Bill Gross

I have mentioned PIMCO a few times already in my posts, and in this entry I want to take a look at Bill Gross's latest 'investment outlook' article (link here), which he writes with his usual urbane wit and intellectual panache. I will quote extensively from the article (I can't write better than him). The past few posts about sovereign debt provide a fitting segue for this discussion.

As Gross says, the recovery from the financial crisis has been driven very much by government support, and while the private sector underwent a hard deleveraging process, the public sector piled on debt. This rise in government debt levels is typical in the aftermath of financial crises, according to the book of the moment, This Time is Different, by Kenneth Rogoff and Carmen Reinhart. Now that most of the government support is due to run its course, many are expecting (or hoping) that the private sector can resume its cyclical bounce, as in other recoveries.

However, while part of the corporate sector may well have gone some distance in repairing its balance sheet, individuals and households remain levered, face grim job market prospects, and along with small businesses, lack access to credit. This, according to Gross, is what puts the operative word "new" in their "new normal", the term used to describe the feeble growth we should expect in the post-crisis developed world.

Perhaps the word "new" is used to drive home the point to those who expect a normal cyclical recovery. However, as Gross acknowledges, if one looks at historical crises where the prevailing conditions were of private sector deleveraging and public sector leveraging and re-regulating, one finds that the "new normal" is perhaps not so "new." Reinhart and Rogoff undertake exactly such a study of debt cycles, and have three main conclusions (quoting Gross):

"1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.
2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.
3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%."

He continues,

"These conclusions are eerily parallel to what has been happening in the past 12 months."

This discussion has major implications to investment choices going forward. From a macro perspective, investors should keep in mind the following:

1. Risk and growth-oriented assets should be generally positioned in Asian and developing countries, which are less levered, have stable debt:GDP ratios, and are thus less easily prone to bubbling and experiencing the negative deleveraging process. In Gross's words (bold emphasis mine),

"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. Although you should seek to invest less risky and fixed income assets in these same countries if possible, bear in mind that they are less liquid and less developed financial markets. Thus, fixed income choices must still be oriented towards developed countries, which have a consistent track record of delivering payments and respecting property rights. However, differentiation within these countries is important (see 3).

3. "Interest rate trends in developed markets may not follow the same historical conditions observed during the recent Great Moderation." Generally, the downward path of yields for developed countries was very similar over the past three decades (with some exceptions, Japan an obvious one). However, going forward, one should not expect to see a coordinated move upwards in yields:

"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."

Given this discussion, PIMCO sees Germany as good potential value, although it notes that its position toward Euro area bailouts must be watched. The harshest words are reserved for the UK, whose gilts are "resting on a bed of nitroglycerine." It has high debt levels, a serious potential to devalue its currency, and according to Gross dubious accounting standards which influence rates, all which present high risks for bond investors.