Tuesday, February 28th, 2012
- 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 –
- 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 –
- 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
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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Tuesday, February 7th, 2012
This week, I’m updating my views on some of the emerging market countries in Asia.
While I’m upgrading Chinese equities from neutral to overweight, I’m downgrading South Korean and Indian stocks from neutral to underweight.
Starting with China and South Korea – the two countries are both highly exposed to global growth, but China currently appears to be the better positioned of the two and is likely to hold up much better from a growth perspective.
First, while Chinese equities have performed well year to date, they are down over the past 12 months. As a result, Chinese equities are cheap compared to other Asian emerging market countries, trading at 1.6x book value.
Recent economic data also suggests that growth in China is stabilizing and supports a soft landing. The most recent purchasing managers index, a key measure of manufacturing activity, came out last week at a better-than-expected 50.5, and retail sales growth is actually up to 18.1% year over year. Finally, Chinese inflation, which we all know was a big problem in 2011, is falling. It’s down to 4.1% from 5.5% in November and 6.5% in August.
To be sure, South Korean equities are also cheap compared to other emerging markets. This, however, is normal. South Korea typically commands a big discount due to ongoing uncertainty over North Korea. The cheapness of South Korean stocks is also justified given the country’s worsening economic outlook. South Korea’s economic readings have particularly suffered recently.
Finally, I’m downgrading India in response to the country’s recent surge in valuations and persistently high inflation. Indian stocks appear expensive once again. They are up more than 20% year to date and are currently trading at 2.6x book value. This compares with the Asian emerging market average of 2.4x book value.
In addition, growth in India is still strongly below trend and while the country’s profitability is respectable, it has been on a downward trend over the last couple of months. Finally, Indian inflation, while down from a couple of months ago, is still in the danger territory at 9.3%. All in all, Indian stocks are simply too expensive given current fundamentals (potential iShares solutions: MCHI, ECNS).
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.
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Tags: 6x, Countries In Asia, Downward Trend, Economic Data, Economic Outlook, Emerging Asia, Emerging Market Countries, Emerging Markets, Global Growth, Growth Perspective, Indian Stocks, inflation, North Korea, Overweight, Profitability, Purchasing Managers Index, Retail Sales Growth, South Korea, South Korean Stocks, Valuations
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Sunday, June 26th, 2011
Emerging Markets Cheat Sheet (June 27, 2011)
- Chinese Premier Wen Jiabao said that China’s efforts to stem inflation have worked and that the pace of consumer price increase will slow. The market is interpreting his statement as a potential tightening pause.
- China’s National Development and Reform Commission (NDRC) wants to change or remove local government limits on the number of license plates issued, the National Business Daily reported.
- China’s A-share market valuation reached an 11-month low this week, and it is in a move to form a short-term technical rebound.
- Moody’s upgraded Brazil’s credit rating to BAA2 from BAA3. Large reserves, estimated at $335 billion, should permit Brazil to weather any contagion from the Greek crisis.
- Brazil’s unemployment in May declined to 6.4 percent from 7.5 percent last year, the lowest level on record. Growth in retail wages of 4 percent year-over-year has been supportive of growth in financial intermediation and retail activity.
- Retail sales in Mexico in April grew by 4.9 percent in April, ahead of estimates of 2.7 percent.
- The European Union’s 10 eastern states lead the 27-nation bloc in boosting productivity. This chart from Bloomberg plots the ratio of industrial production and industry labor indexes, a gauge of productivity changes. Industry in Romania produces 84 percent more per employee than it did in 2005, followed by Slovakia and the Baltic countries. By contrast, companies in Greece are less productive than they were six years ago.
- China’s NDRC says the month of June will see inflation reach the highest level in the last 11 months, and then gradually slow down. Hog prices have reached their highest this week, up 80 percent year-over-year, and pork prices are up 63 percent year over year. Pork prices are expected to continue to rise for the rest of the month.
- China’s Purchasing Manager’s Index (PMI) is in a downward trend, at 50.1 percent for June versus 51.6 percent in May.
- China’s 7-day interbank rate reached 9 percent, reflecting extremely tight liquidity conditions, after recent RRR increases and the expectation for further interest rate increases. China’s monetary tightening this year has slowed the economy and prevented housing prices from dramatic change.
- The La Polar controversy in Chile, related to unauthorized credit activities at the retailer, does not show signs of abating. Following an 80 percent decline in the share price, the stock rebounded by 35 percent in the last two days, prompting an insider trading investigation by the authorities.
- The jobless recovery will make it harder for Central European countries to narrow budget deficits that have ballooned during the crisis, according to Raiffeisen analyst in Prague. Persistent unemployment will cause income-tax revenue to fall short of plan, while welfare spending won’t decline as projected.
- UBS investment research has pointed out that Korean stock market valuation is near a historical bottom. As shown in the chart, implied return on equity is 10.1 percent at the moment, after a market correction of 9 percent in the KOSPI. UBS believes the falling ISM Index and Greek debt crisis have mostly been priced in, and therefore this is a buying opportunity.
- GDP in Colombia in the first quarter grew by 5.1 percent with mining leading the way, up 9.4 percent. Agriculture followed, up 7.8 percent, and commerce, up 6.7 percent. The prospect of lower corporate taxes should be supportive of investment activity in the country.
- The Bogota Stock Exchange is likely to see six to seven IPOs by the end of this year, valued at $3.5 billion. We expect strong demand from investors in this vibrant economy.
- Yesterday, the newly elected president of Peru, Ollanta Humala, indicated he would like to have “strong government that will protect democratic gains of last 10 years and will support investment in Peru’s natural resources.” Mr. Humala will travel to Washington at the beginning of July at the invitation of President Barack Obama, where more clarity on his government program is likely to emerge.
- Global carry trade could finance the current account deficit in Turkey, according to J.P.Morgan. A slowing U.S. economy and the turmoil in Greece mean the rates will likely stay lower for longer, and global fixed-income investors will continue to hunt for yield. And the carry on the lira is one of the highest in the world.
- China’s industrial production may see a further slowdown. This is the result of credit tightening in China to control housing and consumer goods prices.
- It is still unclear if the merger between Perdigao and Sadia, forming Brasil Foods two years ago, will be allowed to proceed on competitive grounds. The final vote was postponed until mid-July to allow the company to come up with a disposal plan for some of its assets.
- Is the Chairman of ASUR, the airports operator in Mexico, likely to sell his 20 percent stake in the company? The rumor in the local paper has put the stock under pressure this week.
- In Turkey, newly elected Kurdish deputies threatened to boycott the Parliament, creating political tension ahead of the debate on a new constitution and the formation of the new government. The boycott has the potential to upset financial markets.
Tags: Baltic Countries, Brazil, Chinese Premier Wen Jiabao, Contagion, Downward Trend, Eastern States, Emerging Markets, Financial Intermediation, Hog Prices, License Plates, Market Valuation, Month Of June, National Business, Ndrc, Pmi, Pork Prices, Premier Wen Jiabao, Purchasing Manager, Retail Activity, Share Market, Wen Jiabao
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Saturday, December 4th, 2010
Investors Warm Up to Equities, Cool Down on Bonds
By John Derrick
Director of Research
We like to follow independent thinkers such as Greg Weldon who published an interesting analysis this week detailing a key change in the flow of investor funds. Since the earliest days of the crisis, investors have been skittish on equities while money poured into bonds despite very low yields. The volume and velocity in which funds left stocks for bonds since 2008 was unprecedented. This chart from Weldon shows the amount of Treasury Securities held by U.S. households since 1960. You can see that the total amount of Treasury holdings skyrocketed from $263.87 billion in December 2008 to greater than $1 trillion in less than two years.
This second chart is a measurement ratio of the S&P 500 Index versus the 10-Year U.S. Treasury Note futures contract. The chart shows that stocks have been in a downward trend since hitting an all-time peak in 2007. Even with the big bounce of 2009, stocks were unable to break this downward trend…until now.
Weldon has drawn in the trend line so it is easy to recognize. You can see that the stock breakout over the past several months has finally broken the downward trend. This is a very bullish signal for stocks as money rotates out of Treasuries and back into equities.
Tags: Bullish Signal, Director Of Research, Downward Trend, Futures Contract, Households, Independent Thinkers, Investor Funds, John Derrick, Key Change, Stock Breakout, Stocks Bonds, Time Peak, Treasuries, Treasury Note, Treasury Securities, Trend Line, Trillion, U S Treasury, Velocity, Weldon
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Wednesday, June 23rd, 2010
This is article is a guest contribution by Paul Kasriel, Northern Trust.
There are legitimate concerns that the U.S. could catch the “Japanese” disease and endure a lost decade in terms of normal economic growth. What would be the recipe for such? Chart 1 shows the behavior of the 40-quarter (10-year) compound annual growth in Japanese nominal GDP and the 120-month (10-year) compound annual growth in the Japanese M-2 money supply. (The shaded areas are periods of economic recession in Japan.) Notice how the 10-year annualized growth in M-2 has been trending ever lower, especially between 1990 and 2000. Since September 2000, the 10-year annualized growth in Japanese M-2 has ranged only from about 3% to about 2%. Chart 2 shows that this downward trend in Japanese M-2 growth has been accompanied by an exceptionally low Bank of Japan policy interest rate.
Now, it is not as though Japanese real GDP did not grow in the past twenty years. It has, as shown in Chart 3. But, not surprisingly, similar to Japanese M-2 growth, trend Japanese real GDP growth has been slowing and has not been up to the 2% mark since 1997. Given a declining population and workforce, we should not expect a high rate of growth in aggregate Japanese real GDP. But as shown in Chart 4, trend real GDP growth in Japan has consistently been below the sum of trend growth in the Japanese labor force and the trend rate of growth in Japanese labor productivity since 1998. Thus, something else has been constraining Japanese economic growth.
I would argue that weak bank lending (see Chart 5), which is related to weak M-2 growth, bears a lot of the responsibility for the trend underperformance of the Japanese economy.
Although the U.S. M-2 money supply growth on a trend basis is currently nowhere near as weak as that of Japan (see Chart 6). On a year-over-year basis, however, U.S. M-2 growth is very slow, just under 2% (see also Chart 6). The reason for the recent weak year-over-year growth in U.S. M-2 is the recent contraction in U.S. commercial bank credit (see Chart 7). And, as has been the case in Japan, weak U.S. money and bank credit growth is occurring in the context of very low monetary policy interest rates. Something is wrong with the transmission mechanism between the Fed and the economy. The private financial system is not transforming the inexpensive credit being offered it by the Fed into credit for the private nonfinancial sector of the U.S. economy. Until this transmission mechanism between the Fed and the economy gets mended, we are unlikely to experience potential economic growth.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
Copyright (c) Northern Trust
Tags: Bank Of Japan, Declining Population, Downward Trend, Economic Growth, Economic Recession, GDP, GDP Growth, Growth Trend, Japan Policy, Japanese Economy, Japanese Labor, Labor Productivity, Legitimate Concerns, Money Supply Growth, Nominal Gdp, Northern Trust, Paul Kasriel, Policy Interest, Real Gdp, Shaded Areas
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Monday, July 27th, 2009
This post is a guest contribution by Rebecca Wilder*, author of the of the News ‘n’ Economics blog.
I have received a lot of requests to visit the velocity of money -the rate at which money changes hands. And I thought that it would be instructive to compare the US velocity to another non-QE G7 economy. And since I have a lot of Canadian readers, I chose Canada. The velocity has seriously slipped in both economies.
The chart above (or to the left, depending on your browser) illustrates the MZM and M2 measures of velocity for the US. The quantity theory of money specifies that the velocity of money = nominal GDP/money supply, but I use personal income rather than nominal GDP, as the BEA reports this on a monthly basis. Given a level of money supply, the recent drop in economic activity, i.e., personal income falls, dragged the velocity of money down quickly. It has started to stabilize since March 2009.
Same in Canada: the money supply dropped sharply in Q1 2009 (velocity = nominal GDP/broad money).
Notice that the velocity in Canada has been on a downward trend spanning 1973-2009, however, the negative slope is falling. I am not too familiar with Canada’s velocity (perhaps some of my readers may be more so), but usually a declining velocity of money is associated with a drop in GDP or inflation. I would have to look into this further, but Canada did experience a term of disinflation from the early 80′s to mid 90′s.
* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.
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Tags: Assistant Professor, Bea, Canadian Market, Canadian Readers, Disinflation, Doctorate, Downward Trend, Economic Activity, G7, Money Changes Hands, Money Supply, Mzm, Negative Slope, Nominal Gdp, Personal Income, Qe, Quantity Theory Of Money, Target, Theory Of Money, Velocity Of Money, Visit News
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