A bit long but PIMPCO's outlook!
William H. Gross | November 2010 Run Turkey, Run
The Fed's announcement of a renewed commitment to Quantitative Easing
has been well telegraphed and the market's reaction is likely to be
subdued.
We are in a "liquidity trap," where interest rates or trillions in asset
purchases may not stimulate borrowing or lending because consumer demand
is just not there.
The Fed's announcement will likely signify the end of a great 30-year
bull market in bonds and the necessity for bond managers and, yes,
equity managers to adjust to a new environment.
They say a country gets the politicians it deserves or perhaps it
deserves the politicians it gets. Whatever the order, America is next in
line, and as we go to the polls in a few short days it's incumbent upon
a sleepy and befuddled electorate to at least ask ourselves, "What's
going on here?" Democrat or Republican, Elephant or Donkey, nothing much
ever seems to change. Each party has shown it can add hundreds of
billions of dollars to the national debt with little to show for it or
move our military from one country to the next chasing phantoms instead
of focusing on more serious problems back home. This isn't a choice
between chocolate and vanilla folks, it's all rocky road: a few
marshmallows to get you excited before the election, but with a lot of
nuts to ruin the aftermath.
Each party's campaign tactics remind me of airport terminals pre-9/11
when solicitors only yards apart would compete for the attention and
dollars of travelers. "Save the Whales," one would demand, while the
other would pose as its evil twin - "Eat Whale Blubber," the makeshift
sign would read. It didn't matter which slogan grabbed you, the end of
the day's results always produced a pot of money for them and the whales
were neither saved nor eaten. American politics resemble an airline
terminal with a huckster's bowl waiting to be filled every two years.
And the paramount problem is not that we contribute so willingly or even
so cluelessly, but that there are only two bowls to choose from. Thomas
Friedman, the respected author of The World Is Flat, and a weekly New
York Times Op-Ed author, recently suggested "ripping open this two-party
duopoly and having it challenged by a serious third party" unencumbered
by special interest megabucks. "We basically have two bankrupt parties,
bankrupting the country," was the explicit sentiment of his article, and
I couldn't agree more - whales or no whales. Was it relevant in 2004
that John Kerry was or was not an admirable "swift boat" commander? Will
the absence of a mosque within several hundred yards of Ground Zero
solve our deficit crisis? Is Christine O'Donnell really a witch? Did Meg
Whitman employ an illegal maid? Who cares! We are being conned, folks;
Democrats and Republicans alike. What have you really heard from either
party that addresses America's future instead of its prurient overnight
fascination with scandal? Shame on them and of course, shame on us.
We're getting what we deserve. Vote NO in November - no to both parties.
Vote NO to a two-party system that trades promises for dollars and hope
for power, and leaves the American people high and dry.
There's another important day next week and it rather coincidentally
occurs on Wednesday - the day after Election Day - when either the
Donkeys or the Elephants will be celebrating a return to power and the
continuation of partisan bickering no matter who is in charge. Wednesday
is the day when the Fed will announce a renewed commitment to
Quantitative Easing - a polite form disguise for "writing checks." The
market will be interested in the amount (perhaps as much as an initial
$500 billion) as well as the targeted objective (perhaps a muddied
version of "2% inflation or bust!"). The announcement, however, has been
well telegraphed and the market's reaction is likely to be subdued. More
important will be the answer to the long-term question of "will it
work?" and perhaps its associated twin "will it create a bond market
bubble?"
Whatever the conclusion, not only investors, but the American people
should recognize that Wednesday, even more than Tuesday, represents a
critical inflection point in determining our future prosperity. Of
course we've tried it before, most recently in the aftermath of the
Lehman crisis, during which the Fed wrote $1.5 trillion or so in
"checks" to purchase Agency mortgages and a smattering of Treasuries. It
might seem a tad dramatic then, to label QEII as "critical," sort of
like those airport hucksters, I suppose, that sold whale blubber for a
living. But two years ago, there was the implicit assumption that the
U.S. and its associated G-7 economies needed just an espresso or perhaps
an Adderall or two to get back to normal. Normal just hasn't happened
yet, and economic historians such as Kenneth Rogoff and Carmen Reinhart
have since alerted us that countries in the throes of delevering can
take many, not several, years to return to a steady state.
The Fed's second round of QE, therefore, more closely resembles an
attempted hypodermic straight to the economy's heart than its mood
elevator counterpart of 2009. If QEII cannot reflate capital markets, if
it can't produce 2% inflation and an assumed reduction of unemployment
rates back towards historical levels, then it will be a long, painful
slog back to prosperity. Perhaps, as a vocal contingent suggests, our
paper-based foundation of wealth deserves to be buried, making a fresh
start from admittedly lower levels. The Fed, on Wednesday, however, will
decide that it is better to keep the patient on life support with an
adrenaline injection and a following morphine drip than to risk its
demise and ultimate rebirth in another form.
We at PIMCO join with Ben Bernanke in this diagnosis, but we will tell
you, as perhaps he cannot, that the outcome is by no means certain. We
are, as even some Fed Governors now publically admit, in a "liquidity
trap," where interest rates or trillions in QEII asset purchases may not
stimulate borrowing or lending because consumer demand is just not
there. Escaping from a liquidity trap may be impossible, much like light
trapped in a black hole. Just ask Japan. Ben Bernanke, however, will try
- it is, to be honest, all he can do. He can't raise or lower taxes, he
can't direct a fiscal thrust of infrastructure spending, he can't change
our educational system, he can't force the Chinese to revalue their
currency - it is all he can do, and as he proceeds, the dual questions
of "will it work" and "will it create a bond market bubble" will be
answered. We at PIMCO are not sure.
Still, while next Wednesday's announcement will carry our qualified
endorsement, I must admit it may be similar to a Turkey looking forward
to a Thanksgiving Day celebration. Bondholders, while immediate
beneficiaries, will likely eventually be delivered on a platter to more
fortunate celebrants, be they financial asset classes more adaptable to
inflation such as stocks or commodities, or perhaps the average American
on Main Street who might benefit from a hoped-for rise in job growth or
simply a boost in nominal wages, however deceptive the illusion. Check
writing in the trillions is not a bondholder's friend; it is in fact
inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public
debt, actually, has always had a Ponzi-like characteristic. Granted, the
U.S. has, at times, paid down its national debt, but there was always
the assumption that as long as creditors could be found to roll over
existing loans - and buy new ones - the game could keep going forever.
Sovereign countries have always implicitly acknowledged that the
existing debt would never be paid off because they would "grow" their
way out of the apparent predicament, allowing future's prosperity to
continually pay for today's finance.
Now, however, with growth in doubt, it seems that the Fed has taken
Charles Ponzi one step further. Instead of simply paying for maturing
debt with receipts from financial sector creditors - banks, insurance
companies, surplus reserve nations and investment managers, to name the
most significant - the Fed has joined the party itself. Rather than
orchestrating the game from on high, it has jumped into the pond with
the other swimmers. One and one-half trillion in checks were written in
2009, and trillions more lie ahead. The Fed, in effect, is telling the
markets not to worry about our fiscal deficits, it will be the buyer of
first and perhaps last resort. There is no need - as with Charles Ponzi
- to find an increasing amount of future gullibles, they will just write
the check themselves. I ask you: Has there ever been a Ponzi scheme so
brazen? There has not. This one is so unique that it requires a new
name. I call it a Sammy scheme, in honor of Uncle Sam and the
politicians (as well as its citizens) who have brought us to this
critical moment in time. It is not a Bernanke scheme, because this is
his only alternative and he shares no responsibility for its origin. It
is a Sammy scheme - you and I, and the politicians that we elect every
two years - deserve all the blame.
Still, as I've indicated, a Sammy scheme is temporarily, but not
ultimately, a bondholder's friend. It raises bond prices to create the
illusion of high annual returns, but ultimately it reaches a dead-end
where those prices can no longer go up. Having arrived at its
destination, the market then offers near 0% returns and a picking of the
creditor's pocket via inflation and negative real interest rates. A
similar fate, by the way, awaits stockholders, although their ability to
adjust somewhat to rising inflation prevents such a startling
conclusion. Last month I outlined the case for low asset returns in
almost all categories, in part due to the end of the 30-year bull market
in interest rates, a trend accentuated by QEII in which 2- and 3-year
Treasury yields approach the 0% bound. Anyone for 1.10% 5-year
Treasuries? Well, the Fed will buy them, but then what, and how will
PIMCO tell the 500 billion investor dollars in the Total Return strategy
and our equally valued 750 billion dollars of other assets that the
Thanksgiving Day axe has finally arrived?
We will tell them this. Certain Turkeys receive a Thanksgiving pardon or
they just run faster than others! We intend PIMCO to be one of the
chosen gobblers. We haven't been around for 35+ years and not figured
out a way to avoid the November axe. We are a survivor and our clients
are not going to be Turkeys on a platter. You may not be strutting
around the barnyard as briskly as you used to - those near 10%
annualized yields in stocks and bonds are a thing of the past - but
you're gonna be around next year, and then the next, and the next.
Interest rates may be rock bottom, but there are other ways - what we
call "safe spread" ways -to beat the axe without taking a lot of risk:
developing/emerging market debt with higher yields and non-dollar
denominations is one way; high quality global corporate bonds are
another. Even U.S. Agency mortgages yielding 200 basis points more than
those 1% Treasuries, qualify as "safe spreads." While our "safe spread"
terminology offers no guarantees, it is designed to let you sleep at
night with less interest rate volatility. The Fed wants to buy, so come
on, Ben Bernanke, show us your best and perhaps last moves on Wednesday
next. You are doing what you have to do, and it may or may not work. But
either way it will likely signify the end of a great 30-year bull market
in bonds and the necessity for bond managers and, yes, equity managers
to adjust to a new environment.
If a country gets the politicians it deserves, then the same can be said
of an investor - you're gonna get what you deserve. Vote No to
Republican and Democratic turkeys on Tuesday and Yes to PIMCO on
Wednesday. We hope to be your global investment authority for a new era
of "SAFE spread" with lower interest rate duration and price risk, and
still reasonably high potential returns. For us, and hopefully you,
Turkey Day may have to be postponed indefinitely. |
