get back to the old nor­mal. They inge­niously dug escape tun­nels and even­tu­ally escaped. It was a real life story in addi­tion to its Hol­ly­wood fla­vor. Sim­i­larly though it is your duty to try to escape today’s repres­sion. Your liv­ing con­di­tions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover lia­bil­i­ties. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this finan­cial repres­sive world.

What hap­pens when we flip the sce­nario or per­haps reach the point at which inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed? The momen­tum we would sug­gest begins to shift: not nec­es­sar­ily sud­denly or swiftly as fat­ter tail bimodal dis­tri­b­u­tions might warn, but grad­u­ally – yields mov­ing mildly higher, spreads sta­bi­liz­ing or mov­ing slightly wider. In such a mildly reflat­ing world where infla­tion itself remains above 2% and in most cases moves higher, deliv­er­ing double-digit or even 7–8% total returns from bonds, stocks and real estate becomes prob­lem­atic and cer­tainly much more dif­fi­cult. Real growth as opposed to finan­cial wiz­ardry becomes pre­dom­i­nant, yet that growth is stressed by exces­sive fis­cal deficits and high debt/GDP lev­els. Com­modi­ties and real assets become ascen­dant, cer­tainly in rel­a­tive terms, as we by neces­sity delever or lever less. As well, finan­cial assets can­not be ele­vated by zero based inter­est rate or other tried but now tired pol­icy maneu­vers that bring future wealth for­ward. Cur­rent prices in other words have squeezed all of the risk and inter­est rate pre­mi­ums from future cash flows, and now finan­cial mar­kets are left with real growth, which itself expe­ri­ences a slower new nor­mal because of less finan­cial leverage.

That is not to say that infla­tion can­not con­tinue to ele­vate finan­cial assets which can adjust to infla­tion over time – stocks being the prime exam­ple. They can, and there will be rel­a­tive win­ners in this con­text, but the abil­ity of an investor to earn returns well in excess of infla­tion or well in excess of nom­i­nal GDP is lim­ited. Total return as a super­charged bond strat­egy is fad­ing. Stocks with a 6.6% real Jeremy Siegel con­stant are fad­ing. Lev­ered hedge strate­gies based on spread and yield com­pres­sion are fad­ing. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all stan­dard asset classes even though betas will be lower. Should you desert bonds sim­ply because they may return 4% as opposed to 10%? I hope not. PIMCO’s poten­tial alpha gen­er­a­tion and the sta­bil­ity of bonds remain crit­i­cal com­po­nents of an invest­ment portfolio.

In sum­mary, what has the poten­tial to deliver the most return with the least amount of risk and high­est infor­ma­tion ratios? Log­i­cally, (1) Real as opposed to finan­cial assets – com­modi­ties, land, build­ings, machines, and knowl­edge inher­ent in an edu­cated labor force. (2) Finan­cial assets with shorter spread and inter­est rate dura­tions because they are more defen­sive. (3) Finan­cial assets for enti­ties with rel­a­tively strong bal­ance sheets that are exposed to higher real growth, for which devel­op­ing vs. devel­oped nations should dom­i­nate. (4) Finan­cial or real assets that ben­e­fit from favor­able pol­icy thrusts from both mon­e­tary and fis­cal author­i­ties. (5) Finan­cial or real assets which are not bur­dened by exces­sive debt and sub­ject to future haircuts.

In plain speak –

For bond mar­kets: favor higher qual­ity, shorter dura­tion and infla­tion pro­tected assets.

For stocks: favor devel­op­ing vs. devel­oped. Favor shorter dura­tions here too, which means con­sis­tent div­i­dend pay­ing as opposed to growth stocks.

For com­modi­ties: favor infla­tion sen­si­tive, sup­ply con­strained products.

And for all asset cat­e­gories, be wary of lev­ered hedge strate­gies that promise double-digit returns that are dif­fi­cult in a delev­er­ing world.

With regard to all of these broad asset cat­e­gories, an investor in finan­cial mar­kets should not go too far on this defen­sive, as opposed to offen­sively ori­ented sce­nario. Unless you want to earn an infla­tion adjusted return of minus 2–3% as offered by Trea­sury bills, then you must take risk in some form. You must try to max­i­mize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essen­tial ele­ment of cap­i­tal­ism – that is investors earn­ing some­thing more than a Trea­sury bill. If and when we can­not, then the sys­tem implodes – espe­cially one with exces­sive lever­age. Paul Vol­cker suc­cess­fully redi­rected the U.S. econ­omy from 1979–1981 dur­ing which investors earned less return than a Trea­sury bill, but that could only go on for sev­eral years and occurred in a much less lev­ered finan­cial sys­tem. Vol­cker had it eas­ier than Bernanke/King/Draghi have it today. Is a sys­temic implo­sion still pos­si­ble in 2012 as opposed to 2008? It is, but we will likely face much more mon­e­tary and credit infla­tion before the bal­loon pops. Until then, you should bud­get for “safe carry” to help pay your bills. The bunker port­fo­lio lies fur­ther ahead.

Two addi­tional con­sid­er­a­tions. In a highly lev­ered world, grad­ual rever­sals are not nec­es­sar­ily the high prob­a­ble out­come that a nor­mal bell-shaped curve would sug­gest. Pol­icy mis­takes – too much money cre­ation, too much fis­cal belt-tightening, geopo­lit­i­cal con­flicts and war, geopo­lit­i­cal dis­agree­ments and dis­in­te­gra­tion of mon­e­tary and fis­cal unions – all of these and more lead to poten­tial bimodal dis­tri­b­u­tions – fat left and right tail out­comes that can inflate or deflate asset mar­kets and real eco­nomic growth. If you are a ratio­nal investor you should con­sider hedg­ing our most prob­a­ble inflationary/low growth out­come – what we call a “C-“ sce­nario – by buy­ing hedges for fat­ter tailed pos­si­bil­i­ties. It will cost you some­thing – and hedg­ing in a low return world is harder to buy than when the cot­ton is high and the liv­ing is easy. But you should do it in amounts that hedge against prin­ci­pal down­sides and allow for prin­ci­pal upsides in bimodal out­comes, the lat­ter per­haps being epit­o­mized by equity mar­kets 10–15% returns in the first 80 days of 2012.

And sec­ondly, be mind­ful of invest­ment man­age­ment expenses. Whoops, I’m not sup­posed to say that, but I will. Be sure you’re get­ting value for your expense dol­lars. We of course – per­haps like many other firms would say, “We’re Num­ber One.” Not always, not for me in the sum­mer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are cer­tainly a #1 seed – with aspi­ra­tions as always to be your #1 Champion.

William H. Gross
Man­ag­ing Director

“Safe Spread” also known as “Safe Carry” is defined as sec­tors that we believe are most likely to with­stand the vicis­si­tudes of a wide range of pos­si­ble eco­nomic sce­nar­ios. All invest­ments con­tain risk and may lose value.
Past per­for­mance is not a guar­an­tee or a reli­able indi­ca­tor of future results. Invest­ing in the bond mar­ket is sub­ject to cer­tain risks includ­ing mar­ket, interest-rate, issuer, credit, and infla­tion risk. Equi­ties may decline in value due to both real and per­ceived gen­eral mar­ket, eco­nomic, and indus­try con­di­tions. Com­modi­ties con­tain height­ened risk includ­ing mar­ket, polit­i­cal, reg­u­la­tory, and nat­ural con­di­tions, and may not be suit­able for all investors. Invest­ing in for­eign denom­i­nated and/or domi­ciled secu­ri­ties may involve height­ened risk due to cur­rency fluc­tu­a­tions, and eco­nomic and polit­i­cal risks, which may be enhanced in emerg­ing mar­kets. Sov­er­eign secu­ri­ties are gen­er­ally backed by the issu­ing gov­ern­ment, oblig­a­tions of U.S. Gov­ern­ment agen­cies and author­i­ties are sup­ported by vary­ing degrees but are gen­er­ally not backed by the full faith of the U.S. Gov­ern­ment; port­fo­lios that invest in such secu­ri­ties are not guar­an­teed and will fluc­tu­ate in value. Inflation-linked bonds (ILBs) issued by a gov­ern­ment are fixed-income secu­ri­ties whose prin­ci­pal value is peri­od­i­cally adjusted accord­ing to the rate of infla­tion; ILBs decline in value when real inter­est rates rise. Tail risk hedg­ing may involve enter­ing into finan­cial deriv­a­tives that are expected to increase in value dur­ing the occur­rence of tail events. Invest­ing in a tail event instru­ment could lose all or a por­tion of its value even in a period of severe mar­ket stress. A tail event is unpre­dictable; there­fore, invest­ments in instru­ments tied to the occur­rence of a tail event are spec­u­la­tive. Deriv­a­tives may involve cer­tain costs and risks such as liq­uid­ity, inter­est rate, mar­ket, credit, man­age­ment and the risk that a posi­tion could not be closed when most advan­ta­geous. Invest­ing in deriv­a­tives could lose more than the amount invested. There is no guar­an­tee that these invest­ment strate­gies will work under all mar­ket con­di­tions or are suit­able for all investors and each investor should eval­u­ate their abil­ity to invest long-term, espe­cially dur­ing peri­ods of down­turn in the mar­ket. An investor should con­sult their finan­cial advi­sor prior to mak­ing an invest­ment decision.

This mate­r­ial con­tains the cur­rent opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only. Fore­casts, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary research and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Pacific Invest­ment Man­age­ment Com­pany LLC. ©2012, PIMCO.

Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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PIMCO's Bill Gross Opines on the Bond Market Moves, QE, Inflation, Et Al

Monday, March 19th, 2012

PIMCO's Bill Gross joined Dan Gross on Yahoo Tech Ticker to dis­cuss a host of bond related and eco­nomic views.  Much like myself, he sees another round of QE (ster­l­ized or oth­er­wise) – in fact he takes it another step fur­ther and says there is a good chance of QE4 as well.

Another round (or two) of quan­ti­ta­tive eas­ing from the Fed­eral  Reserve, muted growth and an end to the 30-year bull run in gov­ern­ment  bonds. That's what Bill Gross,  one of the largest bond investors in the world, sees for the U.S.  econ­omy in the com­ing year.

Despite  the Fed's com­mu­niqué ear­lier this week, Gross doesn't believe the  cen­tral bank's inter­ven­tions in the bond mar­kets are over. In two rounds  of quan­ti­ta­tive eas­ing (QE), the Fed­eral Reserve printed money to buy  hun­dreds of bil­lions of dol­lars of Trea­sury bonds and mortgage-backed  secu­ri­ties. "I believe there will be a QE3, and per­haps a QE4," he said.  Why? In the past few years, when­ever cen­tral banks have stopped or  paused their quan­ti­ta­tive eas­ing efforts, "stock prices have fallen and  economies have slowed." The globe's pri­vate economies sim­ply aren't  suf­fi­ciently strong enough to sup­port robust growth, and the world's  cen­tral banks aren't will­ing to stand by and watch. "That's not a pol­icy  rec­om­men­da­tion, it's sim­ply a real­iza­tion that the sub­sti­tu­tion of  cen­tral bank mon­e­tary pur­chases will con­tinue for a long time, as long  as they [cen­tral banks] try to sup­port pri­vate economies on a global  basis," Gross said.

Still, Gross  believes the 30-year long bull run for bonds may be com­ing to an end.  "We're cer­tainly close and have been close for a num­ber of months," he  said. It's very dif­fi­cult to imag­ine inter­est rates going lower. "The  bond mar­ket, whether it's Trea­suries, mort­gages, or investment-grade  bonds in com­bi­na­tion, basi­cally yield a lit­tle higher than 2%," Gross  said. "And unless the U.S. econ­omy repli­cates Japan, where yields are  down to 1% on aver­age, then you'd have to say that we're close to the  bot­tom in terms of yield." He adds: "It doesn't mean the begin­ning of a  bear mar­ket, but it does sug­gest at least that the great bond bull  mar­ket since 1981 is prob­a­bly over."

Recent mar­ket activ­ity in  some bonds cer­tainly rat­i­fies that view. In recent weeks, the yield on  the 10-year Trea­sury has risen from about 1.8% in late Jan­u­ary to about  2.28% on Thurs­day. But "those yields aren't attrac­tive," Gross says.  Gross rec­om­mends that investors avoid longer-term bonds —  i.e. 10-year and 30-year bonds — whose prices may fall if long-term  growth and infla­tion expec­ta­tions rise. How­ever, they should also avoid  short-term bonds. "The Fed has con­di­tion­ally guar­an­teed that they won't  be rais­ing inter­est rates until late 2014, and that's almost three years  from now." Gross believes that bonds that mature in five, six, or seven  years occupy the sweet spot in today's market.

Bond hold­ers tend  to fear strong growth because it has the poten­tial to ignite infla­tion  and boost inter­est rates, thus reduc­ing their returns. Gross says that  while the econ­omy has improved, it shows no signs of over­heat­ing. He  believes the U.S. econ­omy is grow­ing at about a 2% annual rate in the  first quar­ter "and prob­a­bly beyond." That's about as good as can be  hoped for. While the Fed­eral Reserve has injected close to $1 tril­lion  into the U.S. econ­omy in the past year, growth is in large mea­sure tied  to what hap­pens in the global econ­omy. And the omens from abroad aren't  par­tic­u­larly good. "China is slow­ing and the euro land is in reces­sion,"  Gross said. The U.S. is grow­ing at a decent clip, "what we call a new  nor­mal, but it prob­a­bly won't get back to the 3 or 4% real growth  num­bers that we wit­nessed over the past decades."

Tags: Bill Gross, Bond Investors, Bond Market, Bond Markets, Central Banks, Consumer Price Index, Economic Views, Federal Reserve, Good Chance, Oil Prices, Opines, PIMCO, Principal Reasons, Qe, Qe3, Stock Prices, Term Bonds, Term Debt, Term Interest, Treasury Bonds
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Top Fifteen Stories of February/March According to You

Saturday, March 17th, 2012

AdvisorAnalyst.com's Top Fif­teen Sto­ries (Feb­ru­ary — March 2012) Accord­ing to You

David Rosen­berg: Let's Get Real — Risks are Loom­ing Big Time

A Warn­ing From War­ren Buffett's Top Eco­nomic Indicator

David Rosen­bert Presents the Six Pins That Can Pop the Com­pla­cency Bubble

David Rosen­berg: The Best Cur­rency May Be Phys­i­cal Gold

Jeremy Grantham: We're Eat­ing Our Grandchildren

Jef­frey Saut: How To Posi­tion Port­fo­lios in 2012

Jeremy Grantham's 10 Invest­ment Lessons

Thir­teen Qual­i­ties of North America's Top Advisors

GMO's Jeremy Grantham Q4 2011 Let­ter — The Longest Quar­terly Let­ter Ever

Twelve Steps to Mak­ing Your Busi­ness Fun Again

Bill Gross: Invest­ment Out­look (Feb­ru­ary 28, 2012)

Europe's Cash for Trash LTRO Scam and the Inden­tured Servi­tude of the Citizenry

Eric Sprott: Invest­ment Out­look (Feb­ru­ary 24, 2012)

Jeremy Siegel: 66% Chance of Dow 15,000 — 50% Chance of Dow 17,000 in the Next 2 years

Tags: Big Time, Bill Gross, Citizenry, Complacency, David Rosenberg, Economic Indicator, Eric Sprott, Grandchildren, Gross Investment, Indentured Servitude, Investment Lessons, Investment Outlook, Jeremy Grantham, Jeremy Siegel, physical gold, Portfolios, Quarterly Letter, Thirteen Qualities, Twelve Steps, Warren Buffett
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Bill Gross: Investment Outlook (February 28, 2012)

Tuesday, February 28th, 2012

​

(Defense)

• ​Over the past 30 years, an offen­sively minded Fed­eral Reserve and their global coun­ter­parts were print­ing money, low­er­ing yields and bring­ing for­ward a false sense of mon­e­tary wealth.
• Suc­cess­ful invest­ing in a delever­ag­ing, low inter­est rate envi­ron­ment will require defen­sive in addi­tion to offen­sive skills.
• The PIMCO defen­sive strat­egy play­book: Rec­og­nize zero bound lim­its and sys­temic debt risk in global finan­cial mar­kets. Accept finan­cial repres­sion but avoid its impact when and where pos­si­ble. Empha­size income we believe to be rel­a­tively reliable/safe; seek con­sis­tent alpha.

They say defense wins Super Bowls, but the Man­nings, Bradys and Mon­tanas of grid­iron his­tory are tes­ta­ments to the oppo­site. Putting points on the board, espe­cially in the last two min­utes, has won more games than goal line stands ever have, even if the scor­ing has been done by the field goal kick­ers, the names of whom have been con­fined to the dust­bins of foot­ball his­tory as opposed to the Hall of Fame in Can­ton, Ohio. Can­ton, how­ever, has an approx­i­mately equal num­ber of defen­sive in addi­tion to offen­sively posi­tioned inductees, so there must be a uni­ver­sally acknowl­edged role for both sides of the scrim­mage line. What fan can for­get Mean Joe Greene, Deion Sanders or Mike Ditka? The old, now polit­i­cally incor­rect show­tune laments that “you gotta be a foot­ball hero, to fall in love with a beau­ti­ful girl,” but foot­ball and any of life’s heroes can play on either side of the line, it seems.

My point about pigskin offense and defense is the per­fect metaphor for the world of invest­ing as well. Offen­sively minded risk tak­ers in the mar­kets have his­tor­i­cally been the ones who have dom­i­nated the head­lines and won the hearts of that beau­ti­ful gal (or hand­some guy). Aside from the rare exam­ples of Steve Jobs and Bill Gates, how­ever, the secret to get­ting rich since the early 1980s has been to bor­row some­one else’s money, throw some Hail Mary passes and spike the ball in the end zone as if you had some par­tic­u­lar genius that deserved mon­e­tary rewards 2¹⁰ times more than a Doc­tor, Lawyer or an Indian Chief. Nah, I take that back about the Indian Chief. The Chiefs, at least, have done pretty well with casi­nos these past few decades.

Still, the pri­mary way to coin money over the past 30 years has been to use money to make money. Although the price of it started in 1981 at a rather exor­bi­tantly high yield of 15% for long-term Trea­suries, 20% for the prime, and real inter­est rates at an almost unbe­liev­able 7–8%, the grad­ual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seem­ingly end­less vir­tu­ous time­line. Books such as “Stocks for the Long Run” or arti­cles such as “Dow 36,000” cap­tured the public’s imag­i­na­tion much like a Mon­tana to Jerry Rice pass that always seemed to clinch a 49ers vic­tory. Yet an instant replay of these past few decades would have shown that accel­er­at­ing asset prices weren’t due to any par­tic­u­lar wis­dom on the part of acad­e­mia or the invest­ment com­mu­nity but an offen­sively minded Fed­eral Reserve and their global coun­ter­parts who were print­ing money, low­er­ing yields and bring­ing for­ward a false sense of mon­e­tary wealth that was depen­dent on per­pet­ual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the sin­gu­lar mantra of cen­tral bankers ever since the depar­ture of Paul Vol­cker, but there was no sense that the sham­poo bot­tle filled with money would ever run dry. Well, it has. Inter­est rates have a math­e­mat­i­cal bot­tom and when they get there, the wash­ing of the finan­cial market’s hair pro­duces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields ren­dered impo­tent to ele­vate P/E ratios and lower real estate cap rates, but they begin to poi­son the finan­cial well. Low yields, instead of fos­ter­ing cap­i­tal gains for investors via the magic of present value dis­count­ing and lower credit spreads, begin to reduce house­hold incomes, lower cor­po­rate profit mar­gins and wreak havoc on his­tor­i­cal busi­ness mod­els con­nected to bank­ing, money mar­ket funds and the pen­sion indus­try. The offen­sively ori­ented invest­ment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Invest­ment defense is com­ing of age.

This tran­si­tion is not com­monly observed, although it is rel­a­tively easy to prove sta­tis­ti­cally and even com­mon­sen­si­cally. Take for instance the rather quizzi­cal notion that lower yields must pro­duce an equal num­ber of win­ners and losers since there is a bor­rower for every lender and the net/net there­fore should have no effect on the real econ­omy or its finan­cial mar­kets. Chart 1 shows that since 1981, which marks the begin­ning of the sec­u­lar decline of inter­est rates, per­sonal inter­est income has rather grad­u­ally (and now some­what sud­denly) shrunk rel­a­tive to house­hold debt ser­vice payments.

It is Main Street that has failed to keep up with Wall Street and cor­po­rate Amer­ica in the race to see who can ben­e­fit more from lower yields. As the inter­est com­po­nent of per­sonal income grad­u­ally weak­ens, the abil­ity of the con­sumer to keep up its fre­netic spend­ing is reduced. Metaphor­i­cally, it’s akin to a 4th quar­ter two minute Super Bowl drill, but one where the receivers haven’t been prop­erly hydrated. They’re a half step slow, their legs are cramp­ing, and it shows. Lower inter­est rates are hav­ing a neg­a­tive impact on house­holds because their water bot­tles are filled with 50 basis point CDs instead of Gatorade.

While Wall Street and lev­ered investors have fared bet­ter than their Main Street coun­ter­parts, it’s not as if they’re in “prime­time Deion Sanders” shape either. Con­cep­tu­al­ize the his­tor­i­cal busi­ness model of any financially-oriented firm for the past 30 years and you will see what I mean. Insur­ance com­pa­nies, for instance, whether they be life insur­ance with their long-term lia­bil­i­ties, or property/casualty insur­ance with more imme­di­ate poten­tial pay­outs, have mod­eled their long-term prof­itabil­ity on the assump­tion of stan­dard long-term real returns on invest­ment. AFLAC, GEICO, Pru­den­tial or the Met – take your pick – have hired, staffed, adver­tised, priced and expensed based upon the assump­tion of using their cash flows to earn a pos­i­tive real return on their invest­ment. When those returns fall from 7% pos­i­tive to an approx­i­mate 1% neg­a­tive, then assump­tions – and prac­ti­cal real­i­ties – begin to change. If these firms can’t cover infla­tion with his­tor­i­cal real returns from their float, then they begin to down­size in order to stay prof­itable. The down­siz­ing is just another way of describ­ing a tran­si­tion from offense to defense in a zero bound nom­i­nal inter­est rate world where almost any level of infla­tion pro­duces neg­a­tive real yields on invest­ment.
Not only insur­ance com­pa­nies but banks suf­fer from this inabil­ity to main­tain mar­gins at the zero bound. In the process, they close retail branches that once were assumed to be the golden key to suc­cess­ful bank­ing. Defense! And here’s one of the more inter­est­ing anec­do­tal obser­va­tions on our cur­rent zero-based envi­ron­ment, one to which my invest­ment paragon – War­ren Buf­fett – would prob­a­bly imme­di­ately admit. His busi­ness model – and that of Berk­shire Hath­away – has long ben­e­fit­ted from what he has described as “free float.” Those annual pol­icy pay­ments, whether for hur­ri­cane, life or auto­mo­bile insur­ance, have long given him a com­pet­i­tive fund­ing advan­tage over other busi­ness mod­els that couldn’t bor­row for “free.” Today, how­ever, almost any large busi­ness or wealthy indi­vid­ual can bor­row or lever up with min­i­mal inter­est expense. Buffett’s “Omaha/West Coast” offense is being dupli­cated around the world thanks to cen­tral bank mon­e­tary poli­cies, plac­ing an increas­ing empha­sis on stock and invest­ment selec­tion as opposed to busi­ness model lia­bil­ity fund­ing. Buf­fett will suc­ceed based upon his con­tin­ued strong offen­sive play call­ing, but the rules of the game are changing.

The plight of Buf­fett of course is in some respects the plight of PIMCO or any investment/financially-oriented firm in this new age of the zero bound. And it seems to us at PIMCO that suc­cess­ful invest­ing in a delever­ag­ing, low inter­est rate envi­ron­ment will require defen­sive in addi­tion to offen­sive skills. What does that mean? Well, let’s briefly describe PIMCO’s own his­tor­i­cal invest­ment offense for the past 30 years in order to pro­vide a defen­sive contrast:

PIMCO Offen­sive Strat­egy 1981 – 2011
Ready, Set, Hut 1, Hut 2 –

1. Rec­og­nize down­ward trend in inter­est rates and scale dura­tion accordingly.

   A. Empha­size income and cap­i­tal gains. PIMCO Total Return Strat­egy.
   B. Uti­lize pru­dent deriv­a­tive struc­tures that ben­e­fit from sys­temic lever­ag­ing – finan­cial futures,
   swaps (but no sub­primes!)
   C. Com­bine A and B along with care­ful bottom-up secu­rity selec­tion to seek con­sis­tent alpha.

PIMCO Defen­sive Strat­egy 2012 – ?
Ready, Set, Hut, Hut, Hut –

1. Rec­og­nize zero bound lim­its and sys­temic debt risk in global finan­cial mar­kets. Accept finan­cial repres­sion but avoid its impact when and where pos­si­ble.
   
   A. Empha­size income we believe to be rel­a­tively reliable/safe.
   B. De-emphasize deriv­a­tive struc­tures that are fully val­ued and poten­tially volatile.
   C. Com­bine A and B along with secu­rity selec­tion to seek con­sis­tent alpha with admit­tedly lower nom­i­nal returns than his­tor­i­cal indus­try examples.

So there you have it – the PIMCO play­book. I sup­pose if I had any com­mon sense I would hold up that clip­board to the front of my mouth like side­line coaches do dur­ing big games. Don’t want to chance any of the com­pe­ti­tion read­ing our lips to get a heads up on PIMCO’s next offen­sive play call. But then that’s never been my or Mohamed’s style, given the impor­tance of inform­ing you, our clients, of what we are think­ing when it comes to invest­ing your hard-earned cap­i­tal. Go ahead com­peti­tors and read our lips, we’ll just pound that pigskin down the field any­way. Besides, as I’ve pointed out, the empha­sis these days should be on the defen­sive coach. Lever­ag­ing has turned into delever­ag­ing. 15% yields have turned into 0% money. The Super Bowls of the future will have their Man­nings and Bradys, but the defen­sive line may record more sacks and make more head­lines than ever before.

William H. Gross
Man­ag­ing Director

Tags: Bill Gross, Bradys, Debt Risk, Defensive Strategy, Deion Sanders, Derivative Structures, Downward Trend, Dustbins, Field Goal Kickers, Financial Repression, Football Hero, Global Financial Markets, Gross Investment, Hail Mary, Handsome Guy, Interest Rate Environment, Investment Outlook, Joe Greene, Lamentation, Mike Ditka, Monetary Wealth, Offensive Skills, Offensive Strategy, Pigskin, Printing Money, Rare Examples, Ready Set, Risk Takers, Ron Paul, Scrimmage Line, Superpac, Whimper, Zirp
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TOP 15 Stories of February 2012

Monday, February 20th, 2012

TOP 15 Sto­ries of Feb­ru­ary 2012, Accord­ing to You

David Rosen­berg: Let's Get Real — Risks are Loom­ing Big Time

David Ein­horn: Green­light Cap­i­tal Q4 2011 Let­ter to Investors

The Unlikely Bull Market

Least Volatile Stocks Over The Last Decade (Bespoke)

Jeremy Siegel: 66% Chance of Dow 15,000, and 50% Chance of Dow 17000 in Two Years

Tying It All Together with David Rosenberg

Visu­al­ize: The Euro­pean Super­high­way of Debt

Bill Gross: The Death of Abun­dance and the Birth of Austerity

What The Bond Mar­ket Knows That You Don't

Obama Pup­pet­mas­ter War­ren Buf­fett Biggest Win­ner from Key­stone Pipeline Rejection

The Great Mar­ket Dis­con­nect Seen All Around the Globe (Busi­ness Insider)

Radio Shack Cell Phone Com­mer­cial from 1989

Com­pelling Val­u­a­tion or Value Trap?

World Eco­nomic and Equity Mar­kets Out­look (O'Neill, Faber, Siegel, Dreman)

The Div­i­dend Yield Love Affair

Tags: Austerity, Bill Gross, Bond Market, Business Insider, David Einhorn Greenlight, David Einhorn Greenlight Capital, David Rosenberg, Dividend Yield, Dreman, Insider Radio, Jeremy Siegel, Last Decade, Love Affair, O Neill, Obama, Puppetmaster, Radio Shack, Time David, Volatile Stocks, Warren Buffett
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Jeff Gundlach: Complete "Fall Of The [BLANK] Empire" Slideshow

Wednesday, February 15th, 2012

The defin­ing sound­bite from Jeff Gundlach's call Q&A: Regard­ing Bank of Amer­ica — "It is wise to avoid banks. Not sur­prised BAC has gone up — just like NFLX — just like Ital­ian bonds. Reduce risk right now, includ­ing, Bank of America."

While the star of multi-billionaire Bill Gross may or may not be fad­ing (the jury is still out on what the final out­come will be for the man who so far alone among his peers has dared to point out the lunacy in the Fed's actions), that of his far smaller and nim­bler peer Jeff Gund­lach of Dou­ble­Line Cap­i­tal has been ris­ing rapidly, and at last check has his fund's AUMs at over $25 bil­lion, a dou­bling in a few short months. Gund­lach is con­duct­ing his peri­odic web­cast live at 4:15pm East­ern (i.e., yesterday).

And by the title of the pre­sen­ta­tion, it promises to be quite interesting.

Now enjoy the Gund­lach slides in the leisure of your own unre­hy­poth­e­cated con­crete bunker, 50 feet below sea level.

"The decline and fall of the Roman Empire"

2–14-12 JEG Web­cast Roman Empire — FINAL

Tags: Bac, Bank Of America, Banks, Bill Gross, Billionaire, Bonds, Concrete Bunker, Decline And Fall, Decline And Fall Of The Roman Empire, Empire 2, Fall Of The Roman Empire, Feet Below Sea Level, Gundlach, Lunacy, Nflx, Peers, risk, Slides, Soundbite, Webcast
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Has PIMCO Become Too Big To Fail?

Saturday, February 11th, 2012

While I knew PIMCO was mas­sively influ­en­tial dur­ing the finan­cial cri­sis, I did not real­ize a mutual fund shop could poten­tially be thrown in with banks as "sys­tem­at­i­cally impor­tant" insti­tu­tions.  But con­sid­er­ing just how many bonds they own, I guess it makes sense.  Obvi­ously, Mr. Gross is not happy with this poten­tial sit­u­a­tion, as it would come with more cost and oversight.

But if push comes to shove and there is some sort of bond dis­as­ter down the road, I am sure the Fed would just do QE8 and tar­get all PIMCO's portfolio.

Lengthy story but some snip­pets below via Reuters:

• He is the man who made bond invest­ing sort of sexy – and now he may pay the price.   Over more than three decades, Bill Gross, co-founder of asset-management giant PIMCO, has made so much money for clients that he has become the barom­e­ter by which other bond traders are judged. His West Coast perch, pre­scient calls on the U.S. econ­omy and devo­tion to yoga only added to the mystique.
• But the very recipe that enabled Gross to dom­i­nate his indus­try may now be con­spir­ing against him.  He's com­ing off his worst year in the busi­ness after mak­ing a huge bet against U.S. Trea­suries that back­fired. Last year, for the first time in nearly two decades, investors pulled more money out of PIMCO's flag­ship fund than they put in.
• More trou­bling, U.S. reg­u­la­tors are now con­sid­er­ing whether PIMCO should be deemed a "sys­tem­i­cally impor­tant finan­cial insti­tu­tion" – that is, too big to fail, and thus sub­ject to tighter reg­u­la­tory over­sight. The con­cern: The jug­ger­naut man­ages so much money for pen­sion funds that it could ham­mer the econ­omy if it ever went under. The firm has dou­bled in size to $1.36 tril­lion in assets since the col­lapse of Lehman Broth­ers in 2008.
• The firm is lob­by­ing hard to fend off the "sys­tem­i­cally impor­tant" des­ig­na­tion, accord­ing to reg­u­la­tory dis­clo­sures. Like other finan­cial firms, it also objects to impend­ing rules that could make some of its deriv­a­tives trad­ing more costly.
• Indus­try ana­lysts also won­der whether PIMCO's $250 bil­lion Total Return Fund, the world's largest bond fund, is such a behe­moth that Gross some­times has to swing for the fences to gen­er­ate the kind of returns investors have come to expect. Because PIMCO's flag­ship fund relies heav­ily on deriv­a­tives to bet on bonds, some ana­lysts say it's unnec­es­sar­ily com­plex and poten­tially at risk should one of its trad­ing par­ties fail.
• Gross dis­misses con­cerns about PIMCO's girth. He says the firm isn't "lev­ered," or mak­ing bets with bor­rowed money, in the way that failed play­ers like Bear Stearns or Lehman Broth­ers did. The asset man­ager is using only client money to trade.  "It's not like we are a deposit insti­tu­tion and there'd nec­es­sar­ily be a run on the bank because they thought the bank was going to fail," Gross said in an inter­view. "'Too big to fail' is depen­dent upon tens of thou­sands of clients" aban­don­ing ship at once, and it's "hard to believe they'd want out at the same time."
• The debate over PIMCO's cen­tral­ity to the finan­cial estab­lish­ment is a turn­about: Up until the finan­cial cri­sis, the 67-year-old Gross was largely seen on Wall Street as a West Coast out­sider and a bit of a loner.  But dur­ing the cri­sis, scared investors piled into his funds. Pol­i­cy­mak­ers from the Fed­eral Reserve and Trea­sury Depart­ment turned to PIMCO to help with a raft of pro­grams meant to res­cue the finan­cial sys­tem. That helped forge closer ties between the firm and the gov­ern­ment and raised PIMCO's pro­file even more with investors.
• "The con­cen­tra­tion of bond-market assets in a few firms, which some could argue to be sys­tem­at­i­cally risky, is not of those firms' design, but rather stems from their suc­cess," says Joshua Ros­ner, man­ag­ing direc­tor of Gra­ham Fisher & Co., an adviser to insti­tu­tional investors.

Dis­clo­sure Notice

Any secu­ri­ties men­tioned on this page are not held by the author in his per­sonal port­fo­lio. Secu­ri­ties men­tioned may or may not be held by the author in the mutual fund he man­ages, the Pal­adin Long Short Fund (PALFX). For a list of the afore­men­tioned fund's hold­ings at the end of the prior quar­ter, visit the Pal­adin Funds web­site at http://www.paladinfunds.com/holdings/blog

Tags: Barometer, Bill Gross, Bond Traders, Co Founder, Financial Crisis, Financial Institution, Flagship, Gross Co, Juggernaut, Lehman Brothers, Lengthy Story, More Than Three Decades, Mutual Fund, Mystique, Pension Funds, Regulatory Oversight, Reuters, Snippets, Target, Treasuries
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Bond Math: Duration Risk at the Zero Boundary

Thursday, February 9th, 2012

via Econom­pic Data

There seems to be lots of con­fu­sion sur­round­ing Bill Gross' lat­est Invest­ment Out­look, Life and Death Propo­si­tion. First, some back­ground of what Bill Gross stated...

Investors aren't only con­cerned with credit risk (i.e. the abil­ity to get paid back), but also dura­tion risk (the risk of lend­ing for an extended period of time in fear that rates may rise).
In Bill's words:

What per­haps is not so often rec­og­nized is that liq­uid­ity can be trapped by the “price” of credit, in addi­tion to its “risk.” Cap­i­tal­ism depends on risk-taking in sev­eral forms. Devel­op­ers, home­own­ers, entre­pre­neurs of all shapes and sizes epit­o­mize the risk­i­ness of busi­ness build­ing via equity and credit risk exten­sion. But mod­ern cap­i­tal­ism is depen­dent as well on matu­rity exten­sion in credit mar­kets. No ven­ture, aside from one financed with 100% own­ers’ cap­i­tal, could sur­vive on credit or loans that matured or were callable overnight. Build­ings, util­i­ties and homes require 20– and 30-year loan com­mit­ments to smooth and jus­tify their returns.

Investors had been will­ing to take on this dura­tion risk because they would be com­pen­sated with addi­tional yield AND (this is impor­tant) because bonds could appre­ci­ate if rates fell (i.e. when yields fall, bonds rise).

Back to Bill:

Because this is so, lenders require a yield pre­mium, expressed as a pos­i­tively sloped yield curve, to make the extended loan. A flat yield curve, in con­trast, is a dis­in­cen­tive for lenders to lend unless there is suf­fi­cient down­side room for yields to fall and pro­vide bond mar­ket cap­i­tal gains.

And although the yield curve is steep, it is very low in nom­i­nal terms (i.e. there is less room for rates to move down).
Last time to Bill for his main argument:

Even if nod­ding in agree­ment, an observer might imme­di­ately com­ment that today’s yield curve is any­thing but flat and that might be true. Most short to inter­me­di­ate Trea­sury yields, how­ever, are dan­ger­ously close to the zero-bound which imply lit­tle if any room to fall: no mar­gin, no air under­neath those bond yields and there­fore lim­ited, if any, price appre­ci­a­tion. What incen­tive does a bank have to buy two-year Trea­suries at 20 basis points when they can park overnight reserves with the Fed at 25? What incen­tives do invest­ment man­agers or even indi­vid­ual investors have to take price risk with a five-, 10– or 30-year Trea­sury when there are mul­ti­ples of down­side price risk com­pared to appre­ci­a­tion? At 75 basis points, a five-year Trea­sury can only ratio­nally appre­ci­ate by two more points, but the­o­ret­i­cally can go down by an unlim­ited amount. Dura­tion risk and flat­ness at the zero-bound, to make the sim­ple point, can freeze and trap liq­uid­ity by con­vinc­ing investors to hold cash as opposed to extend credit.

Now my over­sim­pli­fied expla­na­tion using two inter­est rate scenarios...

Sce­nario one... bonds yield­ing 5%.
In this sce­nario, bonds with matu­ri­ties 1 year through 5 are yield­ing 5%. Should rates stay at 5%, the bonds are worth PAR (i.e. $100) in all sce­nar­ios. How­ever, the bonds have the poten­tial to appre­ci­ate should yields move lower. In fact, should rates fall all the way to 1% (a huge decline, but this is meant to illus­trate the point), the bonds actu­ally appre­ci­ate almost 20% in the case of the 5 year Trea­sury. Com­pare that to the one year Trea­sury that gained less than 5%.
In other words, in a flight to qual­ity sce­nario there is a HUGE incen­tive to own the longer dura­tion bond when yields have room to com­press.



Sce­nario two... bonds yield­ing 1%.

In this sce­nario, bonds with matu­ri­ties 1 year through 5 are yield­ing 1% (yes the yield curve is upward slop­ing in "real life", but this isn't far off). Should rates stay at 1%, the bonds are again worth PAR (i.e. $100), but in this case they have lim­ited room to move due to the zero bound­ary. Should rates move all the way to 0%, the five year bonds don't appre­ci­ate 20% like in sce­nario 1, they appre­ci­ate only 5%, while the one year Trea­sury appre­ci­ates around 1%.
In other words, in a flight to qual­ity sce­nario the poten­tial ben­e­fit of a longer dura­tion Trea­sury is 75% lower than in sce­nario one and only 4% higher than the one year matu­rity bond.

The exam­ple above is close to cur­rent rates (as of this writ­ing, a five year bond yields 0.82%). The result, as Bill Gross points out, is a lack of incen­tive for a lender to lend and take that risk as they can get roughly the same yield just putting their money in a mat­tress with­out the risk of rates mov­ing higher (0% isn't far from 0.82%). In addi­tion, for an investor that is allo­cat­ing to bonds to diver­sity their equity hold­ings, fixed income will no longer appre­ci­ate in a flight to qual­ity sce­nario to off­set equity losses. As a result, busi­nesses should in the­ory be hav­ing a hard time get­ting money for their busi­nesses out­side of equity financ­ing.
But, the evi­dence doesn't point to any of this being an issue. As far as I know, investors are still will­ing to extend the dura­tion of their invest­ments to pick up this incre­men­tal yield. And why not? The Fed has made it clear there is zero risk that rates will rise going out to at least 2014. So why not pocket that addi­tional 82 bps regard­less of the lack of cap­i­tal appreciation?

Tags: Bill Gross, Bond Duration, Bond Market, Bond Math, Bou, Business Building, Capital Gains, capitalism, Credit Markets, Credit Risk, Downside, Investment Outlook, Lenders, Life And Death, liquidity, Loan Commitments, Maturity, Shapes And Sizes, Treasury Yields, Yield Curve
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Under Twist, The Fed Has Purchased 91% of All Gross Issuance in Long Dated US Treasurys

Tuesday, February 7th, 2012

One of the salient ques­tions asked of Bernanke by Con­gress relates to a Kevin Warsh oped in the WSJ, in which he said the fol­low­ing: "Pri­vate investors are crowded out of the mar­ket when the Fed shows up as a large and pow­er­ful bid­der. As a result, the admin­is­tra­tion and Con­gress make tax and spend­ing decisions—with huge impli­ca­tions for our stan­dard of living—with height­ened risks around future fund­ing costs." This is arguably the ques­tion that dom­i­nates Fed pol­icy mak­ing under the Oper­a­tion Twist doc­trine, in which the Fed buys up long-dated paper and sells Short dated (under 3 years), the sec­ond leg of which how­ever is com­pletely irrel­e­vant, as the Fed has already guar­an­teed ZIRP until 2014, in essence con­firm­ing that Twist was noth­ing but a stealth QE3 as we have claimed all along, as the Fed's ZIRP4EVA pol­icy effec­tively off­sets any and all short-dated sales. Need­less to say Bernanke's response was irrel­e­vant. How­ever, here is the most jar­ring sta­tis­tic. As Bar­clays showed a few days back, under Twist, the Fed has mon­e­tized vir­tu­ally all, and specif­i­cally 91% of all gross issuance in the 20–30 year matu­rity bucket. In other words, Warsh is absolutely spot on, and once again we are left with an arti­fi­cial mar­ket in which it is only the Fed that defines the UST curve shape by mold­ing the long end. What hap­pens when Twist ends? Will the 30 Year col­lapse? What hap­pens when there is no explicit back stop to the long end? Is this the rea­son why Bill Gross yes­ter­day said that he fully expects much more check writ­ing by the Fed for the next '12, 24, 36 months." And how can it not: we don't have a mar­ket of ratio­nal play­ers any more — the entire mar­ket is merely one irra­tional player, whose biggest coun­ter­party inci­den­tally, the ECB, is beyond broke. Finally, what hap­pens to the Fed's bal­ance sheet when inter­est rates start ris­ing? Hold­ing a port­fo­lio with a dura­tion greater than it has ever been, the DV01 is cur­rently well over $2 bil­lion (i.e. a $2 bil­lion loss on every basis point increase in rates). And rising.

h/t John Lohman

Tags: Balance Sheet, Barclays, Bernanke, Bill Gross, Collapse, Counterparty, ECB, Issuance, Kevin Warsh, Maturity, Offsets, Oped, Private Investors, Qe3, Salient Questions, Statistic, Treasurys, Ust, Wsj, Zirp
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Bill Gross On Minsky's Take Of The Liquidity Trap: From "Hedge" To "Securitised" To "Ponzi"

Monday, February 6th, 2012

Over the week­end, we com­mented on Dylan Grice's sem­i­nal analy­sis which exco­ri­ates the cen­tral plan­ning "fools", who are per­pet­u­ally caught in the "lost pilot" par­a­digm, whereby the world's cen­tral plan­ners increas­ingly oper­ate by the mantra of “I have no idea where we’re going, but we’re mak­ing good time!” and which con­firms that in the absence of real res­o­lu­tions to prob­lems cre­ated by a cen­tury of flawed eco­nomic mod­els, the only option is to con­tinue dou­bling down until ter­mi­nal fail­ure. Basi­cally, the take home mes­sage there is that once "economists" get lost in try­ing to cor­rect the errata their own mod­els out­put as a result of faulty assump­tions (which they always are able to "explain away" as one time events), they drift ever fur­ther into unknown ter­ri­tory until finally we end up with such mon­e­tary aber­ra­tions as "liq­uid­ity traps", "zero bound yields" and, soon, NIRP (which comes after ZIRP), if indeed the Trea­sury pro­ceeds with neg­a­tive yields begin­ning in May under the tute­lage of the Goldman-JPM chaired Trea­sury Bor­row­ing Advi­sory Com­mit­tee. Today, it is Bill Gross who takes the Grice per­spec­tive one step fur­ther, and looks at impli­ca­tions for liq­uid­ity, and the lack thereof, in a world where one of the three pri­mary func­tions of mod­ern finan­cial inter­me­di­aries — matu­rity trans­for­ma­tion (the other two being credit and liq­uid­ity trans­for­ma­tion) is ter­mi­nally bro­ken. He then jux­ta­poses this in the con­text of Hyman Minsky's mon­e­tary the­o­ries, and con­cludes: "What incen­tive does a US bank have to extend matu­rity to a two– or three-year term when Trea­sury rates at that level of the curve are below the 25 basis points avail­able to them overnight from the Fed? What incen­tive does Pimco or banks have to buy five-year Trea­suries at 75bp when the max­i­mum upside cap­i­tal gain is two per cent of par and the down­side sub­stan­tially more?" In other words, Pimco is finally grasp­ing just how ZIRP is punk­ing it and its clients. It also means that very soon all the matu­rity, and soon, credit risk of the world will be on the shoul­ders of the Fed, which in turn labor under a false eco­nomic par­a­digm. And one won­ders why nobody has any faith left in these here "cap­i­tal markets"...

Some of Gross' thoughts in the FT:

Zero-based money is at risk of trap­ping the recovery

Isaac New­ton may have con­cep­tu­alised the effects of grav­ity when that myth­i­cal apple fell on his head, but could he have imag­ined Neil Armstrong’s hop-skip-and-jumping on the moon, or the trap­ping of light inside a black hole? Prob­a­bly not. Like­wise, the deceased eco­nomic mae­stro of the 21st cen­tury – Hyman Min­sky – prob­a­bly couldn’t have con­ceived how his mon­e­tary the­o­ries could be altered by zero-based money.

Min­sky, orig­i­na­tor of the com­mon­sen­si­cal “sta­bil­ity leads to insta­bil­ity” the­sis; the econ­o­mist with nam­ing rights for 2008’s “Min­sky Moment”; the exposer of the finan­cial fragility of mod­ern cap­i­tal­ism; prob­a­bly couldn’t imag­ine the liq­uid­ity trap qual­i­ties of zero-based money, because who could have con­ceived 30 or 40 years ago that inter­est rates could ever approach zero per cent for an extended period of time? Prob­a­bly no one.

Nor, more impor­tantly I sup­pose, can Ben Bernanke, Mario Draghi or Mervyn King. In their his­tor­i­cal mod­els, credit is as credit does, expand­ing per­pet­u­ally after brief peri­ods of reces­sion­ary con­trac­tion, show­er­ing eco­nomic activ­ity with liq­uid fer­tiliser for pro­duc­tive invest­ment and inevitable growth.

If they were to adopt Minsky’s frame­work, they would visu­alise a credit sys­tem expand­ing from “hedge” to “secu­ri­tised” to “Ponzi” finance, pulling back after 2008 to the sta­bil­ity of the less lev­ered “secu­ri­tised” seg­ment, but then expand­ing again as gov­ern­ment credit sub­sti­tuted for pri­vate delever­ag­ing, pro­vid­ing a foun­da­tion for future growth of the finance-based economy.

Well, maybe not. In mod­ern cen­tral bank the­ory, liq­uid­ity traps are a func­tion of fear and unwill­ing­ness to extend credit based upon the increas­ing prob­a­bil­i­ties of default. This world is the sec­ond half of Will Rogers’ famous maxim uttered in the Depres­sion: “I’m not so much con­cerned about the return on my money, but the return of my money.”

...

The mod­ern cap­i­tal­is­tic model depends on risk-taking in sev­eral forms. Loss of prin­ci­pal – as in default – neces­si­tates the cau­tious exten­sion of credit to those that pre­sum­ably can use it most effi­ciently. But our finance-based Minksy sys­tem is depen­dent as well on matu­rity exten­sion. No home, com­mer­cial build­ing or util­ity plant could be cre­ated if the credit lia­bil­ity matured or was callable overnight. Because this is so, lenders require and are incen­tivised by a yield pre­mium for longer term loans, his­tor­i­cally expressed as a pos­i­tively slop­ing yield curve.

...

What incen­tive does a US bank have to extend matu­rity to a two– or three-year term when Trea­sury rates at that level of the curve are below the 25 basis points avail­able to them overnight from the Fed? What incen­tive does Pimco or banks have to buy five-year Trea­suries at 75bp when the max­i­mum upside cap­i­tal gain is two per cent of par and the down­side sub­stan­tially more?

Matu­rity exten­sion for Trea­suries, and then for cor­po­rate and pri­vate credit alike, becomes riskier. The Min­sky assump­tion of reju­ve­na­tion once the pub­lic sec­tor sta­bilises the credit sys­tem then becomes prob­lem­atic. Insta­bil­ity may slouch back towards sta­bil­ity, but that sta­bil­ity may resem­ble more closely the zero-bound world of Japan over the past 10 years than the dynamic devel­oped econ­omy model of the past half century.

The global economy’s quest for a mod­ern day Keynes or Min­sky may be frus­trated by zero-based money that rations credit just as fiercely as it does risk. Minsky’s eco­nomic the­ory is now at the zero-bound.

Con­tinue read­ing here.

Tags: Aberrations, Bill Gross, Central Planners, Economic Models, Faulty Assumptions, Financial Intermediaries, Grice, Hyman Minsky, Jpm, Liquidity Trap, Liquidity Traps, Monetary Theories, PIMCO, S Central, Seminal Analysis, Time Events, Treasury Rates, Unknown Territory, Us Bank, Zirp
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Bill Gross: We're "Witnessing the Death of Abundance, and the Birth of Austerity"

Thursday, February 2nd, 2012

Invest­ment Out­look, Feb­ru­ary 2012


Life – and Death Proposition

by William H. Gross, PIMCO

• ​ Recent cen­tral bank behav­ior, includ­ing that of the U.S. Fed, pro­vides assur­ances that short and inter­me­di­ate yields will not change, and there­fore bond prices are not likely threat­ened on the downside.
• Most short to inter­me­di­ate Trea­sury yields are dan­ger­ously close to the zero-bound which imply lim­ited poten­tial room, if any, for price appreciation.
• We can’t put $100 tril­lion of credit in a system-wide mat­tress, but we can move in that direc­tion by delev­er­ing and refus­ing to extend matu­ri­ties and duration.

​Where do we go when we die?
We go back to where we came from
And where was that?
I don’t know, I can’t remem­ber
Vir­ginia Woolf, “The Hours”

I don’t remem­ber much of this life, and like Vir­ginia Woolf, noth­ing of the here­be­fore. How then, could I expect to know of the here­after? I know at least that we all exist at and of the moment and that we make up those moments as we go along. I became a grand­fa­ther for the first time a few months ago and proud son Jeff asked for some fatherly advice as to how to go about rais­ing his baby daugh­ter Car­o­line. “We all do it in our own way, Jeff, you’ll make it up as you go along,” I said. Par­ent­ing, and life itself, is one giant exper­i­ment. From those first infant steps, to ado­les­cent peer test­ing, fly­ing from and depart­ing the parental nest, gene repli­ca­tion and fam­ily build­ing of our own, matu­rity and acqui­es­cence, aging, decay and inevitable death – we exper­i­ment as best we can and make it up as we go along.

That death part though, oh where do we go after we have done all the mak­ing? There was another Jeff in our fam­ily, beloved brother-in-law Jeff Stub­ban who was as kind a man as there ever could be. Dying within three months of an ini­tial diag­no­sis of pan­cre­atic can­cer, our fam­ily sobbed uncon­trol­lably at his bed­side as his breath, his spirit, his soul, departed almost on cue while a priest recited the rosary. Where had he gone, where is he now, what will become of him and all of us? Like many griev­ing fam­i­lies we look for signs of him and in turn for clues to our own des­ti­na­tion. A lucky penny in the street, a ran­dom men­tion of his beloved New Orleans, an exte­rior resem­blance of his shiny bald head in a min­gling crowd. Where are you, Jeff? Tell us you are safe so that we might meet again.

Hav­ing now matured to trust rea­son more than faith I offer not so much a res­o­lu­tion, but an alter­na­tive to the unan­swer­able ques­tion of Vir­ginia Woolf and the departed souls of Jeff Stub­ban and bil­lions of oth­ers. If we don’t meet again – up there – then per­haps we’ll meet once more – down here. After all, the one thing I know for sure is that we got here once – and because we did, we could do it again. Rest easy, dear Jeff, and wel­come to this world, dear Car­o­line. We’ll all just have to make it up as we go along.

The tran­si­tion from a lev­er­ing, asset-inflating sec­u­lar econ­omy to a post bub­ble delev­er­ing era may be as dif­fi­cult for one to imag­ine as our depar­ture into the here­after. A mul­ti­tude of lia­bil­ity struc­tures depen­dent on a cer­tain level of nom­i­nal GDP growth require just that – nom­i­nal GDP growth with a lit­tle bit of infla­tion, a lit­tle bit of growth which in com­bi­na­tion jus­tify embed­ded costs of debt or lia­bil­ity struc­tures that min­i­mize the hair­cut­ting of or default­ing on prior debt com­mit­ments. Global cen­tral bank mon­e­tary pol­icy – whether explic­itly com­mu­ni­cated or not – is now geared to keep­ing nom­i­nal GDP close to his­tor­i­cal lev­els as is fis­cal deficit spend­ing that sub­sti­tutes for a delev­er­ing pri­vate sector.

Yet the imag­i­na­tion and man­age­ment of the tran­si­tion ush­ers forth a plethora of dis­parate pol­icy solu­tions. Most observers, how­ever, would agree that mon­e­tary and fis­cal excesses carry with them explicit costs. Let­ting your pet retriever roam the woods might do won­ders for his “ani­mal spir­its,” for instance, but he could come back infested with fleas, ticks, leeches or worse. Fed Chair­man Ben Bernanke, dog-lover or not, pre­an­nounced an aware­ness of the dele­te­ri­ous side effects of quan­ti­ta­tive eas­ing sev­eral years ago in a sig­nif­i­cant speech at Jack­son Hole. Ever since, he has been open and hon­est about the draw­backs of a zero inter­est rate pol­icy, but has plowed ahead and unleashed his “QE bowser” into the wild with the under­stand­ing that the neg­a­tive con­se­quences of not doing so would be far worse. At his Novem­ber 2011 post-FOMC news brief­ing, for instance, he noted that “we are quite aware that very low inter­est rates, par­tic­u­larly for a pro­tracted period, do have costs for a lot of peo­ple” – savers, pen­sion funds, insur­ance com­pa­nies and finance-based insti­tu­tions among them. He coun­tered though that “there is a greater good here, which is the health and recov­ery of the U.S. econ­omy, and for that pur­pose we’ve been keep­ing mon­e­tary pol­icy con­di­tions accommodative.”

My goal in this Invest­ment Out­look is not to pick a “dog­gie bone” with the Chair­man. He is makin’ it up as he goes along in order to softly delever a credit-based finan­cial sys­tem which became egre­giously over­lev­ered and assumed far too much risk long before his watch began. My intent really is to alert you, the reader, to the sig­nif­i­cant costs that may be ahead for a global econ­omy and finan­cial mar­ket­place still func­tion­ing under the assump­tion that cheap and abun­dant cen­tral bank credit is always a pos­i­tive dynamic. When inter­est rates approach the zero bound they may tran­si­tion from his­tor­i­cally stim­u­la­tive to poten­tially destimulative/regressive influ­ences. Much like the laws of physics change from the world of New­ton­ian large objects to the world of quan­tum Ein­stein­ian dynam­ics, so too might low inter­est rates at the zero-bound reori­ent pre­vi­ously held mod­els that jus­ti­fied the stim­u­la­tive effects of lower and lower yields on asset prices and the real economy.

It is instruc­tive to men­tion that this is not nec­es­sar­ily PIMCO’s view alone. Chair­man Bernanke and Fed staff mem­bers have been snif­fin’ this trail like the good hound dogs they are for some time now. In addi­tion, Credit Suisse, in their “2012 Global Out­look,” devoted con­sid­er­able pages to specifics of zero-based money with com­mon­sen­si­cal his­tor­i­cal com­par­isons to Japan over the past decade or so. The fol­low­ing pages of this Out­look will do the same. At the heart of the the­ory, how­ever, is that zero-bound inter­est rates do not always and nec­es­sar­ily force investors to take more risk by pur­chas­ing stocks or real estate, to cite the clas­sic cen­tral bank the­sis. First of all, when ratio­nal or irra­tional fear per­suades an investor to be more con­cerned about the return of her money than on her money then liq­uid­ity can be trapped in a mat­tress, a bank account or a five basis point Trea­sury bill. But that com­mon­sen­si­cal obser­va­tion is well known to Fed pol­i­cy­mak­ers, eco­nomic his­to­ri­ans and cer­tainly cit­i­zens on Main Street.

What per­haps is not so often rec­og­nized is that liq­uid­ity can be trapped by the “price” of credit, in addi­tion to its “risk.” Cap­i­tal­ism depends on risk-taking in sev­eral forms. Devel­op­ers, home­own­ers, entre­pre­neurs of all shapes and sizes epit­o­mize the risk­i­ness of busi­ness build­ing via equity and credit risk exten­sion. But mod­ern cap­i­tal­ism is depen­dent as well on matu­rity exten­sion in credit mar­kets. No ven­ture, aside from one financed with 100% own­ers’ cap­i­tal, could sur­vive on credit or loans that matured or were callable overnight. Build­ings, util­i­ties and homes require 20– and 30-year loan com­mit­ments to smooth and jus­tify their returns. Because this is so, lenders require a yield pre­mium, expressed as a pos­i­tively sloped yield curve, to make the extended loan. A flat yield curve, in con­trast, is a dis­in­cen­tive for lenders to lend unless there is suf­fi­cient down­side room for yields to fall and pro­vide bond mar­ket cap­i­tal gains. This nom­i­nal or even real inter­est rate “mar­gin” is why prior cycli­cal peri­ods of curve flat­ness or even inver­sion have been suc­cess­fully fol­lowed by eco­nomic expan­sions. Inter­me­di­ate and long rates – even though flat and equal to a short-term pol­icy rate – have had room to fall, and credit there­fore has not been trapped by “price.”

When all yields approach the zero-bound, how­ever, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sov­er­eigns, then the dynam­ics may change. Money can become less liq­uid and frozen by “price” in addi­tion to the clas­sic liq­uid­ity trap explained by “risk.”

Even if nod­ding in agree­ment, an observer might imme­di­ately com­ment that today’s yield curve is any­thing but flat and that might be true. Most short to inter­me­di­ate Trea­sury yields, how­ever, are dan­ger­ously close to the zero-bound which imply lit­tle if any room to fall: no mar­gin, no air under­neath those bond yields and there­fore lim­ited, if any, price appre­ci­a­tion. What incen­tive does a bank have to buy two-year Trea­suries at 20 basis points when they can park overnight reserves with the Fed at 25? What incen­tives do invest­ment man­agers or even indi­vid­ual investors have to take price risk with a five-, 10– or 30-year Trea­sury when there are mul­ti­ples of down­side price risk com­pared to appre­ci­a­tion? At 75 basis points, a five-year Trea­sury can only ratio­nally appre­ci­ate by two more points, but the­o­ret­i­cally can go down by an unlim­ited amount. Dura­tion risk and flat­ness at the zero-bound, to make the sim­ple point, can freeze and trap liq­uid­ity by con­vinc­ing investors to hold cash as opposed to extend credit.

Where else can one go, how­ever? We can’t put $100 tril­lion of credit in a system-wide mat­tress, can we? Of course not, but we can move in that direc­tion by delev­er­ing and refus­ing to extend matu­ri­ties and dura­tion. Recent cen­tral bank behav­ior, includ­ing that of the U.S. Fed, pro­vides assur­ances that short and inter­me­di­ate yields will not change, and there­fore bond prices are not likely threat­ened on the down­side. Still, zero-bound money may kill as opposed to cre­ate credit. Devel­oped economies where these low yields reside may suf­fer accord­ingly. It may as well, induce infla­tion­ary dis­tor­tions that give a rise to com­modi­ties and gold as store of value alter­na­tives when there is lit­tle value left in paper.

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits eco­nomic growth, and it turns eco­nomic the­ory upside down, ulti­mately chal­leng­ing the wis­dom of pol­i­cy­mak­ers. We’ll all be mak­ing this up as we go along for what may seem like an eter­nity. A 30–50 year vir­tu­ous cycle of credit expan­sion which has pro­duced out­size para­nor­mal returns for finan­cial assets – bonds, stocks, real estate and com­modi­ties alike – is now delev­er­ing because of exces­sive “risk” and the “price” of money at the zero-bound. We are wit­ness­ing the death of abun­dance and the born­ing of aus­ter­ity, for what may be a long, long time.

Past per­for­mance is not a guar­an­tee or a reli­able indi­ca­tor of future results. All invest­ments con­tain risk and may lose value. Com­modi­ties con­tain height­ened risk includ­ing mar­ket, polit­i­cal, reg­u­la­tory, and nat­ural con­di­tions, and may not be suit­able for all investors. This mate­r­ial con­tains the cur­rent opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only. Fore­casts, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary research and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Pacific Invest­ment Man­age­ment Com­pany LLC. ©2012, PIMCO.

Tags: Acquiescence, Austerity, Baby Daughter, Beloved Brother, Bill Gross, Bond Prices, Downside, Fatherly Advice, Gene Replication, Giant Experiment, Inevitable Death, Initial Diagnosis, Investment Outlook, Life And Death, Maturities, PIMCO, Price Appreciation, Proud Son, Treasury Yields, William H Gross
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Bill Gross: Investment Outlook (February 2012)

Wednesday, February 1st, 2012

Invest­ment Out­look, Feb­ru­ary 2012


Life – and Death Proposition

by William H. Gross, PIMCO

• ​ Recent cen­tral bank behav­ior, includ­ing that of the U.S. Fed, pro­vides assur­ances that short and inter­me­di­ate yields will not change, and there­fore bond prices are not likely threat­ened on the downside.
• Most short to inter­me­di­ate Trea­sury yields are dan­ger­ously close to the zero-bound which imply lim­ited poten­tial room, if any, for price appreciation.
• We can’t put $100 tril­lion of credit in a system-wide mat­tress, but we can move in that direc­tion by delev­er­ing and refus­ing to extend matu­ri­ties and duration.

​Where do we go when we die?
We go back to where we came from
And where was that?
I don’t know, I can’t remem­ber
Vir­ginia Woolf, “The Hours”

I don’t remem­ber much of this life, and like Vir­ginia Woolf, noth­ing of the here­be­fore. How then, could I expect to know of the here­after? I know at least that we all exist at and of the moment and that we make up those moments as we go along. I became a grand­fa­ther for the first time a few months ago and proud son Jeff asked for some fatherly advice as to how to go about rais­ing his baby daugh­ter Car­o­line. “We all do it in our own way, Jeff, you’ll make it up as you go along,” I said. Par­ent­ing, and life itself, is one giant exper­i­ment. From those first infant steps, to ado­les­cent peer test­ing, fly­ing from and depart­ing the parental nest, gene repli­ca­tion and fam­ily build­ing of our own, matu­rity and acqui­es­cence, aging, decay and inevitable death – we exper­i­ment as best we can and make it up as we go along.

That death part though, oh where do we go after we have done all the mak­ing? There was another Jeff in our fam­ily, beloved brother-in-law Jeff Stub­ban who was as kind a man as there ever could be. Dying within three months of an ini­tial diag­no­sis of pan­cre­atic can­cer, our fam­ily sobbed uncon­trol­lably at his bed­side as his breath, his spirit, his soul, departed almost on cue while a priest recited the rosary. Where had he gone, where is he now, what will become of him and all of us? Like many griev­ing fam­i­lies we look for signs of him and in turn for clues to our own des­ti­na­tion. A lucky penny in the street, a ran­dom men­tion of his beloved New Orleans, an exte­rior resem­blance of his shiny bald head in a min­gling crowd. Where are you, Jeff? Tell us you are safe so that we might meet again.

Hav­ing now matured to trust rea­son more than faith I offer not so much a res­o­lu­tion, but an alter­na­tive to the unan­swer­able ques­tion of Vir­ginia Woolf and the departed souls of Jeff Stub­ban and bil­lions of oth­ers. If we don’t meet again – up there – then per­haps we’ll meet once more – down here. After all, the one thing I know for sure is that we got here once – and because we did, we could do it again. Rest easy, dear Jeff, and wel­come to this world, dear Car­o­line. We’ll all just have to make it up as we go along.

The tran­si­tion from a lev­er­ing, asset-inflating sec­u­lar econ­omy to a post bub­ble delev­er­ing era may be as dif­fi­cult for one to imag­ine as our depar­ture into the here­after. A mul­ti­tude of lia­bil­ity struc­tures depen­dent on a cer­tain level of nom­i­nal GDP growth require just that – nom­i­nal GDP growth with a lit­tle bit of infla­tion, a lit­tle bit of growth which in com­bi­na­tion jus­tify embed­ded costs of debt or lia­bil­ity struc­tures that min­i­mize the hair­cut­ting of or default­ing on prior debt com­mit­ments. Global cen­tral bank mon­e­tary pol­icy – whether explic­itly com­mu­ni­cated or not – is now geared to keep­ing nom­i­nal GDP close to his­tor­i­cal lev­els as is fis­cal deficit spend­ing that sub­sti­tutes for a delev­er­ing pri­vate sector.

Yet the imag­i­na­tion and man­age­ment of the tran­si­tion ush­ers forth a plethora of dis­parate pol­icy solu­tions. Most observers, how­ever, would agree that mon­e­tary and fis­cal excesses carry with them explicit costs. Let­ting your pet retriever roam the woods might do won­ders for his “ani­mal spir­its,” for instance, but he could come back infested with fleas, ticks, leeches or worse. Fed Chair­man Ben Bernanke, dog-lover or not, pre­an­nounced an aware­ness of the dele­te­ri­ous side effects of quan­ti­ta­tive eas­ing sev­eral years ago in a sig­nif­i­cant speech at Jack­son Hole. Ever since, he has been open and hon­est about the draw­backs of a zero inter­est rate pol­icy, but has plowed ahead and unleashed his “QE bowser” into the wild with the under­stand­ing that the neg­a­tive con­se­quences of not doing so would be far worse. At his Novem­ber 2011 post-FOMC news brief­ing, for instance, he noted that “we are quite aware that very low inter­est rates, par­tic­u­larly for a pro­tracted period, do have costs for a lot of peo­ple” – savers, pen­sion funds, insur­ance com­pa­nies and finance-based insti­tu­tions among them. He coun­tered though that “there is a greater good here, which is the health and recov­ery of the U.S. econ­omy, and for that pur­pose we’ve been keep­ing mon­e­tary pol­icy con­di­tions accommodative.”

My goal in this Invest­ment Out­look is not to pick a “dog­gie bone” with the Chair­man. He is makin’ it up as he goes along in order to softly delever a credit-based finan­cial sys­tem which became egre­giously over­lev­ered and assumed far too much risk long before his watch began. My intent really is to alert you, the reader, to the sig­nif­i­cant costs that may be ahead for a global econ­omy and finan­cial mar­ket­place still func­tion­ing under the assump­tion that cheap and abun­dant cen­tral bank credit is always a pos­i­tive dynamic. When inter­est rates approach the zero bound they may tran­si­tion from his­tor­i­cally stim­u­la­tive to poten­tially destimulative/regressive influ­ences. Much like the laws of physics change from the world of New­ton­ian large objects to the world of quan­tum Ein­stein­ian dynam­ics, so too might low inter­est rates at the zero-bound reori­ent pre­vi­ously held mod­els that jus­ti­fied the stim­u­la­tive effects of lower and lower yields on asset prices and the real economy.

It is instruc­tive to men­tion that this is not nec­es­sar­ily PIMCO’s view alone. Chair­man Bernanke and Fed staff mem­bers have been snif­fin’ this trail like the good hound dogs they are for some time now. In addi­tion, Credit Suisse, in their “2012 Global Out­look,” devoted con­sid­er­able pages to specifics of zero-based money with com­mon­sen­si­cal his­tor­i­cal com­par­isons to Japan over the past decade or so. The fol­low­ing pages of this Out­look will do the same. At the heart of the the­ory, how­ever, is that zero-bound inter­est rates do not always and nec­es­sar­ily force investors to take more risk by pur­chas­ing stocks or real estate, to cite the clas­sic cen­tral bank the­sis. First of all, when ratio­nal or irra­tional fear per­suades an investor to be more con­cerned about the return of her money than on her money then liq­uid­ity can be trapped in a mat­tress, a bank account or a five basis point Trea­sury bill. But that com­mon­sen­si­cal obser­va­tion is well known to Fed pol­i­cy­mak­ers, eco­nomic his­to­ri­ans and cer­tainly cit­i­zens on Main Street.

What per­haps is not so often rec­og­nized is that liq­uid­ity can be trapped by the “price” of credit, in addi­tion to its “risk.” Cap­i­tal­ism depends on risk-taking in sev­eral forms. Devel­op­ers, home­own­ers, entre­pre­neurs of all shapes and sizes epit­o­mize the risk­i­ness of busi­ness build­ing via equity and credit risk exten­sion. But mod­ern cap­i­tal­ism is depen­dent as well on matu­rity exten­sion in credit mar­kets. No ven­ture, aside from one financed with 100% own­ers’ cap­i­tal, could sur­vive on credit or loans that matured or were callable overnight. Build­ings, util­i­ties and homes require 20– and 30-year loan com­mit­ments to smooth and jus­tify their returns. Because this is so, lenders require a yield pre­mium, expressed as a pos­i­tively sloped yield curve, to make the extended loan. A flat yield curve, in con­trast, is a dis­in­cen­tive for lenders to lend unless there is suf­fi­cient down­side room for yields to fall and pro­vide bond mar­ket cap­i­tal gains. This nom­i­nal or even real inter­est rate “mar­gin” is why prior cycli­cal peri­ods of curve flat­ness or even inver­sion have been suc­cess­fully fol­lowed by eco­nomic expan­sions. Inter­me­di­ate and long rates – even though flat and equal to a short-term pol­icy rate – have had room to fall, and credit there­fore has not been trapped by “price.”

When all yields approach the zero-bound, how­ever, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sov­er­eigns, then the dynam­ics may change. Money can become less liq­uid and frozen by “price” in addi­tion to the clas­sic liq­uid­ity trap explained by “risk.”

Even if nod­ding in agree­ment, an observer might imme­di­ately com­ment that today’s yield curve is any­thing but flat and that might be true. Most short to inter­me­di­ate Trea­sury yields, how­ever, are dan­ger­ously close to the zero-bound which imply lit­tle if any room to fall: no mar­gin, no air under­neath those bond yields and there­fore lim­ited, if any, price appre­ci­a­tion. What incen­tive does a bank have to buy two-year Trea­suries at 20 basis points when they can park overnight reserves with the Fed at 25? What incen­tives do invest­ment man­agers or even indi­vid­ual investors have to take price risk with a five-, 10– or 30-year Trea­sury when there are mul­ti­ples of down­side price risk com­pared to appre­ci­a­tion? At 75 basis points, a five-year Trea­sury can only ratio­nally appre­ci­ate by two more points, but the­o­ret­i­cally can go down by an unlim­ited amount. Dura­tion risk and flat­ness at the zero-bound, to make the sim­ple point, can freeze and trap liq­uid­ity by con­vinc­ing investors to hold cash as opposed to extend credit.

Where else can one go, how­ever? We can’t put $100 tril­lion of credit in a system-wide mat­tress, can we? Of course not, but we can move in that direc­tion by delev­er­ing and refus­ing to extend matu­ri­ties and dura­tion. Recent cen­tral bank behav­ior, includ­ing that of the U.S. Fed, pro­vides assur­ances that short and inter­me­di­ate yields will not change, and there­fore bond prices are not likely threat­ened on the down­side. Still, zero-bound money may kill as opposed to cre­ate credit. Devel­oped economies where these low yields reside may suf­fer accord­ingly. It may as well, induce infla­tion­ary dis­tor­tions that give a rise to com­modi­ties and gold as store of value alter­na­tives when there is lit­tle value left in paper.

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits eco­nomic growth, and it turns eco­nomic the­ory upside down, ulti­mately chal­leng­ing the wis­dom of pol­i­cy­mak­ers. We’ll all be mak­ing this up as we go along for what may seem like an eter­nity. A 30–50 year vir­tu­ous cycle of credit expan­sion which has pro­duced out­size para­nor­mal returns for finan­cial assets – bonds, stocks, real estate and com­modi­ties alike – is now delev­er­ing because of exces­sive “risk” and the “price” of money at the zero-bound. We are wit­ness­ing the death of abun­dance and the born­ing of aus­ter­ity, for what may be a long, long time.

Past per­for­mance is not a guar­an­tee or a reli­able indi­ca­tor of future results. All invest­ments con­tain risk and may lose value. Com­modi­ties con­tain height­ened risk includ­ing mar­ket, polit­i­cal, reg­u­la­tory, and nat­ural con­di­tions, and may not be suit­able for all investors. This mate­r­ial con­tains the cur­rent opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only. Fore­casts, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary research and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Pacific Invest­ment Man­age­ment Com­pany LLC. ©2012, PIMCO.

Tags: Acquiescence, Baby Daughter, Beloved Brother, Bill Gross, Bond Prices, Downside, Fatherly Advice, Gene Replication, Giant Experiment, Gross Investment, Inevitable Death, Initial Diagnosis, Investment Outlook, Life And Death, Maturities, PIMCO, Price Appreciation, Proud Son, Treasury Yields, William H Gross
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Bill Gross: "QE 2.5 Today, QE 3, 4, 5, ... lie ahead"

Thursday, January 26th, 2012

PIMCO's Bill Gross commented/tweeted yes­ter­day that "Finan­cial repres­sion" and pos­si­bly three more rounds of QE lie ahead, in response to the Fed's statement.

From Bloomberg:

• The U.S. will suf­fer “finan­cial repres­sion” as the Fed­eral Reserve imple­ments addi­tional quan­ti­ta­tive eas­ing, accord­ing to Bill Gross, who runs the world’s biggest bond fund at Pacific Invest­ment Man­age­ment Co.
• A third, fourth and fifth round of eas­ing “lie ahead,” Gross wrote in a Twit­ter post.
• The Fed will prob­a­bly hold its bench­mark inter­est rate at near zero per­cent for at least the next three years, the post said. Chair­man Ben S. Bernanke said yes­ter­day the Fed is con­sid­er­ing addi­tional bond pur­chases to boost growth after extend­ing its pledge to keep inter­est rates low through at least late 2014.

• “Finan­cial repres­sion depends on neg­a­tive real yields and until infla­tion moves higher for a period of at least sev­eral years, cen­tral banks will hiber­nate at the zero bound,” Gross wrote in his monthly invest­ment out­look on Jan. 4.
• Pol­icy mak­ers are “pre­pared to pro­vide fur­ther mon­e­tary accom­mo­da­tion” and bond buy­ing is “an option that’s cer­tainly on the table,” Bernanke said after offi­cials gath­ered for a meet­ing yes­ter­day. The cen­tral bank has pur­chased $2.3 tril­lion of secu­ri­ties in two rounds of large-scale asset pur­chases known as quan­ti­ta­tive easing.
• The Fed is in the process of replac­ing $400 bil­lion of shorter-maturity Trea­suries in its hold­ings with longer-term debt to “put down­ward pres­sure on longer-term inter­est rates,” based on a state­ment announc­ing the plan in September.
• Gross increased U.S. gov­ern­ment and Trea­sury debt in the $244 bil­lion Total Return Fund to 30 per­cent of assets in Decem­ber, the high­est in 13 months, after bet­ting against the secu­ri­ties dur­ing a rally last year.

Tags: Asset Purchases, Benchmark Interest Rate, Bernanke, Bill Gross, Bond Fund, Central Banks, Downward Pressure, Federal Reserve, Financial Repression, inflation, Investment Management, Investment Outlook, Maturity, Pacific Investment Management Co, Qe 2, Term Debt, Term Interest, Treasuries, Trillion, Zero Percent
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Jeffrey Gundlach's Views on 2012

Monday, January 9th, 2012

Gund­lach smoked PIMCO’s Bill Gross in 2011 and is finally start­ing to get the wide­spread acclaim his per­for­mance has war­ranted.  We are def­i­nitely see­ing much more of him in the media, although it is off a low base.  Ear­lier this week, CNBC dis­cussed his views on 2012. (note Gund­lach is not actu­ally in the video)

Email read­ers will need to come to site to view – 4 min video

Dis­clo­sure Notice

Any secu­ri­ties men­tioned on this page are not held by the author in his per­sonal port­fo­lio. Secu­ri­ties men­tioned may or may not be held by the author in the mutual fund he man­ages, the Pal­adin Long Short Fund (PALFX). For a list of the afore­men­tioned fund's hold­ings at the end of the prior quar­ter, visit the Pal­adin Funds web­site at http://www.paladinfunds.com/holdings/blog

Tags: Bill Gross, Cnbc, Disclosure Notice, Gundlach, Mutual Fund, Personal Portfolio, PIMCO, Portfolio Securities, Video Email
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Bill Gross: Investment Outlook (January 2012)

Friday, January 6th, 2012

Invest­ment Outlook

Towards the Paranormal

by William H. Gross, PIMCO

Jan­u­ary 2012

• The New Nor­mal, pre­vi­ously believed to be bell-shaped and thin-tailed in its depic­tion of growth prob­a­bil­ity and finan­cial mar­ket out­comes, appears to be mor­ph­ing into a world of fat-tailed, almost bimodal outcomes.
• A new dual­ity – credit and zero-bound inter­est rate risk – char­ac­ter­izes the finan­cial mar­kets of 2012, offer­ing the fat left-tailed pos­si­bil­ity of unfore­seen pol­icy delev­er­ing or the fat right-tailed pos­si­bil­ity of cen­tral bank infla­tion­ary expansion.
• Until the out­come becomes clear, investors should con­sider ways to hedge their bets, includ­ing: max­i­miz­ing dura­tions, U.S. Trea­sury bonds that may poten­tially offer cap­i­tal gains, long-term Trea­sury Infla­tion Pro­tected Secu­ri­ties (TIPS), high qual­ity cor­po­rates and senior bank debt, and select U.S. munic­i­pal bonds.

How many ways can you say “it’s dif­fer­ent this time?” There’s “abnor­mal,” “sub­nor­mal,” “para­nor­mal” and of course “new nor­mal.” Mohamed El-Erian’s awak­en­ing phrase of sev­eral years past has vir­tu­ally been adopted into the lex­i­con these days, but now it has an almost anti­quated vapor to it that reflected calmer seas in 2011 as opposed to the pos­si­bil­ity of a per­fect storm in 2012. The New Nor­mal as PIMCO and other econ­o­mists would describe it was a world of muted west­ern growth, high unem­ploy­ment and rel­a­tively orderly delev­er­ing. Now we appear to be mor­ph­ing into a world with much fat­ter tails, bor­der­ing on bimodal. It’s as if the Earth now has two moons instead of one and both are grow­ing in size like a can­cer­ous tumor that may threaten the finan­cial tides, oceans and eco­nomic life as we have known it for the past half cen­tury. Wel­come to 2012.

The Old/New Nor­mal
But before ring­ing in the New Year with a rather grim fore­bod­ing, let me at least describe what finan­cial mar­kets came to know as the “old nor­mal.” It actu­ally began with early 20th cen­tury frac­tional reserve bank­ing, but came into its adult­hood in 1971 when the U.S. and the world departed from gold to a debt-based credit foun­da­tion. Some called it a dol­lar stan­dard but it was really a credit stan­dard based on dol­lars and unlike gold with its scarcity and hard money char­ac­ter, the new credit-based stan­dard had no anchor – dol­lar or oth­er­wise. All devel­oped economies from 1971 and beyond learned to use credit and the expan­sion of debt to drive growth and pros­per­ity. Almost all devel­oped and some emerg­ing economies became hooked on credit as a sub­sti­tu­tion for invest­ment in tan­gi­ble real things – plant, equip­ment and an edu­cated labor force. They made paper, not things, so much of it it seems, that they debased it. Inter­est rates were low­ered and assets secu­ri­tized to the point where they could go no fur­ther and in the after­math of Lehman 2008 mar­kets sub­sti­tuted sov­er­eign for pri­vate credit until it appears that that trend can go no fur­ther either. Now we are left with zero-bound yields and cred­i­tors that trust no one and very few coun­tries. The finan­cial mar­kets are slowly implod­ing – delev­er­ing – because there’s too much paper and too lit­tle trust. Good­bye “Old Nor­mal,” standby to rede­fine “New Nor­mal,” and wel­come to 2012’s “paranormal.”

2012 Para­nor­mal
This process of delev­er­ing has con­sis­tently been a part of PIMCO’s sec­u­lar the­sis but “implo­sion” and “bimodal fat tailed” out­comes are New Age and very “2012ish.” Per­haps the first obser­va­tion to be made is that most devel­oped economies have not, in fact, delev­ered since 2008. Cer­tain por­tions of them – yes: U.S. and Euroland house­holds; south­ern periph­eral Euroland coun­tries. But credit as a whole remains resilient or at least sta­tic because of a mul­ti­tude of quan­ti­ta­tive eas­ings (QEs) in the U.S., U.K., and Japan. Now it seems a gigan­tic tidal wave of QE is being gen­er­ated in Euroland, thinly dis­guised as an LTRO (three-year long term refi­nanc­ing oper­a­tion) which in effect can and will be used by banks to sup­port sov­er­eign bond issuance. Amaz­ingly, Ital­ian banks are now issu­ing state guar­an­teed paper to obtain funds from the Euro­pean Cen­tral Bank (ECB) and then rein­vest­ing the pro­ceeds into Ital­ian bonds, which is QE by any def­i­n­i­tion and near Ponzi by another.

So global economies and their credit mar­kets instead of delev­er­ing and con­tract­ing, con­tinue to mildly expand. Yet there is bimodal fat-tailed risk in early 2012 that was seem­ingly invis­i­ble in 2008. Granted, the fat right tail of eco­nomic expan­sion and poten­tially higher infla­tion has existed for the 3+ year dura­tion. QEs and 500 bil­lion euro LTROs can do that. At the other tail, how­ever, is the poten­tial for “implo­sion” and actual delev­er­ing. To the extent that most sov­er­eign debt is now viewed as “credit” in addi­tion to “inter­est rate” risk, then its inte­gra­tion into pri­vate mar­kets can­not be assured. If only Ital­ian banks buy Ital­ian bonds, then Ital­ian yields are arti­fi­cially sup­ported – even at 7%. If so, then pri­vate bond mar­kets and non-peripheral banks in par­tic­u­lar may refuse to play ball the way ball has been played since 1971– pur­chas­ing gov­ern­ment debt, repo­ing the paper at their respec­tive cen­tral banks and using the pro­ceeds to aid and assist pri­vate eco­nomic expan­sion. Instead, fear­ing default from their sov­er­eign hold­ings, any overnight or term financ­ing begins to accu­mu­late in the safe haven vaults of the ECB, Bank of Eng­land (BOE) and Fed­eral Reserve. Sov­er­eign credit risk rein­tro­duces “liq­uid­ity trap” and “push­ing on a string” fears that seemed to have been long buried and for­got­ten since the Great Depres­sion in the 1930s.

But delev­er­ing now has a new spec­tre to deal with. Not just credit default but “zero-bound” inter­est rates may be eat­ing away like invis­i­ble ter­mites at our 40-year global credit expan­sion. His­tor­i­cally, cen­tral banks have com­fort­ably relied on a model which dic­tates that lower and lower yields will stim­u­late aggre­gate demand and, in the case of finan­cial mar­kets, drive asset pur­chases out­ward on the risk spec­trum as investors seek to main­tain higher returns. Near zero pol­icy rates and a series of “quan­ti­ta­tive eas­ings” have tem­porar­ily suc­ceeded in keep­ing asset mar­kets and real economies afloat in the U.S., Europe and even Japan. Now, with pol­icy rates at or approach­ing zero yields and QE fac­ing polit­i­cal lim­its in almost all devel­oped economies, it is appro­pri­ate to ques­tion not only the effec­tive­ness of his­tor­i­cal con­cep­tual mod­els but enter­tain the pos­si­bil­ity that they may, coun­ter­in­tu­itively, be haz­ardous to an economy’s health.

Impor­tantly, this is not another name for “push­ing on a string” or a “liq­uid­ity trap.” Both of these con­cepts depend sig­nif­i­cantly on per­cep­tion of increas­ing risk in credit mar­kets which in turn reduces the incen­tive of lenders to expand credit. Rates at the zero bound do some­thing more. Zero-bound money – credit qual­ity aside – cre­ates no incen­tive to expand it. Will Rogers once fondly said in the Depres­sion that he was more con­cerned about the return of his money than the return on his money. But from a system-wide per­spec­tive, when the return on money becomes close to zero in nom­i­nal terms and sub­stan­tially neg­a­tive in real terms, then nor­mal func­tion­al­ity may break­down. We all start to resem­ble Will Rogers.

A good exam­ple would be the rever­sal of the money mar­ket fund busi­ness model where oper­at­ing expenses make it per­pet­u­ally unprof­itable at cur­rent yields. As money mar­ket assets then decline, system-wide lever­age is reduced even if clients trans­fer hold­ings to banks, which them­selves rein­vest pro­ceeds in Fed reserves as opposed to pri­vate mar­ket com­mer­cial paper. Addi­tion­ally, at the zero bound, banks no longer aggres­sively pur­sue deposits because of the dif­fi­culty in prof­it­ing from their deploy­ment. It is one thing to pur­sue deposits that can be rein­vested risk-free at a term pre­mium spread – two/three/even five-year Trea­suries being good exam­ples. But when those front end Trea­suries yield only 20 to 90 basis points, a bank’s expen­sive infra­struc­ture reduces profit poten­tial. It is no coin­ci­dence that tens of thou­sands of lay­offs are occur­ring in the bank­ing indus­try, and that branch expan­sion is revers­ing industry-wide.

Tags: Bank Debt, Bill Gross, Bimodal, Cancerous Tumor, Different This Time, Fractional Reserve Banking, Gross Investment, Inflation Protected Securities, Inflationary Expansion, Interest Rate Risk, Investment Outlook, Market Outcomes, Mohamed El Erian, Municipal Bonds, New Duality, PIMCO, Ringing In The New Year, Treasury Inflation Protected Securities, Two Moons, U S Treasury, U S Treasury Bonds, William H Gross
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Neils Jensen: Investment Outlook (December 2011) — "The Facts They Don't Want You To Know"

Friday, December 30th, 2011

The Absolute Return Let­ter Decem­ber 2011

The Facts They Don’t Want You to Know

by Niels Jensen, Absolute Return Partners

What have Bill Gross, John Paul­son, Anthony Bolton and Bill Miller all got in com­mon? They are all ‘rock star’ fund man­agers who have fallen on hard times more recently. Life in the fund man­age­ment indus­try is not what it used to be like. Life is tough even for the supremely skilled. Mar­kets are chang­ing, fund man­agers are strug­gling to adapt and clients are grow­ing rest­less as a result. If I told you that the com­po­si­tion of an aver­age UK equity fund changes by 90% a year, would that star­tle you? How would you feel if I added that the 20 funds with the high­est turnover returned just 4.7% to investors in the 3 years to the end of March 2011 whereas the 20 funds with the low­est turnover returned 16.8% over the same period?¹

From the same source: Out of 1,230 funds across 12 dif­fer­ent strate­gies, only 35 fund man­agers pro­duced a per­for­mance con­sis­tent enough to earn their fund a place in the top quar­tile in each of the last three years (upper half of chart 1). In a uni­verse of 1,230 funds, over a three year period and com­pletely dis­re­gard­ing skill, the expected num­ber of funds con­sis­tently ranked in the top quar­tile is 1,230*0.253=19.22.

In other words, more than half the 35 man­agers were there not because of skill but because, sta­tis­ti­cally, some­one was always likely to ‘over-achieve’. This leaves about 15 fund man­agers out of a uni­verse of 1,230 – ca. 1% — who could with some right claim that they have con­sis­tently been in the top quartile.

The prob­lem is we don’t know who they are. All we know is that none of them are man­ag­ing Asian equi­ties, North Amer­i­can equi­ties or Global fixed income funds as those three strate­gies didn’t pro­duce a sin­gle top quar­tile per­former between them. And when you look at the sec­ond, and slightly less demand­ing, part of the study – those who have been in the top half in each of the past 3 years – the pic­ture is broadly the same (lower half of chart 1). 177 fund man­agers achieved the required con­sis­tency but 154 of the 177 are likely to have done so because of luck, not skill.

I have never come across a fund man­ager who openly admits that his (or her) out­per­for­mance is down to luck. On the other hand, I often come across fund man­agers who sug­gest their under­per­for­mance is down to bad luck. I sup­pose no man­ager ever skil­fully under­per­forms, but to put it down to bad luck is an insult when we all know that human error is the most com­mon cause of underperformance.

If a fund manager’s out­per­for­mance is based on skill rather than luck, wouldn’t one expect the major­ity of the out­per­for­mance to come from those stocks with the high­est weights in the port­fo­lio? This seems a rea­son­able assump­tion given that one would expect any ratio­nal fund man­ager to allo­cate the most cap­i­tal to his/her high­est con­vic­tion ideas.

How­ever, in a study con­ducted by UK con­sult­ing firm Ina­lyt­ics (see here), 39 of 42 Aus­tralian funds man­agers who out­per­formed their bench­mark owed their out­per­for­mance to the ‘under­weights’ in the port­fo­lios — sug­gest­ing that human error is not only the source of under­per­for­mance but per­haps also of some of the outperformance.

Bestin­vest pro­duces an annual sur­vey called Spot the Dog (see here for the lat­est sur­vey) which has gained con­sid­er­able atten­tion in the UK fund man­age­ment indus­try, although it is not a league table you will be proud to be men­tioned in. Accord­ing to the 2011 sur­vey pub­lished back in August, over £23 bil­lion is cur­rently man­aged in so-called dog funds², an increase of no less than 74% since the pre­vi­ous report.

You don’t become a dog just because you have a bad quar­ter or two. The mem­bers of that exclu­sive club have a his­tory of ser­ial under­per­for­mance, yet they will gen­er­ate in the region of £350 mil­lion of fees to their firms this year despite the obvi­ous value destruction.

And the story gets worse — much worse in fact. Accord­ing to an unpub­lished report con­ducted by IBM, our indus­try destroys $1,300 bil­lion of value annu­ally – a stag­ger­ing 2% of global GDP (see here for details). This includes about $300 bil­lion in fees on actively man­aged long-only funds which fail to out­per­form their bench­marks, $250 bil­lion spent on wealth man­age­ment fees for ser­vices which do not meet their bench­marks and $50 bil­lion in fees on hedge funds which under­per­form. Do I need to say any more?

Why are fund man­agers find­ing it harder than ever to out­per­form and what are the long term impli­ca­tions of those mis­er­able per­for­mance sta­tis­tics? Let’s deal with the ‘why’ first. There is no ques­tion that man­ag­ing money – in par­tic­u­lar equity man­dates – has been a del­i­cate affair over the past decade.

Through the 1980s and 1990s global equity mar­kets ben­e­fit­ted from a strong under­cur­rent of bull­ish­ness. As a result, fund man­agers went into the bear mar­ket of 2000-01 on a wave of opti­mism (who doesn’t recall the repeated calls in the late 1990s of a new invest­ment par­a­digm?) epit­o­mised by the record high P/E lev­els in 1998–1999 just before it all went pear shaped in 2000.

Tags: 3 Years, Absolute Return, Asian Equities, Bill Gross, Bill Miller, Equity Fund, Fixed Income, Fund Changes, Fund Management Industry, Fund Managers, Investment Outlook, John Paulson, Neils, Niels Jensen, Period 1, Quartile, Rock Star, Star Fund, Tho, Turnover, Uk Equity
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