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Ijust got back over the weekend from a two-week sojourn through (ex-Japan) Asia, visiting with PIMCO clients. It was my fourteenth whirlwind through the region since 1993 - twice a year during my days on the sell side of Wall Street, and once a year since coming home to PIMCO in 1999. It is always a delight to spend time with long-time (not old!) friends, who love to think out loud about global macroeconomic themes. Making new friends who like doing the same thing is wonderful. And when the talk is not just talk, but a discussion of the fundamental foundation for PIMCO's positioning of portfolios, including their own, conversations take on a particular poignancy. On the sell-side, the skin in the game was bragging rights about the forecast. On the buy side, the skin in the game is winning the game, defined as consistently adding value - alpha! - to clients' portfolios. I like it better on this side. The cornerstone of PIMCO's approach to winning the game for our clients is a long-term, or secular orientation. Indeed, we schedule this Asia trip right after PIMCO's annual Secular Economic Forum in early May, so as to brief our clients on PIMCO's evolving thoughts. This year's Forum was a "biggie," in that PIMCO declared a major secular turning point: America's twenty-year journey toward more unfettered capitalism, fueled by a shifting of power over resources from the public to the private sector, is over. The years ahead will involve a remixing of America's mixed economy - indeed the global mixed economy - toward greater public sector power over resources. Accordingly, secular investment themes founded on America's celebration of capitalism need to be reassessed; and changed. We did this at our Secular Forum, as Bill Gross delightfully detailed in his May/June Investment Outlook. 1 My mission in Asia was to run a customized rotor tiller over the ground that Bill had plowed with his big tractor. Democratic Capitalism Is Not An Oxymoron For me, secular analysis starts with the proposition that a mixed economy is the natural order of things: neither the public sector nor the private sector is inherently good or bad. Yes, they compete for power over resources, with long secular shifts in power between the two. But most fundamentally, the public sector and the private sector need each other. Property rights are the nexus between the two: only the public sector, through the political process, can define and enforce property rights, and without property rights, the private sector could not pursue capitalism. The most valuable asset that "we the people" own is our collective decision, through the political process, to govern ourselves through the "rule of law." It cannot be privatized. Yes, private sector tribunals of all sorts can exist. But the "rule of law" itself cannot be privatized. Its value as an organizing tenet of capitalism depends elementally on our collective, political decision to function as "we the people" in defining property rights, the quintessence of the "rule of law."
Here in the United States, the political process we chose for ourselves, as "we the people," is democracy, founded on the principle of one person, one vote. In contrast, capitalism is founded on the principle of one dollar (monetary unit), one vote. Thus, democracy and capitalism are in inherent conflict, with the conflict resolved via the "rule of law." It's a messy co-existence of systems, which Churchill mused was the worst possible arrangement, except for all others! Churchill was right. Democracy and capitalism need each other, and the competing needs of the two systems set the stage for secular shifts in the power relationship between the two. Democracy celebrates the power of the individual, giving each the same vote, which begets populist, re-distributive proclivities. Capitalism celebrates the power of money, which is not distributed equally, begetting anti-populist, boom-bust pathologies. Put differently, democracy promotes fairness in the distribution of the economic pie, while capitalism promotes growth in the economic pie. The interaction between the public and private sectors in a framework of "democratic capitalism" is about the pursuit of the fairest, biggest pie. President Bush calls that pursuit "compassionate conservatism," which could also be nicely, and alliteratively called "compassionate capitalism." I call the same pursuit "principled populism," which could also be called "populist capitalism." 2 Regardless of the label, a never-ending power struggle between the private sector and the public sector is an inherent feature of capitalism in a democracy. Secular forecasting demands anticipating structural change in that power struggle. Capitalism's Ascendancy For the last twenty years, and particularly for the last ten years, capitalism has been winning the power struggle.
Making Money On Capitalism's Ascendancy The secular investment implications of this three-pronged shift in power from the public sector to the private sector were really quite straightforward. First and foremost, a celebration of capitalism was inherently a disinflationary force, because capitalism is about creative destruction: extraordinary profits through technology and pricing power are but transitory, as falling barriers to competition (entry) attract entrepreneurial capital that competes away extraordinary profits. Put differently, entrepreneurial capitalism has a nasty (or is that delicious?) habit of "commoditizing" all manner of economic activity, and history teaches that commodities secularly deflate. Thus, a party in celebration of capitalism, which post-Cold War America in the 1990s was all about, was inherently disinflationary, particularly when reinforced by a Federal Reserve listening to the private sector's capital market "vigilantes." At the highest level, the associated investment theme for asset allocation was to sell tangible assets into financial assets, as falling inflation would lift valuation for all things financial. At the next level down, the investment theme was to overweight stocks versus bonds. Falling inflation would be good for both assets, but since stocks are a call option on capitalism's upside, while bonds are an upside-limited legal contract between borrowers and lenders, stocks would be the drink of choice at the here-comes-capitalism party. At the level of investment themes for bond portfolios, the associated implications were to run neutral-to-long duration versus benchmarks, and neutral-to-short credit risk versus benchmarks. The long-duration risk call was obvious; of course, as inflation would, like gravity, pull down nominal (default-free) interest rates and yields. The short-credit risk call was less obvious to most (but not here at PIMCO!), as "crowding in" of capitalism would inevitably involve "crowding in" of private sector default risk, as the public sector de-levered and the private sector levered up. In the most extreme case, capitalists running on hubris were issuing debt to retire stock, so as to gear the upside to remaining stock holders (or themselves, in the case of capitalist leaders feeding at the call option trough). It was not a time to take credit risk greater than benchmark, but less, on the simple proposition that bad loans are made in good times, particularly when good times are fueled by the hubris of capitalists. A related global investment theme under the let's-celebrate-capitalism secular umbrella was to be neutral-to-long the dollar versus benchmarks: if the capitalist party was originating in America and stocks were going to be the drink of choice, then global investors would have to pay the cover charge in dollars to enter the saloon. Yet another related investment theme for the 1990s was to expect that the party would end not with a whimper but a bubble, and then a bust. Secular shifts in the power relationship between the public sector and the private sector tend to reverse only when the sector in ascendancy has overplayed its hand, setting the stage for the sector in decline to reassert its power. The Invisible Hand Collides With The Visible Hand As Bill cogently explained in his Investment Outlook (why is it that he can say in one word what always takes me two!?!), PIMCO's investment professionals concluded at our Forum that just such a secular hand-off in power lies on the horizon: the invisible hand of capitalism will be re-fettered with the visible hand of government power.
Making Money On Democracy's Renaissance If we are right in our identification of a secular turn (return) of power toward the public sector, and incoming evidence is cumulating mightily in that direction, the core investment themes of the 1990s are no longer "operative," as they used to say in the Nixon White House. Most important, secular disinflation is rapidly approaching its sell-by date. Thus, financial asset returns will no longer be riding a tide of rising valuation. Earnings and dividends will be what matter for total returns in stocks, and coupons/spreads will be what matter for total returns in bonds. Stocks face a particular challenge, of course, because if stocks were a call option on capitalism's ascendancy, they have become calls on yesterday, not tomorrow; meanwhile, dividend yields - the dominant historical driver of equity total returns - are close to being an oxymoron. Bonds look better as an asset class, but they, too, face a valuation challenge, as a secular turn to rising inflation will ineluctably beget a rise in risk-free yields. Within the bond asset class, however, euthanasia of crony capitalism in America will be a constructive force for corporate bonds. Once cowboy corporate leaders have reached the cusp of bankruptcy risk, as many have, they must surrender control of the corporation to bond holders - either explicitly in bankruptcy, or implicitly by diluting the stuffing out of shareholders with the issuance of more shares. Either way, corporate leaders must now put the interest of the creditors ahead of shareholders, not because they want to, but because they have no choice. Good loans are indeed made in bad times, because in bad times, contractual obligations legally trump capitalists' hopes, dreams and prayers. On this score, our cover graph showing the relative valuation of corporate equity and corporate debt is the picture that paints a thousand words. Accordingly, the right secular themes for bond portfolios in the years ahead will be neutral-to-short benchmark duration, and neutral-to-overweight benchmark credit risk. Yes, that's a dramatic reversal of the 1990s, but then, that's what secular turning points are all about. Finally, if the dollar was the cover charge for non-U.S. investors to celebrate capitalism in America, and the cult-of-equity party is over, the dollar is now set for a secular decline. For portfolios, that implies a neutral-to-short dollar position versus benchmarks, the opposite of the 1990s. Bottom Line None of these secular shifts in investment themes necessarily imply that investors do anything today, or tomorrow. Secular shifts by definition occur in the context of cyclical exigencies, which shape the prices for secularly oriented portfolio shifts. That said, sometimes it is important to buy and sell at the right price, and sometimes it is important to buy and sell. So, dear reader, if you are still lifting your glass in celebration of the ascendancy of capitalism in our mixed economy, don't just stand there: do something!
Paul A. McCulley Managing Director June 6, 2002
1 See "Episode II," Investment Outlook, May/June 2002 2 "Principled Populism," Fed Focus, September 7, 1999.
Past performance is no guarantee of future results. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. The credit quality of the investment in the portfolio does not apply to the stability or safety of the portfolio. Duration is a measure of the portfolios price sensitivity expressed in years. Stocks represent a share in the ownership of a particular company. If the company does well, the value of each share generally goes up. Although common stocks have a history of long-term growth, their prices fluctuate based on changes in a company's financial condition and on the overall market and economic conditions. The value of stocks are more volatile than other types of investments shown and therefore may entail greater risk. Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company LLC. This article is distributed for educational purposes only and does not represent a recommendation of any particular security, strategy, or investment product. The author's opinions are subject to change without notice.
Pacific Investment Management Company LLC (PIMCO). Copyright 2002 PIMCO.