Attention K-Mart shoppers and the private sector everywhere! You have morphed into a wet log. Uncle Sam, Uncle Alan, and assorted global kin are trying to light your fire again, but so far there’s been mainly smoke and very little heat. Wet logs don’t burn very well.
OK, now that I’ve got your attention, what could that possibly mean? Well, PIMCO’s Secular Forum which meets annually for three days in May to discuss the fate of the world and the global markets over the next few years, spent much of the time talking about firewood and the use of newspaper, kindling, or even a blowtorch to get it burning. This was our approach to conceptualizing the plight of policymakers as they confront a post-bubble, debt laden, American centric/savings short, financial imbalanced, demographically challenged global economy. Could government, we asked, reflate the world when the private sector was hung over, cranky, irritable, and ill disposed to do what it used to do best – spend money?
We answered this critical secular question with a metaphorical response in firewood terminology: Yes, they could, but wet logs don’t burn very well. Sure, policy makers could keep on applying the kindling – low interest rates, increasing fiscal deficits, and perhaps even a Bernanke blowtorch if need be – but that’s not a self-sustaining fire. If anything it leads to more bubbles and new instabilities. For a fire to keep on burning late into the night you need the logs to catch, and the world’s economic firewood has long since been soaked by oversupply and feeble demand now exacerbated by a post-bubble psychology discouraging risk taking. Wet logs in economic terms imply slow growth, relatively benign inflation, and near historically low interest rates in which “carry” and “roll-down” become fundamental to returns and outperformance, TIPS do especially well. It is a world in which stock returns do a slow burn along with everything else and institutional and individual investors eventually resign themselves to less heat, and making do with a cup of coffee or hot chocolate. Corporations and their investors have for several years now been making like Jim Morrison and imploring policymakers to “light their fire” and restore pricing power. They will, but at our secular horizon’s end, Morrison may in turn change his sex and morph into a mellow version of Peggy Lee, wailing “Is that all there is – to a fire?” To find out why, cuddle up with any blankets you can find and listen to our following pyrotechnical discussion of a global economy whose fate is still in the balance.
Historical Secular Review
To start at the beginning folks, let me just say that this fire starting stuff is pretty complicated. For three days, over 100 Secular Forum participants along with guest presenters – economist Martin Feldstein, PBGC’s Executive Director Steven Kandarian, Strategist Rob Arnott, and authors William Greider and Kevin Phillips – went back and forth on budget deficits, currency devals, various estimates of real interest rates, trade deficits, post 9/11 syndrome, SARS, Iraq, and the appropriate value of the Renminbi. Just pronouncing Renminbi (RMB) is hard enough when you’re 59 like yours truly. Thank goodness we were well stocked with some cosmopolitan, currency-savvy MBA draft picks to show a few of us where the matches were stored.
In any case, let me attempt to outline as simply as possible the global economy’s primary problem: It suffers from a lack of aggregate demand and too much supply. Because of globalization and Chinese overproduction; because of high debt levels and its suffocating impact on business investment and personal spending; because of a creeping, almost imperceptible demographic muting of consumption in aging societies such as Japan, Germany, and Italy; because of market bubble popping and the negatives of receding wealth; because of the dragnet of post 9/11 and now SARS, because of all of that and more we live in a world where we have too much relative to what we can afford to, or want to spend.
If you accept this PIMCO economic axiom, then certain private sector behavior becomes more understandable. In order to get out from under the 16-ton sledgehammer of debt, companies use cash flow to build reserves or retire bonds – they don’t invest. Consumers begin to put away money instead of spend, which was the pattern of the late 90s. And the combination induces a negative spiral or vicious cycle of even more conservative behavior including job layoffs, which leads to muted growth in personal income. In combination, this private sector response to a high debt, reduced wealth, increased risk laden economic environment can produce a slowdown or even a recession – Japan off and on for years now, the U.S. in 2001/2002, Europe in 2003. This sometimes voluntary, sometimes imposed economic diet is graphically displayed in the chart below.
As the U.S. private sector retrenches to a more normal historic average level of total savings, it necessarily acts as an economic drag – it throws more water on the logs. Were we to return to typical peaks of the past 30 years near 4% of GDP, then real growth will be reduced by 1% annually over our 3-5 year secular time frame, relative to what it would otherwise have been.
This self-imposed, squirrel-like behavior, which retrains the savings center in our societal brains, may be exacerbated by enforced changes in government re-regulation typified in the pension accounting area. Britain’s new accounting standard, FRS17, seems likely to become more of a global norm, compelling companies to value their pension assets at current market prices. In addition new more conservative future return assumptions may flush global corporate pension funds out into the open, showing underfunding at levels such as the U.K.’s displayed below, or even worse.
Steven Kandarian, our guest speaker from the PBGC, estimates the U.S. private pension system is under water by over $300 billion. Public sector plan totals make the number much worse. So expect tens of billions of future cash flow to be diverted into bonds and not productive plant and equipment – payback time – wet logs for the next few years, although long term, healthy pension plans and corporate balance sheets are the foundations for eventual recoveries.
Then there is the problem of our growing current account deficit, a mysterious chicken and egg conundrum that stirs intense debate but little common sense or logic. The fact is that we are overspending by nearly 6% of GDP – that’s what a trade deficit means. To a certain extent, that number is reflected in Chart I, but here’s the point. Moving towards trade account balance/returning to a private sector savings mode can be either voluntary or forced. If we don’t go there on our own, eventually the world via a depreciating dollar, a sale of our widely foreign owned stocks and bonds, or both, will impose an inflationary tax or a negative wealth effect that will mandate the savings via reduced consumption. The U.S. over the next 3-5 years may still be the strongest non-Asian economy in the world but it will by no means be a locomotive.
That negative might be mitigated of course if some able and willing global competitor would step up to the plate and lead – some country or sector with dry firewood – undrenched by high debt, slowing demographics, and overpowering regulation. There are few contestants. Euroland is plagued by an aging work force, regulatory webs of unfathomable complexity, floundering financial institutions, a straightjacket called the “Stability Pact,” and a central bank obsessed with the rear view mirror mirage called “inflation.” Japan is a basket case whose only investment opportunity might be to buy its stocks whose prices can’t go much lower. China is advanced by some as the “Great Asian Hope,” but it is still more of a producer than a consumer. As noted in last year’s review, China is a significant deflationary influence. It (and India) makes the logs in the U.S., the U.K., and Euroland even wetter by hollowing out our manufacturing and services industries, leaving us less and less to export except for our paper assets.
The entire globe of course is shrouded by geopolitical veils emanating from 9/11. Consumer and business confidence is periodically exposed to terrorist shocks, or unilateral U.S. decisions as to current or future “evil doer” national behavior and our self-imposed remedies. Preludes to war seem to be far more confidence inhibiting than the short afterglow of their conclusion. One significant terrorist attack in future months or years could be economically calamitous. And airline travel/tourism, already affected for 20 months by fear and security measures surrounding the World Trade Center attacks is now doubly vulnerable to the perceived plague of SARS. This is not the normal world we once knew and believed in at the turn of the millennium. Drying these logs will take an extended period of sunshine or perhaps government sector kindling of bonfire magnitude.
That bonfire, of course, has been burning for some time now. Last year’s Secular Outlook, and summaries (entreaties) by PIMCO’s Paul McCulley in the past 12 months have aptly described the transition of influence (and power) that takes place during periods of private sector malaise. Budget surpluses are turned into deficits with the tap of a legislative wand. Short-term real interest rates drop to 0% levels or below. While all central banks are not created or conceived equally, it’s fair to say that monetary gasoline is being poured on the global economy’s wet logs in significant quantities. Greenspan has pegged the Fed Funds rate at 1¼%. That is a nominal rate, which when adjusted for current inflation of about 2¼% converts to a negative real fed funds rate of -1%. Similarly, the ECB is at 2½% nominal or about 0% in real terms. The Japanese central bank is, of course, nominally if not absolutely UNREAL. Add to all of this the vow by the Fed’s Bernanke and now Greenspan to defeat deflation at any cost with any means and you get a sense as to the “fire” power at their command.
Fiscal policy is proactive too, although held back in Euroland by the (3% max deficit) Stability Pact and in the U.S. by Clintonian advocacy of a decade past, which ascribed the miracle of the New Age Economy to balanced budgets. Japan has its limits as well, less they risk a rating agency downgrade close to junk bond status. But we expect more fiscal gasoline in future years from each of these burdened economic societies. $500 billion+ will be the U.S. standard; a “see no evil” fudge of the Stability Pact will be Europe’s. For Japan, changes are always out there – “somewhere.”
So government is fighting back, and before we morph from Jim Morrison to Peggy Lee, we must critically ask – what kind of fire will this be a few years hence? Standard cyclical economists and firestarters answer that it will be a pretty hot one – Greenspan certainly talks that way as he points to a New Age Economic revival. We are less optimistic for all of the reasons cited that have provided and will maintain wet logs. We see 2-3% inflation in the U.S. and 2-3% max real growth over the next 3-5 years; 1-2% inflation in Euroland and 1-2% max real growth, – barely above the line in Japan. Not much of a fire. Some emerging market economies may do relatively better as lower real interest rates and more aggressive reforms lead to increased reserves and a greater sense of stability. Nonetheless, it will be a Peggy Lee world, but the mellowness of the inflation and real growth will mask the potential volatility engendered by a levered world dependent upon finance for it’s warmth. A system built on the basis of a free flow of capital can be severely damaged by volatility within the system itself. Peggy Lee never lived in Butler Creek – (PIMCO’s phrase in the mid-90s for a placid economy and financial markets). Our perceived economy may at the average appear to be an eddy, but there are rapids on either side. This will be a global economy fraught with risk. Unregulated hedge funds, collateralized debt obligations, and poorly structured derivatives of all kinds that redistribute risk but do not eliminate it portend the likelihood of another LTCM debacle at some point. Greenspan is clearly off base in his support of derivatives and their medicinal “hedging” qualities. Leverage cannot ultimately be hedged in a finance dominated global economy when interest rates rise. There will be a piper to pay when the firestarters run out of fuel.
So where should you put, how might we invest your money in this global economy with insufficient heat, but more than enough volatility? With government yields at near record lows, we remain convinced that Treasury bond’s salad days are over – no more capital gains – but that a bear market may be years away. As critical a question to ask in addition to “Is that all there is – to a fire?” is, “How long does the Fed (and the ECB) stay low and what is a sustainable real interest rate in this new environment?” Answer that and you have a big piece of the future’s investment puzzle. Our current supposition is that they stay low for several years at least and that a real interest rate of 1% after that, instead of the historic 2-3% level, may become the standard. A debt laden, levered global economy cannot stand much in the way of interest rate hikes. The past few years’ reductions have barely kept us above water – mortgage refis and all. Just think of what happens to housing and housing equalization when the cycle reverses. Economy GONZO.
Bond investors should not be shocked by this 1% real rate assumption. The chart below points out that it was only during the post-1980 period that short-term real interest rates were abnormally high on a global basis. Periods of disinflation (and certainly deflation) tend to produce high real rates because central banks are squeezing inflation out of the system. All other periods including reflationary ones have much lower real rates, averaging – believe it or not – a negative .7% globally for the first 80 years of the 20th century.
This 1% real rate assumption in the U.S., and even lower elsewhere, is critical because if true, it allows bond portfolio managers to profit not only from the carry of higher yields of longer duration instruments but from what is known as “roll-down” – the mild appreciation of price as a 5-year note matures into a 4-year note at lower yields – rising in price simply by surviving for 12 more months. This little trick of alchemy that requires of course a rebalancing and reextension of maturities at the appropriate period’s end, essentially adds 1% to total Treasury returns. In combination with appropriate slightly longer than market durations, an annual return of nearly 5% from Treasuries is not out of the question as long as the Fed stays low and 1% “real” becomes the norm. So 5-15 year Treasuries with yield and roll downs are not as bad as they appear on their yield surface. The days of eating salad may be over, but 5% is ample sustenance in a low inflationary environment. This secular horizon should also be an attractive relative period for holding TIPS. Their current prices depend upon low real interest rates staying close to existing levels yet they guard against inflationary excess.
The “roll down” of risk assets can be captured as well of course, but their wider bid-ask spreads and reduced liquidity force an analysis of their attractiveness more on a yield standard as well as their ability to narrow the “basis” spread to Treasuries. The past few month’s remarkable rally in credit product, including high yield and emerging market debt make us more cautious in this area than we were 12 months ago when opportunity was just opening up. Besides, if another LTCM or terrorist attack is out there somewhere in our future, risk assets will have a good chance of living up to their name. U.S. stocks in our opinion remain more than fully valued using dividend yield, Tobin’s Q, and price to book standards of more rational periods. European markets where dividend yields nearly match 10-year bond rates (U.K., France) are far more appealing as are many of those in Asia including that of Japan!
Non-U.S. bond markets may still have a little salad left on the table. The ECB has lagged the Fed and will undoubtedly have more firewood to chop in order to hold their economies above the 0% growth rate line, especially in light of the super strong Euro which is a deflationary influence on the continent. We are not significant currency investors but despite the dollar’s weakness in recent months, there may be more ahead in future years in order to redress our current account balance. In addition, Euroland and Asia may not always support our lifestyle and military supremacy that is reflected in the trade deficit. A further dollar debacle from here based on politics and the sale of U.S. financial assets is a possibility. What that implies about an uncompetitive European manufacturing base is a chapter for Alice in Wonderland – it probably means the ECB will come closer to mimicking Japanese interest rates than we will – but only the monetary firestarters can determine the timing.
Individual investors who read this Outlook and have stuck with this lengthy summary to this point can take advantage of these low short term interest rate trends/forecasts by purchasing municipal closed-end bond funds that take advantage of mild leverage and borrowing costs near 1% to offer yields in excess of 6% in the case of tax-free municipals. Research is important, but a broad list of existing publicly traded funds can be viewed in Barron’s, The Wall Street Journal or The New York Times on a weekly basis. PIMCO, of course, has numerous municipal bond funds that are listed on the NYSE.
Well we’ve gone on long enough now – talking about fires and pop-singers as if we know a lot about both. We know some things though. We know that a look at the secular investment horizon eliminates some emotion and induces at least a modicum of critical analysis on the valuation of fixed income and other securities. We know that we’re not perfect at it, that we make mistakes and that in the process there are opportunity costs and a few absolute black hole losses. We know that we have a responsibility, to our clients in the primary instance but to economic society as well in order to distribute capital rationally and productively over time. We are not firestarters, nor even fire extinguishers, but fire marshals in the investment world. There will be much to marshal and monitor in the years ahead.
William H. Gross