Investment Bill Gross Outlook March 2010 Don’t Care I haven’t gone to a cocktail party in over Cocktail Party Empathy Chart 10 years. Granted, perpetually watching 10 Seinfeld reruns on Friday and Saturday 9 About What You’re Saying How Much I Really Care 8 nights makes for a dull boy, but the 7 Do alternative is excruciating. Uh, which would 6 n’ tC ar e I prefer – solitary confinement or water 5 4 boarding? I lean strongly in the direction 3 of a warm bed and peace as opposed to a 2 1 glass full of tinkling ice cubes and a room 30 60 90 120 resonating with high- decibel blather. I Seconds into Conversation suppose the parties wouldn’t be so bad if Chart 1 there was something original to be said, or 1) Where are you from? (If it’s not a place if “you” had a genuine interest in “me” as where I’ve been or have a distant opposed to “you,” but let’s face it folks, no second cousin – don’t care.) one does. The only reason any of us really cares about cocktail conversations is to 2) How’s the family? (If Johnnie is in quickly redirect someone else’s stories into advanced placement courses and my autobiographies that we assume to be instant kids aren’t – don’t care. Don’t care about bestsellers if only in print. If not, if the doe- your kids’ soccer games either or that eyed listener seems simply fascinated by upcoming wedding.) what you’re saying, you can bet there’s a 3) Medical problems. (Unless you’re requested personal favor coming when you dying from cancer – don’t care. Your finally shut up. “Say Bill, I was wondering if artificial hip and kidney stone stories you knew somebody at…that could…” Yeah are important only to let me tell you right! But, as my chart shows, 90 seconds into about mine.) a typical conversation, no one gives a damn about you and your problems – maybe those 4) How’s work? (Forgot where you work, shoes and that dreadful eye shadow you’re but it’s a good lead in. Don’t really care wearing, but not anything audible coming though unless you can direct some out of your mouth. business my way.) During that unbearable minute-and-a-half, 5) Can you believe Tiger? (Now there’s however, you’re likely to have covered some something I care about, but the wife is of the following topics: only five feet away.) Investment Outlook Actually, the “afterparty” is the best party In order to get us out of the sinkhole and of all – driving home with your partner and avoid another Great Depression, the visible dissing all of the guests. Still, give me a home fist of government stepped in to replace the where Seinfeld roams, I suppose. Boring is invisible hand of Adam Smith. Short-term better – cocktail parties are so 1990s. interest rates headed to 0% and monetary policies of central banks incorporated new In contrast to those cocktail parties, I‘ve got measures labeled “quantitative easing,” so much to say in this Investment Outlook that which essentially involved the writing of I don’t know where to start. Don’t be lookin’ trillions of dollars of checks to replace the around for something more important trillions of dollars of credit that disappeared though, like you do at a cocktail party; I after Lehman Brothers. In addition, need your undivided attention for the full government fiscal policies, in combination 90 seconds allotted me. with declining revenues, led to double-digit To begin with, let’s get reacquainted with deficits as a percentage of GDP in many the fundamental economic problem of our countries, a condition unheard of since the age – lack of global aggregate demand – Great Depression. (3) For awhile it seemed and how we got to where we are today: that all was well, that the government’s (1) Twenty years of accelerated globalization checkbook could replace the private market’s incrementally undermined the real incomes wallet and credit cards. Risk markets of most developed countries’ workers/ returned to normal P/Es as did interest rate citizens, forcing governments to promote spreads, and GDP growth resumed; it was leverage and asset price appreciation only a matter of time before job growth in order to fill in what is known as an would assure the world that we could believe “aggregate demand” gap – making sure in the tooth fairy again. Capitalism based on that consumers keep buying things. When asset price appreciation was back. It would the private sector assumed too much debt only be a matter of time before home prices and asset prices bubbled (think subprimes followed stock prices higher and those and houses, or dotcoms/NASDAQ 5000), refis and second mortgages would stuff American-style capitalism with its leverage, our wallets once again. (4) Ah, but Dubai, deregulation, and religious belief in lower Iceland, Ireland and recently Greece pointed and lower taxes reached a dead end. There to a potential flaw in the model. Shaking hands with the government was a brilliant was a willingness to keep on consuming, strategy in 2009 when it was assumed that there just wasn’t the wallet. Vigilantes – governments had an infinite capacity to bond market or otherwise – took away the leverage themselves. credit card like parents do with a mall- crazed teenager. (2) The cancellation of But what if they didn’t? What if, as Carmen credit cards led to the Great Recession and Reinhart and Kenneth Rogoff have pointed private sector deleveraging, the beginning of out in their book, “This Time is Different,” government policy reregulation, and gradual our modern era was similar to history deglobalization – a reversal of over 20 years over the past several centuries when of trade policies and free market orthodoxy. financial crises led to sovereign defaults or March 2010 Page 2 at least uncomfortable economic growth market for sovereign countries. Greece has environments where real GDP was subpar taken the headlines with its 350–400 basis based on onerous debt levels – sovereign point cost of “protection,” but even Japan and private market alike. What if – to put and the U.K. approach 100 and the U.S. it simply – you couldn’t get out of a debt is nearly half of that. Markets, in fact, are crisis by creating more debt? demanding 20–30 basis points of higher insurance premiums for the best of credits You are now up-to-date and I’ve used up all relative to levels prior to Dubai and Greece. of my 90 seconds, but bear with me, patient The inflation component of sovereign reader. I may not be able to get your kid a job issuance is obvious as well. Potential serial at PIMCO, but maybe I could give you an idea reflators such as the U.K. and U.S. both or two as to what lies ahead. Let’s explore show an increase of 50 basis points in their the last line in the previous paragraph first – 10-year notes since the Dubai crisis in late can you get out of a debt crisis by piling on November. While a portion of that 50 may another layer of debt? The answer, of course, in fact be credit related as pointed out above, is that “it depends.” Replacing corporate and the combination of credit and inflationary mortgage debt with a government checkbook protection demanded by the market is initially beneficial because the sovereign suggests, as Reinhart and Rogoff point out is assumed to be more creditworthy than in their book, that government securities its private market serfs. It taxes, it prints, following a financial crisis are subject to it confiscates wealth if need be and so this huge increases in supply and accordingly, substitution is medicinal in the early stages significant increases in risk and real of a financial crisis aftermath – especially if yield levels. debt/GDP levels are low to begin with. That is the case currently at most G7 countries, It is interesting to observe that over the past with the exception of Japan, although the few months when investors have begun to balance sheets of Germany/France are question the ability of governments to exit obviously contaminated by its weaker EU the debt crisis by “creating more debt,” that increases in bond market yields have been members, and that of the U.S. by its Agencies confined almost exclusively to Treasury/Gilt- and other off-balance-sheet liabilities. But type securities, and long maturities at that. based on existing deficit trends and the There has even been a developing debate in expectation that not much progress will be the press (and here at PIMCO) as to whether made in reducing them, markets are raising a highly-rated corporation could ever interest rates on sovereign debt issuance consistently trade at lower yields compared either in anticipation of higher future to its home country’s debt. I suspect not, inflation, increased levels of credit risk, or but the narrowing in spreads since late both. This places a potential “cap” on the November solicits an interesting proposition: “debt” that supposedly can be created to get Government bailouts and guarantees out of the “debt crisis.” such as those evidenced and envisioned The threat of credit deterioration is clearly in Dubai and Greece, as well as those for evidenced in the CDS or credit default the last 18 months with banks and large Page 3 industrial corporations across the globe, with past and future bailouts is a leveler, a suggest a more homogeneous “unicredit” homogenizer, a negative for those sovereigns IO Podcast… type of bond market. If core sovereigns that fail to exert necessary discipline. Only To download Bill Gross’ such as the U.S., Germany, U.K., and Japan if global economies stumble and revisit the IO Podcast, check “absorb” more and more credit risk, then recessionary depths of a year ago should pimco.com or iTunes.com. the credit spreads and yields of these the process reverse direction and place Facebook… sovereigns should look more and more like Treasuries, Gilts, et al. back in the Stay up to date on the markets that they guarantee. The Kings, driver’s seat. PIMCO with Facebook. in other words, in the process of increasingly Search “PIMCO.” Investors should obviously focus on those shedding their clothes, begin to look more sovereigns where fundamentals promise twitter… and more like their subjects. Kings and serfs lower credit or inflationary risk. Germany Stay in touch begin to share the same castle. and Canada are amongst those at the with PIMCO. This metaphor doesn’t really answer the top of our list while a rogues’ gallery of Search “PIMCO.” critical question of whether a debt crisis can the obvious, including Greece, Euroland Kindle… be cured by issuing more debt. The answer lookalikes, and the U.K. gather near the The IO is now available. remains: It depends – on initial debt levels bottom. PIMCO’s “Ring of Fire” remains Search “PIMCO.” and whether or not private economies can white hot and action, as opposed to cocktail be reinvigorated. But it does suggest the blather, is required to maintain or regain likely direction of sovereign yields If trust in sovereign credits approaching global policymakers are successful with the rocks. Just last week Bank of England their rescue efforts: Sovereign yields will Governor Mervyn King said that it would be narrow in spreads compared to other difficult to cut government spending quickly, high-quality alternatives. In other words, but that there needs to be a clear plan for sovereign yields will become more credit doing so. Not good enough, Mr. King. Don’t like. When sovereign issues become more care. Show investors the money, not vice- credit-like, as evidenced in Greece, Spain, versa. An investor’s motto should be, “Don’t Portugal, and a host of others, they move trust any government and verify before you closer in yield to the corporate and Agency invest.” The careful discrimination between debt that supposedly rank lower in the sovereign credits is becoming more than hierarchy. That process of course can be casual cocktail conversation. A deficiency of accomplished in two ways: high-quality global aggregate demand and the potential non-sovereigns move down to lower levels impotency of policymakers to close the gap or governments move up. The answer to are evolving into a life or death outcome for which one depends significantly on future the weakest sovereigns, with consequences inflation, the aftermath of quantitative for credit and asset markets worldwide. easing programs, and the vigor of the William H. Gross private economy going forward. But the Managing Director contamination of sovereign credit space Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to 840 Newport Center Drive certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original Newport Beach, CA 92660 cost when redeemed. Sovereign securities are generally backed by the issuing government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. 949.720.6000 This article contains the current opinions of the author but not necessarily those of the PIMCO Group. 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