Investment Outlook, Let's Get Fiscal

PIMCO (Pacific Investment Management Group) ^ | January 2010 | William Gross

[Comrade Brother Abu Bubba]

Investment Outlook, Let's Get Fiscal

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.

The problem that the U.S. Fed’s “exit” poses: Fiscal 2009 deficit totaled nearly 12% of GDP, requiring over $1.5 trillion of new debt to finance. The Chinese bought a little ($100 billion), but as shown in Chart 2, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds. The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009. Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely. Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases...

William Gross
Managing Director
PIMCO

[Comrade Brother Abu Bubba]

"Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.” There’s no tellin’ where the money went? Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010."

Gross apparently believes and I agree 100 percent that the Fed’s lack of continued participation in the Treasury and GSE market will result in USD interest rates rising precipitously. Of course, such an outcome would immediately cause a dramatic unwinding of the carry trade [carry trade - investors can borrow money in a low interest rate currency (like the U.S. dollar), then loan it out again in a currency with higher interest rates. The “carry,” or the return from this investment, equals the difference in yield between the funding currency instrument and the destination currency instrument. “Positive carry” occurs when the interest rate received surpasses the interest rate paid to fund the investment. “Negative carry” is the opposite. Because the carry from a single trade is often small, carry trades are usually conducted in large volumes through leverage or are held for relatively long periods of time (months or years) so that the small amount of rollover interest collected on a daily basis can add up to a worthwhile amount of passive income] particularly to the extent it is dependent on the USD as the funding currency

[familyop]

The real title is "Let’s Get Fisical." And here's what's really remarkable about the article.

"There has been no change, there will be no change, until we the American people decide to publicly finance all national and local elections and ban the writing of even a $1 check for our favorite candidates...When special interests, even singular citizens write a check, it represents a perversion of democracy not the exercise of the First Amendment."

Follow the link, and read the article in order to find out what Bill proposes to do about the situation at hand (re. moving investments elsewhere. He's not the only one advising that way. Other influential advisors have been doing the same with their clients.

And Chart 3. Go to the link, and have a look at that. And Table 1 in this other article by Bill. You'll see in that Table, that the propaganda about China lacking consumers and caving in under its own debt is false. The dollar will fall, or the dollar will crash. One or the other will occur, depending on how big government and its bipartisan, favored constituents try to deal with it.

[Southack]

"...increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases..."

Nope. See Japan 1989 to 2010. Japan has higher deficits, current and projected, yet lower interest rates.

Moreover, the tired excuse that "the Japanese are savers" is gone. Not anymore, they're not.

So we won't see interest rate hikes in the U.S. anymore than the Japanese saw. Which is to say, we'll see even lower interest rates.

Deflation.

Classic economics turned onto its head, with ivory-tower academics left scratching their heads...unable to explain why Japan has been in deflation...unable to grasp that the U.S. is following Japan's two-decade-long path by copying Japan's Quantitative Easing, public works projects, and vast government over-spending + deficits.

But here are a few clues that the children of today's eggheads will use to explain after-the-fact what their parents could not explain during the crisis today:

#1: debt is deflationary
#2: automation is deflationary
#3: productivity gains are deflationary
#4: increased government regulations are deflationary when they slow the speed of money
#5: shrinking pools of educated workers...demographics...is likewise deflationary. Think: 77 million Baby Boomers hitting retirement age between 2007 and 2025...similar to Japan's shrinking population.

Deflation. Even in the face of massive spending.

#6: reduced credit availability is...drum roll...

D E F L A T I O N A R Y

*ssssssssshhhhhhhh....it's a secret!

[familyop]

Ultimately, yes, unless China inflates her product prices. Impossible? We’ll see. With the various ways that economic leadership moves are likely to go, we’ll be buying much less at some point in time. And the canard that we see about Chinese production and consumerism taking a dive is getting to be several years old.

Granted, there will probably still be deflation for American labor—especially when a great part of the government employee pool is dismissed. “Printing presses” fired up without real assets (manufacturing base) to back currency breeds worthless currency. And intra-American deflation certainly won’t necessitate international inflation. Both, in particular circumstances, could coexist. But baseless pride in many does keep them blind to that.

Pride goes before the fall. ...little related story here. American ingenuity was often conceived from a unique kind of American modesty. For example, during WWII, our infantry did not continue to dismount and march into hedgerow ambushes. They realized that they were not inherently superior and did some hard work to do some additions to existing equipment (fixed cutting blades on armored vehicles, for one). They did so without phoning contractors to fix the problem for them. The commanders listened to the tradesmen in their ranks and gave them enough room for initiative to get the job done. Mobility was much improved. ...some of the history of a few among the Corps of Engineers—combat soldiers, whose specialty attached them to the infantry in times of combat.

We’ve changed. But after survival becomes the obvious consideration, we’ll change back. And don’t get me wrong. I’m very much in favor of smaller government. ...problem is, I would rather have much smaller government than nearly all politicos of either party could stand. Welcome the big default, then rebuild.

[familyop]

Correction...my mistake. Where I wrote, “And intra-American deflation certainly won’t necessitate international inflation,” I meant to say, “And intra-American deflation certainly won’t necessitate international deflation.” Both intra-American deflation and international inflation could coexist. Imagine being an American farmer during the 1800s and trying to buy something imported from a developed country of today. ...or being Chinese during the early 1900s and trying to import a Model T to yourself (deflation between us and inflation of foreign products).

[familyop]

BTW, every one of the bulleted points in your comment #3 are true. Every interested reader should read and consider those. ...very important.

[Comrade Brother Abu Bubba]

And Chart 3. Go to the link, and have a look at that. And Table 1 in this other article by Bill. You'll see in that Table, that the propaganda about China lacking consumers and caving in under its own debt is false. The dollar will fall, or the dollar will crash. One or the other will occur, depending on how big government and its bipartisan, favored constituents try to deal with it.

Bill Gross was ostracized on Wall Street when he criticized the "wiser" Greenspan and predicted that a recession would occur a few years ago . Greenspan now has no reputation.

[Southack]

Nope. The Dollar should fall, but instead it will rise. This will confuse the eggheads in NYC and DC to no end.

What will fall is the Euro. For that matter, the very question of the EU is in play. It could fall as easily as did the CCCP.

Unemployment is already 18+% in Spain, officially. Greece is set to default on its soveriegn debt. Should Germany decide to not save all of the PIIGS, then the EU will break up faster than the Berlin Wall fell.

It’s all up to Germany.

On the other side of the world, Japan is falling from a 20 year Recession into a Depression. Its debt is out of control and its manufacturing is getting clobbered by China.

China, for its part, is overly dependent on exports (which are in turn dependent on propping up the Dollar) and vastly over-invested in real-estate+stocks.

In short, the world is staring at a replay of the Panic of 1893 (which was likewise started by a convergence of bad mortgage paper being left unbought by private investors + a shift in demographics due at that time to a dearth of immigration).

Then, as now, the monied class fought over devaluing the currency (William Jennings Bryan’s goal with his “cross of gold” speech) or letting the market sort out the problem (the view that ended the entire global crisis in a mere 3 years instead of the 20+ years of pain that the current global crisis is already in).

[familyop]

That’s a good point. Greenspan was part of a free-wheeling movement that’s on the decline, I think. It takes a big government to clean up after all kinds of sanctioned social and pecuniary libertine behaviors, IMO. If revenues become slim enough, many crooks will be forced to contract their spheres of influence. That’s one of the reasons that I have hopes for the other side of the “big default.”

[familyop]

"The Dollar should fall, but instead it will rise."

That's interesting. What do you think will cause the dollar to rise?

My guess (so far) that it will fall is based on the following.

* As heavy manufacturing continues in countries like China, wages will go up, and consumer product prices up along with wages (taught in university Macro- classes in regards to inflation in our US past).

* How much will we be able to buy tomorrow? Even our local capable consumers (local government employees) are looking at a future without revenues. ...can't get blood from rocks. See the many pages of loan and tax foreclosures in our locales. If we spend too little on foreign products in the near future, we will become less significant to our trading partners. Visiting the USA ten years from now might be much like visiting small Mexican towns during the early 1960s.

* In order for the dollar to stay high, foreigners must be willing to pay plenty for our products (exchange more of their currency for our currency in order to pay high prices). Granted, there are T-bills and the like, too, which will be mentioned in the next point.

* Too much foreign debt in our national budget and lack of future foreign investor confidence in their investments in our Government. Our Government needs honest revenues from a large, US manufacturing base instead of the current debt-for-foreign-products regime supported by grand, periodical Ponzi schemes pushed into government by special interests. Investment advisors have been chasing their US clients toward BRIC countries for months, in part, even to intentionally break those special interests (import interests, government interests, government contractor interests and others).

...sorry about the mess. This is only written during a few breaks from a personal design task. Not being an investment advisor or economics academic, I am really interested in considerations that I'm probably missing out on and have respected your well-thought-out opinions over the years.

[Southack]

Deflation can be viewed, in a credit-based economy, as a reduction in available credit.

Deflation means that the value of your currency rises.

[familyop]

I agree. Too much debt with too little work and savings in our US economy will lead to deflation within the US economy. But how will that cause rich folks in foreign nations to value our dollar very highly? Increasing future wealth in those countries and others is only my assumption from the current trends, but widely known opinions to the contrary so far from special interest writers have no real basis (well, those that I’ve read from).

As for the proclamations of the great fall of China for more than a couple of years now (since at latest, around early December, 2007), Chinese debt is only about 20% of its GDP, and its latest shown GDP increase, if I remember correctly, was, or is expected to be, over 8%. If China is so dependent on our buying power, the reports from investment advisors (with numbers instead of rhetoric) are incongruent with the proclamations.

There have been reports of woe in regards to east-west container yards being nearly idle relative to the years before December 1st, 2007. Inventories must be burdensome.

There are quite a few countries selling commodities to China. I can’t help but wonder if people in those countries might not soon be buying sizable imports of Chinese manufactured products.

I have no problem with the issue of China getting rich in itself, but I still have doubts that our USD will increase in the long run. I see old Mexico materializing around us. There, pesos were still extremely valuable, when we Americans weren’t browsing in the old markets. The groups of women and children begging did do better, when we were around, though.

What made our Nation great (the ingenuity of men) is sitting, watching television and drawing welfare, mostly with no memory of traditional American fatherhood or productive labor at making anything useful. What I see in our country is downright disgusting and detestable. Even our political speech on all sides is gutter talk from streets around houses of ill repute.

I’m not saying that our situation is absolutely hopeless. See what will happen, after the revenues from debt are no longer amply existent or of significant value. Anti-competition regulations can be difficult to enforce with few government employees and none willing to enforce them. Dire necessity will trump effete social desires and unproductive business interests.

I do buy tools and materials—two of each—for building/making things, BTW, but not much else. ...no services and no entertainment except for our own (humorous bluegrass, anyone?). Wealthy young folks are wearing the apparel of distopia and chatting with us builders in support, when their feminist/romantic/socialized parents aren’t watching. Nearly everyone I know is doing the same. In my opinion, everyone, especially retirees, should get ready.

I know young, former greenie leftists, who are following our skills and philosophy now (men and women who design and build without licenses or income, so far). It’s only beginning to dawn on them, that they are becoming more properly conservative than those who claim to be. But they don’t have much problem with that, now that their pot is going to $400-$700 per ounce in some places (see “medicinal marijuana” laws)—not an outcome expected by the chemical-mesmerizing, slaver liberaltarians.

I’ll continue to read your comments with interest (sincerely) and keep an open mind.