Bill Gross, co-founder and co-CIO of PIMCO, is to my mind one of the shrewdest money men around. His monthly newslet­ter, this month enti­tled “The Ring of Fire”, there­fore always makes for thought-provoking reading.

Here is the audio ver­sion, read by Bill Gross himself:

The Ring of Fire

The fol­low­ing are a few excerpts from the report:

“In this New Nor­mal envi­ron­ment it is instruc­tive to observe that the oper­a­tive word is ‘new’ and that the use of his­tor­i­cal mod­els and econo­met­ric fore­cast­ing based on the expe­ri­ence of the past sev­eral decades may not only be use­less, but coun­ter­pro­duc­tive. When lever­ag­ing and dereg­u­lat­ing not only slow down, but move into reverse gear encom­pass­ing delever­ag­ing and rereg­u­lat­ing, then it pays to look at his­tor­i­cal exam­ples where those con­di­tions have pre­vailed. Two excel­lent stud­ies pro­vide assis­tance in that regard — the first, a study of eight cen­turies of finan­cial cri­sis by Car­men Rein­hart and Ken­neth Rogoff titled This Time is Dif­fer­ent, and the sec­ond, a study by the McK­in­sey Global Insti­tute speak­ing to ‘Debt and delever­ag­ing: The global credit bub­ble and its eco­nomic consequences.’

“… bank­ing crises are fol­lowed by a delever­ag­ing of the pri­vate sec­tor accom­pa­nied by a sub­sti­tu­tion and esca­la­tion of gov­ern­ment debt, which in turn slows eco­nomic growth and (PIMCO’s the­sis) low­ers returns on invest­ment and finan­cial assets. The most vul­ner­a­ble coun­tries in 2010 are shown in PIMCO’s chart ‘The Ring of Fire’. These red zone coun­tries are ones with the poten­tial for pub­lic debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yel­low and green areas are con­sid­ered to be the most con­ser­v­a­tive and poten­tially most sol­vent, with the poten­tial for higher growth.

“What then is an investor to do? If, instead of econo­met­ric mod­els founded on the past 30–40 years, an analy­sis must depend on centuries-old exam­ples of delever­ag­ing economies in the after­math of a finan­cial cri­sis, how does one select and then time an invest­ment theme that can be expected to gen­er­ate out­per­for­mance, or what pro­fes­sion­als label “alpha?” Care­fully and cau­tiously with regard to tim­ing, I sup­pose, but rather aggres­sively in the selec­tion process under the assump­tion that it’s never “dif­fer­ent this time” and that his­tory repeats as well as rhymes. Rein­hart and Rogoff’s book, if any­thing, points to the inescapable con­clu­sion that human nature is the one defin­ing con­stant in his­tory and that the cycles of greed, fear and their eco­nomic con­se­quences paint an indeli­ble land­scape for investors to observe. If so, then investors should focus on the fol­low­ing 30,000-foot obser­va­tions in the selec­tion of global assets:

1.     Risk/growth-oriented assets (as well as cur­ren­cies) should be directed towards Asian/developing coun­tries less lev­ered and less eas­ily prone to bub­bling and there­fore the neg­a­tive delever­ag­ing aspects of bub­ble pop­ping. When the price is right, go where the growth is, where the con­sumer sec­tor is still in its infancy, where national debt lev­els are low, where reserves are high, and where trade sur­pluses promise to gen­er­ate addi­tional reserves for years to come. Look, in other words, for a savings-oriented econ­omy which should grad­u­ally evolve into a consumer-focused econ­omy. China, India, Brazil and more miniature-sized exam­ples of each would be excel­lent exam­ples. The old estab­lished G-7 and their looka­likes as they delever have lost their posi­tion as dri­vers of the global economy.

2.     Invest less risky, fixed income assets in many of these same coun­tries if pos­si­ble. Because of their reduced liq­uid­ity and less devel­oped finan­cial mar­kets, how­ever, most bond money must still look to the ‘old’ as opposed to the new world for returns. It is true as well, that the ‘old’ offer a more favor­able envi­ron­ment from the stand­point of prop­erty rights and ‘will­ing­ness’ to make inter­est pay­ments under duress. There­fore, see #3 below.

3.     Inter­est rate trends in devel­oped mar­kets may not fol­low the same his­tor­i­cal con­di­tions observed dur­ing the recent Great Mod­er­a­tion. The down­ward path of yields for many G-7 economies was remark­ably sim­i­lar over the past sev­eral decades with excep­tion for the West German/East Ger­man amal­ga­ma­tion and the Japan­ese expe­ri­ence which still places their yields in rel­a­tive iso­la­tion. Should an investor expect a sim­i­larly cor­re­lated upward wave in future years? Not as much. Not only have credit default expec­ta­tions begun to widen sov­er­eign spreads, but ini­tial con­di­tion debt lev­els … will be impor­tant as they influ­ence infla­tion and real inter­est rates in respec­tive coun­tries in future years. Each of sev­eral dis­tinct devel­oped econ­omy bond mar­kets presents inter­est­ing aspects that bear watch­ing: 1) Japan with its aging demo­graph­ics and need for exter­nal financ­ing, 2) the US with its large deficits and explod­ing enti­tle­ments, 3) Euroland with its dis­parate mem­bers — Ger­many the extreme saver and pro­duc­tive pro­ducer, Spain and Greece with their exces­sive reliance on debt and 4) the UK, with the high­est debt lev­els and a finance-oriented econ­omy — exposed like Lon­don to the cold dark win­ter nights of deleveraging.

"Of all of the devel­oped coun­tries, three broad fixed-income obser­va­tions stand out: 1) given enough liq­uid­ity and cur­rent yields I would pre­fer to invest money in Canada. Its con­ser­v­a­tive banks never did par­tic­i­pate in the hous­ing cri­sis and it moved toward and stayed closer to fis­cal bal­ance than any other coun­try, 2) Ger­many is the safest, most liq­uid sov­er­eign alter­na­tive, although its lead­er­ship and the EU's poten­tial stance toward bailouts of Greece and Ire­land must be watched. Think AIG and GMAC and you have a sim­i­lar com­par­a­tive predica­ment, and 3) the U.K. is a must to avoid. Its Gilts are rest­ing on a bed of nitro­glyc­er­ine. High debt with the poten­tial to devalue its cur­rency present high risks for bond investors. In addi­tion, its inter­est rates are already arti­fi­cially influ­enced by account­ing stan­dards that at one point last year pro­duced long-term real inter­est rates of 1/2 % and lower."

“The last decade — the ‘aughts’ — were remark­able in a num­ber of areas: job­less recov­er­ies in major economies, neg­a­tive equity returns in US and other devel­oped mar­kets, and of course the finan­cial cri­sis and its after­math. If an invest­ment man­ager and an invest­ment man­age­ment firm proved to be good stew­ards of cap­i­tal mar­kets dur­ing the tur­bu­lent but vapid ‘aughts’, they may be granted a license to nav­i­gate the rapids of the “teens,” a decade likely to be fed by the melt­ing snows of debt delever­ag­ing, offer­ing life for unlev­ered emerg­ing and devel­oped economies, but risk and uncer­tainty for those overfed on a diet of financed-based con­sump­tion. Beware the ring of fire!”

Click here for the full article.

Source: Bill Gross, PIMCO — Invest­ment Out­look, Feb­ru­ary 2010.

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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