Don't Care By Bill Gross of PIMCO

For the original article from PIMCO, click here.

I haven’t gone to a cocktail party in over 10 years. Granted, perpetually watching Seinfeld reruns on Friday and Saturday nights makes for a dull boy, but the alternative is excruciating. Uh, which would I prefer – solitary confinement or water boarding? I lean strongly in the direction of a warm bed and peace as opposed to a glass full of tinkling ice cubes and a room resonating with high-decibel blather. I suppose the parties wouldn’t be so bad if there was something original to be said, or if “you” had a genuine interest in “me” as opposed to “you,” but let’s face it folks, no one does. The only reason any of us really cares about cocktail conversations is to quickly redirect someone else’s stories into autobiographies that we assume to be instant bestsellers if only in print. If not, if the doe-eyed listener seems simply fascinated by what you’re saying, you can bet there’s a requested personal favor coming when you finally shut up. “Say Bill, I was wondering if you knew somebody at…that could…” Yeah right! But, as my chart shows, 90 seconds into a typical conversation, no one gives a damn about you and your problems – maybe those shoes and that dreadful eye shadow you’re wearing, but not anything audible coming out of your mouth.

During that unbearable minute-and-a-half, however, you’re likely to have covered some of the following topics:

Where are you from? (If it’s not a place where I’ve been or have a distant second cousin – don’t care.)

How’s the family? (If Johnnie is in advanced placement courses and my kids aren’t – don’t care. Don’t care about your kids’ soccer games either or that upcoming wedding.)

Medical problems. (Unless you’re dying from cancer – don’t care. Your artificial hip and kidney stone stories are important only to let me tell you about mine.)

How’s work? (Forgot where you work, but it’s a good lead in. Don’t really care though unless you can direct some business my way.)

Can you believe Tiger? (Now there’s something I care about, but the wife is only five feet away.)
Actually, the “afterparty” is the best party of all – driving home with your partner and dissing all of the guests. Still, give me a home where Seinfeld roams, I suppose. Boring is better – cocktail parties are so 1990s.

In contrast to those cocktail parties, I‘ve got so much to say in this Investment Outlook that I don’t know where to start. Don’t be lookin’ around for something more important though, like you do at a cocktail party; I need your undivided attention for the full 90 seconds allotted me.

To begin with, let’s get reacquainted with the fundamental economic problem of our age – lack of global aggregate demand – and how we got to where we are today: (1) Twenty years of accelerated globalization incrementally undermined the real incomes of most developed countries’ workers/citizens, forcing governments to promote leverage and asset price appreciation in order to fill in what is known as an “aggregate demand” gap – making sure that consumers keep buying things. When the private sector assumed too much debt and asset prices bubbled (think subprimes and houses, or dotcoms/NASDAQ 5000), American-style capitalism with its leverage, deregulation, and religious belief in lower and lower taxes reached a dead end. There was a willingness to keep on consuming, there just wasn’t the wallet. Vigilantes – bond market or otherwise – took away the credit card like parents do with a mall-crazed teenager. (2) The cancellation of credit cards led to the Great Recession and private sector deleveraging, the beginning of government policy reregulation, and gradual deglobalization – a reversal of over 20 years of trade policies and free market orthodoxy. In order to get us out of the sinkhole and avoid another Great Depression, the visible fist of government stepped in to replace the invisible hand of Adam Smith. Short-term interest rates headed to 0% and monetary policies of central banks incorporated new measures labeled “quantitative easing,” which essentially involved the writing of trillions of dollars of checks to replace the trillions of dollars of credit that disappeared after Lehman Brothers. In addition, government fiscal policies, in combination with declining revenues, led to double-digit deficits as a percentage of GDP in many countries, a condition unheard of since the Great Depression. (3) For awhile it seemed that all was well, that the government’s checkbook could replace the private market’s wallet and credit cards. Risk markets returned to normal P/Es as did interest rate spreads, and GDP growth resumed; it was only a matter of time before job growth would assure the world that we could believe in the tooth fairy again. Capitalism based on asset price appreciation was back. It would only be a matter of time before home prices followed stock prices higher and those refis and second mortgages would stuff our wallets once again. (4) Ah, but Dubai, Iceland, Ireland and recently Greece pointed to a potential flaw in the model. Shaking hands with the government was a brilliant strategy in 2009 when it was assumed that governments had an infinite capacity to leverage themselves.

But what if they didn’t? What if, as Carmen Reinhart and Kenneth Rogoff have pointed out in their book, “This Time is Different,” our modern era was similar to history over the past several centuries when financial crises led to sovereign defaults or at least uncomfortable economic growth environments where real GDP was subpar based on onerous debt levels – sovereign and private market alike. What if – to put it simply – you couldn’t get out of a debt crisis by creating more debt?

You are now up-to-date and I’ve used up all of my 90 seconds, but bear with me, patient reader. I may not be able to get your kid a job at PIMCO, but maybe I could give you an idea or two as to what lies ahead. Let’s explore the last line in the previous paragraph first – can you get out of a debt crisis by piling on another layer of debt? The answer, of course, is that “it depends.” Replacing corporate and mortgage debt with a government checkbook is initially beneficial because the sovereign is assumed to be more creditworthy than its private market serfs. It taxes, it prints, it confiscates wealth if need be and so this substitution is medicinal in the early stages of a financial crisis aftermath – especially if debt/GDP levels are low to begin with. That is the case currently at most G7 countries, with the exception of Japan, although the balance sheets of Germany/France are obviously contaminated by its weaker EU members, and that of the U.S. by its Agencies and other off-balance-sheet liabilities. But based on existing deficit trends and the expectation that not much progress will be made in reducing them, markets are raising interest rates on sovereign debt issuance either in anticipation of higher future inflation, increased levels of credit risk, or both. This places a potential “cap” on the “debt” that supposedly can be created to get out of the “debt crisis.”

The threat of credit deterioration is clearly evidenced in the CDS or credit default market for sovereign countries. Greece has taken the headlines with its 350–400 basis point cost of “protection,” but even Japan and the U.K. approach 100 and the U.S. is nearly half of that. Markets, in fact, are demanding 20–30 basis points of higher insurance premiums for the best of credits relative to levels prior to Dubai and Greece. The inflation component of sovereign issuance is obvious as well. Potential serial reflators such as the U.K. and U.S. both show an increase of 50 basis points in their 10-year notes since the Dubai crisis in late November. While a portion of that 50 may in fact be credit related as pointed out above, the combination of credit and inflationary protection demanded by the market suggests, as Reinhart and Rogoff point out in their book, that government securities following a financial crisis are subject to huge increases in supply and accordingly, significant increases in risk and real yield levels.

It is interesting to observe that over the past few months when investors have begun to question the ability of governments to exit the debt crisis by “creating more debt,” that increases in bond market yields have been confined almost exclusively to Treasury/Gilt-type securities, and long maturities at that. There has even been a developing debate in the press (and here at PIMCO) as to whether a highly-rated corporation could ever consistently trade at lower yields compared to its home country’s debt. I suspect not, but the narrowing in spreads since late November solicits an interesting proposition: Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee. The Kings, in other words, in the process of increasingly shedding their clothes, begin to look more and more like their subjects. Kings and serfs begin to share the same castle.

This metaphor doesn’t really answer the critical question of whether a debt crisis can be cured by issuing more debt. The answer remains: It depends – on initial debt levels and whether or not private economies can be reinvigorated. But it does suggest the likely direction of sovereign yields IF global policymakers are successful with their rescue efforts: Sovereign yields will narrow in spreads compared to other high-quality alternatives. In other words, sovereign yields will become more credit like. When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they move closer in yield to the corporate and Agency debt that supposedly rank lower in the hierarchy. That process of course can be accomplished in two ways: high-quality non-sovereigns move down to lower levels or governments move up. The answer to which one depends significantly on future inflation, the aftermath of quantitative easing programs, and the vigor of the private economy going forward. But the contamination of sovereign credit space with past and future bailouts is a leveler, a homogenizer, a negative for those sovereigns that fail to exert necessary discipline. Only if global economies stumble and revisit the recessionary depths of a year ago should the process reverse direction and place Treasuries, Gilts, et al. back in the driver’s seat.

Investors should obviously focus on those sovereigns where fundamentals promise lower credit or inflationary risk. Germany and Canada are amongst those at the top of our list while a rogues’ gallery of the obvious, including Greece, Euroland lookalikes, and the U.K. gather near the bottom. PIMCO’s “Ring of Fire” remains white hot and action, as opposed to cocktail blather, is required to maintain or regain trust in sovereign credits approaching the rocks. Just last week Bank of England Governor Mervyn King said that it would be difficult to cut government spending quickly, but that there needs to be a clear plan for doing so. Not good enough, Mr. King. Don’t care. Show investors the money, not vice-versa. An investor’s motto should be, “Don’t trust any government and verify before you invest.” The careful discrimination between sovereign credits is becoming more than casual cocktail conversation. A deficiency of global aggregate demand and the potential impotency of policymakers to close the gap are evolving into a life or death outcome for the weakest sovereigns, with consequences for credit and asset markets worldwide.

William H. Gross
Managing Director

Investment: Thoughts From My Watch List By Gareth Milliams

Below are some random thoughts on some markets that have been in the news
and on my watch list. These are all long term buys but at the moment some
may have temporarily stalled.

China

The central government is looking to slow down the economy. Lending has
become more restrictive and banks have been told to increase their reserves.
There is a fear that the Chinese economy is overheating, but it still
appears to be quite a distance from an actual correction.

A strong indication of potential contraction could be a significant decline
in domestic demand coinciding with an increase in supply. However it may be
simply that the Chinese government has underestimated the weakness of the
western economies and the return of demand for material goods. The stimulus
is economic bridging designed to keep the economy strong until the rest of
the world recovers. The inability of the western economies to return to
sustainable growth fast enough could prove to be significant.

Gold

Whilst happy that we sold gold at a peak four weeks ago, my belief that it
would test $1,000 per ounce has not materialised yet. The Greek crisis led
initially to Euro weakness but in the last three days as Germany announced
it would buy Greece's bonds, the dollar declined against Euro, supporting
the gold price. Additionally, unsubstantiated rumours from a Russian website
called Rough & Polished have spread that China has purchased 191 tons of
gold. The market reacted by pushing the price up by $10 per ounce. However,
the dynamic with the dollar is further strengthening, which will lead to
lower commodity prices and particularly with gold.

The sale of my clients gold was a strategy designed to protect client
capital values against a potentially serious drop in value. However, I still
believe that gold @ $2,000 per ounce is almost inevitable. Gold is a hedge
against inflation and dollar weakness. It is entirely possible that the Fed
will continue to keep monetary policy loose until consumer inflation becomes
an issue. Gold works under both circumstances. We will buy again.

Silver

Silver has underperformed gold thus far YTD. However, it is traditionally
more volatile than the yellow metal. My belief is that (long term) silver
can enjoy a more sustained rally than gold because of its industrial usage.
Clients who know me well, also know of my admiration for Silver Wheaton
(SLW). Silver Wheaton is a company that finances mining companies who mine
silver as a byproduct in order to buy the silver from the mines at a fixed
price of $3.90.

Therefore as the price of silver rises and SLW buys it at $3.90, it is
almost as if buying with leverage.

Russia

This is the only European economy completely dependent upon commodities. It
is in the words of President Medvedev, "a primitive economy based on raw
materials and endemic corruption." Unfortunately, Medvedev is a President
who does not preside. That honour, is claimed by Vladimir Putin. Russia is
lawless and a producer of manufactured goods of almost inevitable low
quality.

However, the Russian economy is expected to grow by 6.2% this year according
to Citibank. Russia's GDP shrank by an annual 2.2% during the last quarter
according to ING Bank NV, compared to an 8.9% decline in the third quarter
and a record-breaking 10.9% decline during the second quarter. Therefore an
increase of 6.2% is massive.

Citibank said that "Loose fiscal and monetary policies will, in our view,
stoke domestic demand and inflation, forcing the central bank to allow
rouble appreciation" during the second half of the year. The report also
predicted that the Russian rouble will strengthen to about 34 against the
euro-dollar basket.

Turkey

Turkey was the recipient of upgrades in its credit rating. However the
recent increase in its islamification and the trial of the General of the
1st Army and the head of the Special Forces has some potential investors
preferring to sit on the sidelines. Citi has downgraded Turkey from
overweight to neutral accordingly.

Verdict: Still a great opportunity, but not for the moment. Dissatisfaction
in the traditionally secular officer class could lead to unrest in the
military. Additionally, Prime Minister Tayyip Erdogan's ruling AK Party is
also embroiled in a clash with the secularist judiciary and is becoming
increasingly vocal in its calls for constitutional reform -- a move which
could fuel discord.