Bill Gross: Beware the Ring of Fire

Wednesday, January 27th, 2010

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:

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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.

Tags: Bill Gross, Canada, Carmen Reinhart, China, Credit Bubble, Econometric Models, Economic Consequences, Emerging Markets, Escalation, Financial Assets, Fire Bill, Global Credit, Government Debt, Gross Co, India, Mckinsey Global Institute, Money Men, Operative Word, PIMCO, Public Debt, Red Zone, Returns On Investment, Ring Of Fire, Vulnerable Countries
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Jan Hatzius on US Growth, Rates, and Economists

Monday, September 14th, 2009

This post features a three-part video interview with Jan Hatzius, chief US economist for Goldman Sachs, by Aline van Duyn, FT’s US Markets Editor. Whether you like Goldman or not, Hatzius is worthwhile viewing material.

Part 1: Hatzius on US growth
Hatzius expects “the second half of 2009 … to be quite strong” but “in 2010 we’ll probably see some renewed deceleration in growth”. He sees temporary measures including the inventory cycle and the fiscal stimulus as being responsible for “growth in the second half of 2009, but … by late 2010 that number is going to be somewhere around zero”.

Click here or on the image below to view Part 1 of the video clip.

Part 2: Hatzius on US rates
Hatzius sees “no rate hikes … through the end of 2010″. He points to high unemployment and low core inflation as “a strong statement … from the Fed’s perspective that low interest rates are going to be warranted”.

Click here or on the image below to view Part 2.

Part 3: Hatzius on economists
Hatzuis points to humility and being “realistic in one’s ability to predict the future … as an important part” of his job. He says “the biggest problems have been seen by people who rely on more mechanical models” including “large scale econometric models of the business cycle, because it’s harder to adjust those types of forecasting models for judgment”. “More electric forecasters have had perhaps a somewhat easier time …. Using a judicious mix of estimating models, looking at numbers and relying, at least to some extent, on more anecdotal indicators that are a little harder to… download in a time series form.”

Click here or on the image below to view Part 3.

Source: Financial Times, September 11, 2009.

Tags: Aline, Business Cycle, Core Inflation, Deceleration, Econometric Models, Economist, Economists, Financial Times, Fiscal Stimulus, Forecasters, Gold, Goldman Sachs, Humility, Inventory Cycle, Low Interest Rates, Mechanical Models, Rate Hikes, Source Financial, Time Series, Van Duyn, Video Interview
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Bill Gross: From Feast to Fast - July 2009 Outlook

Friday, July 3rd, 2009

Bill Gross, the “Bond King” is going to great lengths to get us to understand that the world is in a state of reversion to what he and El-Erian, his co-chief at PIMCO coined as the “New Normal” 3 months ago, in his latest missive - “Bon” or “Non” Appétit?.

Our economy which once feasted, no, binged, unable to stop itself, on debt and leverage, and on the basis that home and other asset prices would rise to the sky, is now fasting, cleansing itself of the fat that accumulated, and it is a long-term process that will take many years to complete.

Click Play to Listen to Bill Gross’ Investment Outlook:

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Here are some of the highlights from the letter, which you may download here:

Gross re-iterates the “New Normal” - Its starting to sound a lot like “The Emperor’s New Clothes“:

Our economy’s lights, if not switched off in a rehash of the 1930s Depression, have certainly been dimmed in a 21st century version likely to be labeled the Great Recession. Much like John McSherry, U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be. Now, however, with financial markets seemingly calmed and an inventory-based recovery in store for the balance of 2009, there is a developing optimism that we can go back to the lifestyle of yesteryear. PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past.

Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking.

Others are starting to wonder about the emperors new clothes, the “green shoots”:

I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, “How do you put together a consumer economy that works when the consumers are out of work?” That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an “old normal.” As unemployment approaches 10%, what is less well publicized is that the number of “underutilized” workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model.

Fifteen Words to describe the era that led us to our current economic crisis:

The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in fifteen words our most recent brush with irrational behavior and inefficient markets. Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum. The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Global estimates are less reliable, but certainly in multiples of that figure. And when potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one that predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3½%. There’s no magic in that number, and no model to back it up, just a lot of commonsense that says this is how people and economic societies behave when stressed and stretched to a near breaking point.

Where do we go from here:

Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the U.S. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk. Investors should stress secure income offered by bonds and stable dividend-paying equities. Consumer Cuisinart consumption is a relic of the past.

Tags: Asset Prices, Asset Returns, Bill Gross, Burgers, Econometric Models, Excessive Amounts, Financial Markets, Global Consumers, Global Economy, Great Lengths, Gross Investment, Investment Outlook, John Mcsherry, Juxtaposition, Missive, Mistaken Assumption, PIMCO, Profit Margins, Recession, Reversion, Yesteryear
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