IO MARCH 2010 Web_FINAL by Titleist015


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
         Seinfeld reruns on Friday and Saturday                                          9

                                                             About What You’re Saying
                                                              How Much I Really Care
         nights makes for a dull boy, but the
                                                                                         7        Do
         alternative is excruciating. Uh, which would                                    6
         I prefer – solitary confinement or water                                        5
         boarding? I lean strongly in the direction                                      3
         of a warm bed and peace as opposed to a                                         2
         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                    or
the credit spreads and yields of these                                  the process reverse direction and place
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. The author’s opinions are
subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain
information contained herein are based upon proprietary research and should not be considered as investment advice or a
recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from
sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any               
other publication, without express written permission of Pacific Investment Management Company LLC. ©2010, PIMCO.

To top