Advice on bonds from the largest domestic holder, Pimco:
Global Markets Watch
Dr. Lee R. Thomas, III June 2003
The Road Ahead
Three years ago, in March 2000, Global Watch predicted a hard rain was about to fall. It was time to batten down the hatches. During the collapse of the equity market bubble it has been difficult to see where the storm would finally blow us. The markets, as markets tend to do, have tacked from too much optimism to too much pessimism, and back again. But now, three years on, the challenges ahead are becoming clearer.
In order to understand how, and why, the times they are a changin’, there are three themes to focus on: demographics; China; and the global economy’s exaggerated reliance on U.S. spending.
Demographics will be a Drag
The West is aging, and demographics matter. Demographics argue for increased saving, which is unfriendly for growth, in the U.S., Europe, and Japan. Savers are particularly “behind the curve” in the U.S. and Europe. There the long equity bull market masked a looming pensions crisis. Now, with stock-market boom turned into stock-market bust, the need to save more has become immediate. But for the economy as a whole, savings equals investment. More of one requires more of the other. The key economic problem of the next decade will be how to recycle increasing savings into profitable capital spending projects.
Japan was the first country in the West to face this demographically driven, macroeconomic conundrum. Japan failed, squandering its wealth on “bridges to nowhere” and extravagant spending to shield the politically favored from the discipline of competition. Its economy stagnated. Now it is the turn of the U.S. and Europe to confront the same challenge.
A second theme is the rise of China as the world’s low-cost producer of manufactured products. China’s relentless emergence as a global economic competitor means that capital that was invested to create manufacturing capacity in the West was located in the wrong place. It isn’t worth as much as it used to be, which is one reason stock markets re-priced it downwards. China’s rise makes finding attractive investments to absorb rising savings an even more challenging problem.
The third theme is balance. During the bubble years the global economy became unbalanced, too reliant on the U.S. to serve as the “consumer of last resort.” Unfortunately, in the U.S. investors suffer from post-bubble malaise. Businesses and consumers have too much debt; profits are weak; and capacity utilization is low. There is little appetite for new capital spending projects.
Investment Strategy
The result of this post-bubble world is low growth, low inflation and low interest rates. A “growth recession” in the U.S. and Europe threatens to push unemployment up and push inflation further down. Deflation represents an implausible scenario in Europe and the U.S. – though not so unlikely in Germany – but only because policy-makers will act to preempt it. So expect further cuts by the Fed and the ECB. The U.S. budget deficit will grow. The Growth and Stability Pact, which handcuffs fiscal policy in Europe, will be amended or violated.
Real interest rates need to stay low in the medium term, to facilitate recycling aging boomers’ savings into investment spending by businesses. And real interest rates need to stay even lower in the short term, to counter deflationary pressures from post-bubble overcapacity and wealth destruction.
All and all, this does not appear too promising for investors, because it means prospectively low real returns for both stocks and bonds. But there is a way out. What is the solution if Japan, the U.S. and Europe all need to save more, but it is getting hard to find places to invest all this savings? The answer is to invest elsewhere, in the parts of the world where capital is still scarce, and where populations are still young. During the 18th century, the advice to anyone seeking to grow his wealth was, “Go west, young man.” Today the advice a western investor should heed is, “Go east, young man (or woman).” Or, perhaps, “Go south.” Go anywhere, anywhere capital still is scarce and prospective real returns remain high. Invest in the emerging markets.
We flatter ourselves that we now live in a global village, with one worldwide capital market connecting investors on Main Street with borrowers in Malawi. Like many of the myths of the last decade, this one contains a core of truth surrounded by a lot of exaggeration. While we are heading that direction, we certainly are not there yet. People prefer to invest at home, even when profitable investment opportunities at home are becoming scarce. Part of the problem is it is so hard to know which parts of the world are most promising, and which will be the next financial black holes – once your capital goes in, it doesn’t come back.
Which is building up to my first ever book plug: if you have not read Adventure Capitalist, by Jim Rogers, read it. It is unusual to find an experienced investor – in this case, a former hedge fund manager – who will take the time to get to know foreign economies from the bottom up. And it is even more unusual to find one who can write with wit, clarity, and solid economic reasoning.
Bubble, Bubble, Toil and Trouble
Investing in the young, vigorous emerging economies may be the way to grow your wealth, but for most of us, most of our investments are still in the West. What does the new investing environment offer here?
Unfortunately it doesn’t look good. Once upon a time, one U.S. central banker defined his role as taking away the punch bowl just as the party was getting going. Times have changed. Now the Fed encourages us to party like rock stars. Copious servings of punch will, we are reassured, be on offer for a long, long time. And if you don’t drink enough, we’ll serve even more! In fact, if we do not have you swinging from the chandeliers, 1990s style, pretty soon, Dr. Greenspan hints he knows where to find some moonshine, too. He and his buddy Bernanke may spike the punch.
Of course the Fed has little choice. They were slow to take the punch bowl away during the 90s, and the party got out of hand. Crash. Hangover. Spectre of Japan. Faced with a post-Bubble economic debacle, the Fed stimulated and stimulated, then stimulated some more. It worked well enough to prevent the economic wheels from coming off in the short run, but problems loom going forward. For one thing, the response to more and more stimulus was an economy that has become insensitive to further stimulus. The Fed needs to print more and more money just to get any response from the markets at all. And the economy is growing in an unbalanced way – only the interest-sensitive sectors, housing and autos, have shown any real gusto. So, pessimists say, Greenspan is losing control. We are about to slip into a double-dip recession, plus a deflation, which not even “the Maestro” himself will be able to wave away. If the U.S. faces a Japan-style economic collapse, you need to buy bonds.
I don’t believe it, and neither should you.
Economists have squabbled amongst themselves for decades about what central bankers can do, and what central bankers cannot do. On a few issues a consensus has emerged; others are still controversial. For example, few main-stream economists believe central banks can durably raise real economic growth. Some economists think it is possible for central bankers to smooth the business cycle, while others are skeptical. But mainstream macroeconomists agree emphatically that there is one thing a central bank certainly can do, if it wants to: create inflation. Milton Friedman, a Nobel Prize winner, put it succinctly: “Deflation is the easiest thing in the world to avoid. You just print money” (1998).
Drs. Greenspan and Bernanke might not agree with Dr. Friedman, the grand old man of monetarist economics, on every point of theory, but they believe him on this one. The way Dr. Bernanke phrased it, in the now-famous speech that touched off the current rally in risk assets, “sufficient injections of money will ultimately always reverse a deflation.” Presumably, the only worrying word here is “ultimately.” On how long “ultimately” is, well, honest economists could disagree. If a deflation did start in the U.S. or Europe, it wouldn’t be very much fun waiting around two years – a reasonable, if pessimistic, estimate – until “ultimately” arrived.
But market psychology doesn’t suggest this is our fate. Part of the game in fighting DEflation is promoting the anticipation of future INflation. In case you missed the message, in language that is startlingly direct for a central banker, Bernanke went on to tell us what the Fed could do: “…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation” (2002). Not as pithy as Friedman’s “you just print money,” but Bernanke’s point is the same.
Unlike Dr. Friedman, Drs. Greenspan and Bernanke can back their conviction with action. They control the printing press, and “its electronic equivalent.” The “value of a dollar in terms of goods and services” has already fallen a lot, if those goods and services are imported from abroad. Measured in terms of European goods and services, the value of a dollar is down about 30 percent already. In the fullness of time, the value of a dollar measured in terms of U.S. goods and services will fall faster, too. In other words, inflation is going to pick up, if the Fed keeps this up, and the evidence is that they do intend to keep it up for a long, long time. This is not a time to look for deflation hedges.
Where will it all end? Well, wherever it ends, it is unlikely to be bond heaven. Today’s investor confronts as undemanding a bond decision as he or she ever is likely to face. Consider the case against bonds:
Among the chief problems facing the U.S. economy today is debtors with not enough equity to support their liabilities. A little inflation will make it easier for debtors – individuals and corporations alike – to repair their balance sheets.
So you might conclude that the nation’s economic leaders would like to see inflation rise. You would be right. This country’s head central banker has said he would like companies to have more “pricing power.”
The Fed’s rhetoric has been matched by action. Not only is the Fed very loose, it has signaled it is willing to get even looser.
At the same time, the U.S. is moving from a modest federal government surplus to a substantial deficit. The administration is committed to new defense spending and also to cutting taxes. So common sense says the deficit is likely to grow further.
The dollar is falling.
Putting it all together, the bond market’s fundamentals are as one-sided as they ever will get. The Fed-on-steroids policy of the past few years always was likely to create another bubble in something, and many observers (myself included) expected the bubble to appear in real-estate prices. It has, at least in some property markets. But a much bigger bubble has developed in bonds. That is where the greater opportunity for wealth destruction now lies. Bonds are priced for perfection. In the upside-down world of bonds, “perfection” means economic collapse. So, unless you expect the U.S. to do a Japan-like swoon, you cannot rationalize long-maturity bond yields where they are today.
Sell bonds.
Dr. Lee R. Thomas, III
Managing Director, PIMCO |
