Bill Gross: Investment Outlook (April 2012)

The Great Escape:
Deliv­er­ing in a Delev­er­ing World

by William H. Gross, PIMCO

April 2012

• When inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed, the momen­tum begins to shift, not nec­es­sar­ily sud­denly, but grad­u­ally – yields mov­ing mildly higher and spreads sta­bi­liz­ing or mov­ing slightly wider.
• In such a mildly reflat­ing world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Trea­sury bills, then you must take risk in some form.
• We favor high qual­ity, shorter dura­tion and inflation-protected bonds; div­i­dend pay­ing stocks with a pref­er­ence for devel­op­ing over devel­oped mar­kets; and inflation-sensitive, supply-constrained com­mod­ity products.

About six months ago, I only half in jest told Mohamed that my tomb­stone would read, “Bill Gross, RIP, He didn’t own ‘Trea­suries’.” Now, of course, the days are get­ting longer and as they say in golf, it is bet­ter to be above – as opposed to below – the grass. And it is bet­ter as well, to be deliv­er­ing alpha as opposed to delev­er­ing in the bond mar­ket or global econ­omy. The best way to visu­al­ize suc­cess­ful deliv­er­ing is to rec­og­nize that investors are locked up in a finan­cially repres­sive envi­ron­ment that reduces future returns for all finan­cial assets. Break­ing out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delev­er­ing implies a period of prior lever­age, and lever­age there has been. Whether you date it from the begin­ning of frac­tional reserve and cen­tral bank­ing in the early 20th cen­tury, the debase­ment of gold in the 1930s, or the ini­ti­a­tion of Bret­ton Woods and the coör­di­nated dol­lar and gold stan­dard that fol­lowed for nearly three decades after WWII, the trend towards finan­cial lever­age has been ever upward. The aban­don­ment of gold and embrace­ment of dol­lar based credit by Nixon in the early 1970s was cer­tainly a lever­ag­ing land­mark as was the dereg­u­la­tion of Glass-Steagall by a Demo­c­ra­tic Clin­ton admin­is­tra­tion in the late 1990s, and else­where glob­ally. And almost always, the pri­vate sec­tor was more than will­ing to play the game, invent­ing new forms of credit, loosely known as deriv­a­tives, which avoided the con­cept of con­ser­v­a­tive reserve bank­ing alto­gether. Although there were acci­dents along the way such as the S&L cri­sis, Con­ti­nen­tal Bank, LTCM, Mex­ico, Asia in the late 1990s, the Dot-coms, and ulti­mately global sub­prime own­er­ship, finan­cial insti­tu­tions and mar­ket par­tic­i­pants learned that pol­i­cy­mak­ers would sup­port the sys­tem, and most indi­vid­ual par­tic­i­pants, by extend­ing credit, low­er­ing inter­est rates, expand­ing deficits, and dereg­u­lat­ing in order to keep economies tick­ing. Impor­tantly, this com­bined fis­cal and mon­e­tary lever­age pro­duced out­sized returns that exceeded the abil­ity of real economies to cre­ate wealth. Stocks for the Long Run was the almost uni­ver­sally accepted mantra, but it was really a period – for most of the last half cen­tury – of “Finan­cial Assets for the Long Run” – and your house was included by the way in that cat­e­gory of finan­cial assets even though it was just a pile of sticks and stones. If it always went up in price and you could bor­row against it, it was a finan­cial asset. Secu­ri­ti­za­tion ruled supreme, if not subprime.

As nom­i­nal and real inter­est rates came down, down, down and credit spreads were com­pressed through pol­icy sup­port and secu­ri­ti­za­tion, then asset prices mag­i­cally ascended. PE ratios rose, bond prices for 30-year Trea­suries dou­bled, real estate thrived, and any­thing that could be lev­ered did well because the global econ­omy and its finan­cial mar­kets were being lev­ered and lev­ered consistently.

And then sud­denly in 2008, it stopped and reversed. Lever­age appeared to reach its lim­its with sub­primes, and then with banks and invest­ment banks, and then with coun­tries them­selves. The game as we all have known it appears to be over, or at least sub­stan­tially changed – mov­ing for the moment from pri­vate to pub­lic bal­ance sheets, but even there fac­ing investor and polit­i­cal lim­its. Actu­ally global finan­cial mar­kets are only selec­tively delev­er­ing. What delev­er­ing there is, is most vis­i­ble with house­hold bal­ance sheets in the U.S. and Euroland periph­eral sov­er­eigns like Greece. The delev­er­ing is also rel­a­tively hid­den in the recap­i­tal­iza­tion of banks and their looka­likes. Increas­ing cap­i­tal, in addi­tion to hair­cut­ting and defaults are a form of delever­ag­ing that is long term healthy, if short term growth restric­tive. On the whole, how­ever, because of mas­sive QEs and LTROS in the tril­lions of dol­lars, our credit based, lever­age depen­dent finan­cial sys­tem is actu­ally lever­age expand­ing, although only mildly and sys­tem­i­cally less threat­en­ing than before, at least from the stand­point of a growth rate. The total amount of debt how­ever is daunt­ing and con­tin­ued credit expan­sion will pro­duce accel­er­at­ing global infla­tion and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Nor­mal world that levers much more slowly in total, and can delever sharply in selec­tive sec­tors and coun­tries? Look at it this way rather sim­plis­ti­cally. Dur­ing the Great Lever­ag­ing of the past 30 years, it was finan­cial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more lev­ered those flows, then the bet­ter they did. That is because, as I’ve just his­tor­i­cally out­lined, future cash flows are dis­counted by an inter­est rate and a risk spread, and as yields came down and spreads com­pressed, the greater return came from the longest and most lev­ered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the abil­ity of global economies to con­sis­tently repli­cate them. Finan­cial assets rel­a­tive to real assets out­per­form in such a world as wealth is brought for­ward and stolen from future years if real growth can­not repli­cate his­tor­i­cal total returns.

To put it even more sim­ply, finan­cial assets with long inter­est rate and spread dura­tions were win­ners: long matu­rity bonds, stocks, real estate with rental streams and cap rates that could be com­pressed. Com­modi­ties were on the rel­a­tive los­ing end although infla­tion took them up as well. That’s not to say that an oil com­pany with reserves in the ground didn’t do well, but the oil for imme­di­ate deliv­ery that couldn’t ben­e­fit from an expan­sion of P/Es and a com­pres­sion of risk spreads – well, not so well. And so com­modi­ties lagged finan­cial asset returns. Our num­bers show 1, 5 and 20-year his­to­ries of finan­cial assets out­per­form­ing com­modi­ties by 15% for the most recent 12 months and 2% annu­ally for the past 20 years.

This out­per­for­mance by finan­cial as opposed to real assets is a result of the long jour­ney and ulti­mate des­ti­na­tion of credit expan­sion that I’ve just out­lined, result­ing in neg­a­tive real inter­est rates and nar­row credit and equity risk pre­mi­ums; a state of finan­cial repres­sion as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie star­ing Steve McQueen called The Great Escape where Amer­i­can pris­on­ers of war were con­fined to a POW camp inside Ger­many in 1943. The liv­ing con­di­tions were OK, much like today’s finan­cial mar­kets, but cer­tainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and Amer­i­can offi­cers to try to escape and get back to the old nor­mal. They inge­niously dug escape tun­nels and even­tu­ally escaped. It was a real life story in addi­tion to its Hol­ly­wood fla­vor. Sim­i­larly though it is your duty to try to escape today’s repres­sion. Your liv­ing con­di­tions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover lia­bil­i­ties. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this finan­cial repres­sive world.

What hap­pens when we flip the sce­nario or per­haps reach the point at which inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed? The momen­tum we would sug­gest begins to shift: not nec­es­sar­ily sud­denly or swiftly as fat­ter tail bimodal dis­tri­b­u­tions might warn, but grad­u­ally – yields mov­ing mildly higher, spreads sta­bi­liz­ing or mov­ing slightly wider. In such a mildly reflat­ing world where infla­tion itself remains above 2% and in most cases moves higher, deliv­er­ing double-digit or even 7–8% total returns from bonds, stocks and real estate becomes prob­lem­atic and cer­tainly much more dif­fi­cult. Real growth as opposed to finan­cial wiz­ardry becomes pre­dom­i­nant, yet that growth is stressed by exces­sive fis­cal deficits and high debt/GDP lev­els. Com­modi­ties and real assets become ascen­dant, cer­tainly in rel­a­tive terms, as we by neces­sity delever or lever less. As well, finan­cial assets can­not be ele­vated by zero based inter­est rate or other tried but now tired pol­icy maneu­vers that bring future wealth for­ward. Cur­rent prices in other words have squeezed all of the risk and inter­est rate pre­mi­ums from future cash flows, and now finan­cial mar­kets are left with real growth, which itself expe­ri­ences a slower new nor­mal because of less finan­cial leverage.

That is not to say that infla­tion can­not con­tinue to ele­vate finan­cial assets which can adjust to infla­tion over time – stocks being the prime exam­ple. They can, and there will be rel­a­tive win­ners in this con­text, but the abil­ity of an investor to earn returns well in excess of infla­tion or well in excess of nom­i­nal GDP is lim­ited. Total return as a super­charged bond strat­egy is fad­ing. Stocks with a 6.6% real Jeremy Siegel con­stant are fad­ing. Lev­ered hedge strate­gies based on spread and yield com­pres­sion are fad­ing. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all stan­dard asset classes even though betas will be lower. Should you desert bonds sim­ply because they may return 4% as opposed to 10%? I hope not. PIMCO’s poten­tial alpha gen­er­a­tion and the sta­bil­ity of bonds remain crit­i­cal com­po­nents of an invest­ment portfolio.

In sum­mary, what has the poten­tial to deliver the most return with the least amount of risk and high­est infor­ma­tion ratios? Log­i­cally, (1) Real as opposed to finan­cial assets – com­modi­ties, land, build­ings, machines, and knowl­edge inher­ent in an edu­cated labor force. (2) Finan­cial assets with shorter spread and inter­est rate dura­tions because they are more defen­sive. (3) Finan­cial assets for enti­ties with rel­a­tively strong bal­ance sheets that are exposed to higher real growth, for which devel­op­ing vs. devel­oped nations should dom­i­nate. (4) Finan­cial or real assets that ben­e­fit from favor­able pol­icy thrusts from both mon­e­tary and fis­cal author­i­ties. (5) Finan­cial or real assets which are not bur­dened by exces­sive debt and sub­ject to future haircuts.

In plain speak –

For bond mar­kets: favor higher qual­ity, shorter dura­tion and infla­tion pro­tected assets.

For stocks: favor devel­op­ing vs. devel­oped. Favor shorter dura­tions here too, which means con­sis­tent div­i­dend pay­ing as opposed to growth stocks.

For com­modi­ties: favor infla­tion sen­si­tive, sup­ply con­strained products.

And for all asset cat­e­gories, be wary of lev­ered hedge strate­gies that promise double-digit returns that are dif­fi­cult in a delev­er­ing world.

With regard to all of these broad asset cat­e­gories, an investor in finan­cial mar­kets should not go too far on this defen­sive, as opposed to offen­sively ori­ented sce­nario. Unless you want to earn an infla­tion adjusted return of minus 2–3% as offered by Trea­sury bills, then you must take risk in some form. You must try to max­i­mize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essen­tial ele­ment of cap­i­tal­ism – that is investors earn­ing some­thing more than a Trea­sury bill. If and when we can­not, then the sys­tem implodes – espe­cially one with exces­sive lever­age. Paul Vol­cker suc­cess­fully redi­rected the U.S. econ­omy from 1979–1981 dur­ing which investors earned less return than a Trea­sury bill, but that could only go on for sev­eral years and occurred in a much less lev­ered finan­cial sys­tem. Vol­cker had it eas­ier than Bernanke/King/Draghi have it today. Is a sys­temic implo­sion still pos­si­ble in 2012 as opposed to 2008? It is, but we will likely face much more mon­e­tary and credit infla­tion before the bal­loon pops. Until then, you should bud­get for “safe carry” to help pay your bills. The bunker port­fo­lio lies fur­ther ahead.

Two addi­tional con­sid­er­a­tions. In a highly lev­ered world, grad­ual rever­sals are not nec­es­sar­ily the high prob­a­ble out­come that a nor­mal bell-shaped curve would sug­gest. Pol­icy mis­takes – too much money cre­ation, too much fis­cal belt-tightening, geopo­lit­i­cal con­flicts and war, geopo­lit­i­cal dis­agree­ments and dis­in­te­gra­tion of mon­e­tary and fis­cal unions – all of these and more lead to poten­tial bimodal dis­tri­b­u­tions – fat left and right tail out­comes that can inflate or deflate asset mar­kets and real eco­nomic growth. If you are a ratio­nal investor you should con­sider hedg­ing our most prob­a­ble inflationary/low growth out­come – what we call a “C-“ sce­nario – by buy­ing hedges for fat­ter tailed pos­si­bil­i­ties. It will cost you some­thing – and hedg­ing in a low return world is harder to buy than when the cot­ton is high and the liv­ing is easy. But you should do it in amounts that hedge against prin­ci­pal down­sides and allow for prin­ci­pal upsides in bimodal out­comes, the lat­ter per­haps being epit­o­mized by equity mar­kets 10–15% returns in the first 80 days of 2012.

And sec­ondly, be mind­ful of invest­ment man­age­ment expenses. Whoops, I’m not sup­posed to say that, but I will. Be sure you’re get­ting value for your expense dol­lars. We of course – per­haps like many other firms would say, “We’re Num­ber One.” Not always, not for me in the sum­mer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are cer­tainly a #1 seed – with aspi­ra­tions as always to be your #1 Champion.

William H. Gross
Man­ag­ing Director