Investment Outlook

You Can’t Always Get What You Want…(A Speech In Three Part Harmony)

Good Morning to you all. Actually instead of Good Morning I suppose I should have said Guten Morgan. I can do that pretty well, as you’re about to find out. That’s because I was once a foreign exchange student from The American Field Service who spent nearly five months of my senior year in a German high school, living, speaking, and dreaming in German in a little town called Zweibrucken in Southern Germany near the French border of Alsace-Lorraine. It sounds enlightening and looked good on my college application but actually it was a disaster. At 17, I was living with a 14-year-old “Bruder” or brother who cared more about ping-pong, while I was interested in beer and girls. But I did learn how to speak German and that, as it turns out, was a key criterion when it came to the PIMCO/Allianz merger, as you will understand shortly.

Mergers, as I’ve discovered, are often put together on the strangest of criteria. You may have thought that our investment acumen and the distribution power of Allianz were the key elements in our coming together and I suppose they were, but there was something else that was critical in the process. It seems that Allianz Vice-Chairman Hans Strumple wanted a firm that could not only manage bonds but whose Chief Investment Officer could pronounce them properly in guttural Hoch Deutsch, or “high German.” During our first meeting, as I later found out, my pronunciation of German “Bunds” was the most outstanding imitation of his own dialect he had heard during their entire search for a partner. Furthermore, at dinner that night after a few beers, I innocently spewed forth my imitation of JFK’s “Ich bin ein Berliner” and that almost sealed the deal. Seems Strumple had a Kennedy thing and was obsessed with the Wall and all of that, and my words pretty well brought tears to his eyes. And so PIMCO and I passed the test – leading to billions of dollars of assets and millions of dollars personally, the latter of which I vehemently deny despite those SEC filings. I figure if stonewalling worked for Clinton it can work for me too. And by the way, I too, did not have sexual relations with that woman, Ms. Lewinsky.

Anyway, back to the story of how the merger came about. After the language criterion was dispensed with, we quickly talked about PIMCO’s role in the new company, the importance of maintaining our independence, keeping our good people - all of which took about five minutes or so – perhaps ten. It was then that Strumple asked me that fateful question – “Bill, what else do you want?” Well, little did he know that for years I had been responding to my own children’s request for toys and then money, with that famous Rolling Stones verse that goes, “You can’t always get what you want, but if you try sometimes, you just might find you get what you need.” So I said, “Herr Strumple” – playing up my German, of course – “Herr Strumple, das ist der wronge Frage,” which is broken German for “that is the wrong question.” “You can’t always get what you want,” I said in English now because I had no idea how to translate The Stones into German, “but if you try sometimes, you just might find you get what you need.” Well, Strumple was somewhat taken aback but old pro that he is, he quickly countered with “Well, Bill what is it that you need?”

“Well,” I said, and being in an honest mode – especially after a few of those high octane German Beers, “here’s my shopping list of needs, Herr Strumple.”

(1) “I have two houses and several cars, some of which I don’t use very much, but I think I need another house – that I won’t use very much. The reason is that my first two homes I turned over to my wife and her decorator, who stuffed all of our sofas with so many poofy pillows that there’s no room to sit. I need a house with a sofa I can sit in,” I said, and Strumple nodded in what I assumed was total agreement, although I had no idea whether he had ever used a decorator or even whether he dislikes poofy pillows.

(2) I also need a plane, I said, for all those client visits I don’t take anymore. I wasn’t sure what kind it should be and I’d heard that Allianz had a corporate jet of its own, but I decided to change directions and put myself in some lofty company by referring to the plane flown by Warren Buffet. “Buffet, you know,” I said, “named his first plane the “Indefensible” and his second jet the “Indispensable.” Strumple’s English was perhaps a little lacking because he didn’t seem to react to this obvious play on words. In an attempt to lighten the moment I interjected, “Perhaps I’ll name mine the Irresistible.” No luck – perhaps he was getting a little tired of my short list of needs.

(3) But I carried on. “I need some art,” I said. Remembering Strumple’s Kennedy fetish I interjected that perhaps an original oil of Warhol’s “Jackie O” might fit well in the family room of my new house that I needed but couldn’t use, or perhaps a “Marilyn” or two. When I mentioned The Marilyn though, he frowned – perhaps because of some negative connotations, so I quickly deleted my planned impersonation of “Happy Birthday, Mr. Vice-Chairman” because I sensed the negotiations were taking a turn for the worse.

(4) So I said something I was sure would bring a smile to his lips – a proven, heart rendering statement that rich people for centuries past had used to their benefit. “I need to give something back to the community,” I said.

Well, that brought a smile to his lips but mistakenly so. Perhaps he thought I meant his community in Munich or something, but no, I quickly disabused him of any such notion. My community has many needs I said. There’s the Laguna Beach Museum of Modern Art, and the Newport Performing Arts Center and a local hospital where I’d hoped to get first class service in the years ahead as my body went South for the duration. Somehow I failed to mention the barrios of Santa Ana or scholarships for underprivileged children, but they weren’t really part of my community anyway. Besides, those causes didn’t throw good dinner parties where my wife could show off her expensive jewelry and the men could politely nod as I entered the ballroom in recognition of my esteemed status.

(5) Well, Strumple seemed to have had enough and even perhaps to be ready to back out of the deal, so I decided to shift tactics and stress the team concept – I started to talk about what we needed. “I am not alone in all of this,” I said. Many PIMCO professionals have similar needs – second homes that they won’t use, sofas of their own to undecorate and scores of communities to give back to – almost all of which resemble my own pet cause – the Laguna Beach Museum of Modern Art. Well, with that explanation Strumple seemed to smile from what I thought was complete agreement but which later, I realized, was from the passing of a large intestinal deposit of gas. It seemed he had heard enough. He took out a pen, signed on the dotted line and walked out of the room, mumbling something in German I couldn’t understand to the tune of the Rolling Stones “I Can’t Get No – Satisfaction…No No No…No.”

Well, much of this has been tongue-in-cheek, of course. And almost all of you have little concern as to what we need or how we spend our money. You’re more concerned with how we invest yours. That, of course, must be our primary focus. And aside from strategies and long-term secular outlooks, my main concern, as well as that of Bill Thompson and others in senior management ranks, is that we continue to preserve the intensity of our company and its people – which to me, in part, means weeding out those who have more concern about their money than yours, and filling their spots with world class talent. It also means educating, nurturing, and promoting the cause of almost all the PIMCO people you see today who have made this company a world class financial institution. To that end, I and Bill Thompson pledge you our increasing efforts over the next five, seven, or however many years we have left to spend in this exciting and, I think, ultimately worthwhile profession.

And now for the investment story. Great investors or investment firms have one thing in common in my opinion: they simplify. John Bogle, who built the Vanguard Group, for instance, believed in one primary idea throughout his entire business career, and that was to keep expenses low. His concept and conception of index funds were built upon that very philosophy which allowed for minimal trading, almost no analysts, and 15-20 basis point fees for investors. On the slightly more active side, but not by much, Warren Buffet believed in companies with strong franchises that could maintain pricing power during periods of inflation. The purchases of those stocks, of course, were financed via the cash flow of insurance companies, allowing Buffet to lever his concept to astronomical levels of capital gains. Neither of these men, however, were frenetic traders or arbitrageurs in the modern sense. They had a simple idea and stuck with it.

Likewise at PIMCO, we’ve tried to simplify the process of bond investing since the early 1970s. It seemed to me that interest rates moved on broad secular glide paths sometimes encompassing periods of 20-30 years. While that stretch was far too long for an investor/economist to forecast, the long-term, or what we called the secular time frame, would nevertheless be dominant in determining trends which encompassed the span of several 1970s or 1980s business cycles. Not only was the big money made over the longer-term, but by focusing on the long-term road map, PIMCO was able to avoid the psychological whipsaws of daily, weekly, and annual market moves that play havoc with one’s investing at just the wrong time, and allow fear and greed to dominate the portfolio mix instead of long-term secular analysis. Throughout the past few decades PIMCO has been associated with three broad interest rate themes – bearish until 1981, bullish until 1994, and ambivalent ever since in an environment which we called Butler Creek. Catching those three waves has provided a significant portion of our long-term outperformance.

In addition to our secular time frame, PIMCO has had another simple philosophy: innovate or get left behind. While the lead soldier is often susceptible to snipers (as are the stragglers at the end of the formation), those near the front with the courage to lead usually reap the medals of honor. Our innovations throughout the years have included GNMA mortgages in the mid-70’s, financial futures in the early 80s, international bonds in 1987, and TIPS in 1998, among others. In addition, our innovative introduction of account management, significantly divorced from day-to-day portfolio trading, and our enthusiastic endorsement of technology nearly 20 years ago paved the way for additional performance throughout those years.

Two simple concepts - secular forecasting and innovation - have been our keys to the performance lock that all managers hope to discover. They are the reasons why you are here today and why PIMCO remains at the top of its field in the bond arena.

Now let me turn to the order of the day – the outlook for the U.S. and global bond markets. To do so, let me introduce a chart that displays a simplified diagram of how economic growth is spawned and nurtured, because as growth goes, so goes the bond market, even if it’s the Goldilocks, productivity-related growth of this current financial era. Aside from the physical addition of bodies to the labor force, the primary ingredient for economic growth comes from additional investment and higher rates of productivity growth. Those ingredients, however, develop in a delicate atmosphere balanced between what I call the “real economy” and “finance” as seen in the following chart:

Figure 1 is a simple illustration of three boxes, labeled “real economy,” “growth,” and “finance.”  The “growth” is at the bottom and is linked to each of the other two boxes above with a line.
Figure 1

Viewed in this simplified way, long-term secular trends such as the dynamic and long lasting economic growth of the 1990s can be more easily understood. The “real economy” portion of the input has come about through trends PIMCO identified in their early stages of gestation such as globalization, technological innovation, and demographics (which favored investment and savings at the margin and not consumption).

Figure 2 is a simple illustration of four boxes arranged in a pyramid format. The one box on top is labeled “1990s real economy,” and is linked by lines to three boxes side-by-side below it. Those boxes underneath are labeled “globalization,” “technological innovation,” and “demographics.”
Figure 2

Since economies cannot thrive without appropriate and consistent levels of finance, the “finance” side of the equation has been equally important. Fiscal and monetary discipline mandated by capital market vigilantes has been key to providing a well-balanced long lasting recovery. Government deficits moving closer to balance, and in some cases outright surplus as in the United States, has provided the room for the private sector to invest in profit-enhancing technology. Central bank policies geared towards inflationary levels approximating 2% in Europe and the U.S., as well as the U.K., Canada, Australia and New Zealand have allowed for thriving capital markets, both equity and bond, and provided the atmosphere under which economic growth could thrive. This success story is in no small part due to the globalization of finance itself, the advent of its vigilantes, and the discipline they enforce on both governments and central banks in the process of allocating their funds; another trend, I might add, that PIMCO was onto in its early stages.

Figure 3 is a simple illustration (similar to Figure 2) of four boxes arranged in a pyramid format. The one box on top is labeled “1990’s Finance,” and is linked by lines to three boxes side-by-side below it. Those boxes underneath are labeled “Move Towards Fiscal Balance,” “Tight Monetary, Anti-Inflation Policy,” and “Ample Funds for Private Sector.”
Figure 3

But it was only 18 months ago that this dynamic global economy appeared to be threatened with a remake of the 1930s, and the committee to save the world (Greenspan, Rubin, Summers) made their appearance on the cover of Time Magazine. And it became apparent then, as it has at various times in centuries past, that certain imbalances existed in the financial arena that threatened prosperity. Too much short-term Asian debt, reckless lending to unproven sovereigns such as Russia, and leveraged hedge funds pursuing seemingly riskless arbitrage nearly sank the global economy as financiers pulled back their bullish horns, creating even more imbalance in the process.

I mention all of this, in part, to present the simple themes of globalization, technology, demographics and governmental and central bank discipline that have been part of PIMCO’s rather accurate forecast of global growth accompanied by disinflation during these past five years – our own Butler Creek scenarios which stressed mild inflation and range-bound trading of interest rates. Those secular trends remain in place and do not appear likely to diminish in significance over the next few years, which argues in turn for continuing low levels of inflation, say 1-3%. I also have gone over this perhaps lengthy and too academic dialogue in an effort to show that in the 1990s, imbalances that have developed have invariably occurred in the arena of finance and not in secular economic trends involving trade or the pursuit of capitalistic policy per se, and it has been those imbalances of finance which have threatened the ranges of our 4 1/2 - 6 1/2% Treasury bond forecast. The Asian, Russian, LTCM imbalances of 1998 led to 4 3/4% long-term yields and the realistic threat of deflation. Likewise, the exuberance of the U.S. stock market in late 1999 led to inflationary fears and a brief push to 6 3/4% just a few months ago.

My point is that any bond market forecast, while dependent on the disinflationary forces of globalization, technological innovation, favorable demographics, and sound fiscal and monetary policies, must now look primarily to the “ finance” side of the equation for its direction and ultimate scope. Not only the exuberance of stock prices or lack thereof, but the economic fate of the U.S. budget surplus, our own trade deficit, the direction of the U.S. Dollar, and the fiscal deficits in Japan, will significantly determine the level of yields and perhaps the ultimate fate of Butler Creek. And while time doesn’t permit a separate analysis of each and every one of these trends, at the heart of each of them lies a common unifying element: the new burgeoning level and excessive use of debt in both the U.S. and Japan. In the United States, this debt has taken the form of speculative borrowing flowing into margin accounts and employed by corporations in the buybacks of their common stock, which in combination may have produced the makings of a potentially destructive bubble. It has sprung from consumers in the process of fueling a retail spending boom of near unparalleled proportions. And it has come from optimistic corporations fueling an investment boom which may or may not prove prescient. In combination, this debt displayed below has led to an unsustainable trade deficit of 4% of GDP and Gross U.S. debt of 260% of GDP.

U.S. Private-Sector Debt as % of GDP

 Figure 4 is a line graph showing U.S. private (non-financial) sector debt from 1960 to the late 1990s. The debt is expressed as a percentage of U.S. gross domestic product, and it trends upward during the period. By the late 1990s, it peaked at an estimate of around 130%, its highest point on the chart. That compares with its most recent trough of around 120% in the mid-1990s. The metric starts the graph in 1960 at around 80%.
Figure 4
Source: U.S. Federal Reserve



U.S. Trade Balance as % of GDP

Figure 5 is a line graph showing the U.S. trade balance as a percentage of gross domestic product, from 1968 to 2000. On the Y-axis, the scale ranges from positive 2% up top to negative 4% at the bottom, with deficits being negative and surpluses positive. The metric trends downward over the period, ending the chart in the late 1990s at a low (deficit) at around negative 3%, a level last seen in the late 1980s. Both are the chart-lows on the graph. In 1969 the metric is around zero, and fluctuates within a range of about negative 0.5% and positive 0.5% up until 1975, when it peaks for a chart high at around 1%, then embarks on its downward trend. It dips to negative 2% around 1978, then rises back to almost zero by the early 1980s, before moving downwards to its lows of around negative 3% in the late 1980s. It rises to almost zero around 1992, then again falls to its chart low by late 1999.

Figure 5
Source: Bridgewater

Gross U.S. Debt as % of GDP

The figure is a line graph showing the gross U.S. debt as a percentage of gross domestic product, from 1955 to 1999. The metric trended upwards over the period, especially in the early 1980s, when it displayed a steeper slope. It rose to a chart-high of about 280% by 1999, up from about 130% in 1955. In 1970 it was about 140%, and about 160% in 1980. By 1990, it climbed to around 240%.

Figure 6
Source: Bridgewater

In Japan, the government itself has been the force behind the debt buildup, acting in near desperation to prop up its recessionary economy with fiscal deficits approaching 10% of GDP. The Japanese predicament is made clear in the following chart which shows the Land of the Rising Sun soon exceeding debt levels once held by Italy.

What is the proper level of debt both here and in Japan? Clearly in Japan the situation is out of control. Its primary deficit (ex-interest) is running at 6.5% of GDP and eventually even balancing the budget would not be enough to reverse the increasing debt as a percent of GDP. Either higher interest rates or an attempt to move towards balance would likely sink the economy back into recession, affecting not only Asia but the global economy as well.

In the U.S., as in any economy, the appropriate level of debt depends on the level of interest rates and expected growth in income. While the New Age economy makes both of these determining factors more supportive of higher debt levels, there’s little doubt that higher interest rates and/or a declining level of asset prices makes the current levels of debt increasingly vulnerable, which in turn could promote an economic downturn of unexpected length, if not magnitude. 

Gross Public Sector Debt as % of GDP

Figure 7 is a line graph showing the gross public sector debt for four countries, Italy, Japan, Germany, and the United States, from 1990 to 2004, with forecasts after 2000. Debt is expressed as a percentage of gross domestic product. By 2004, Japan’s debt-to-GDP ratio, which increased almost the entire period, was projected to reach about 150% of GDP, much higher than the three other countries. By 2004, Italy’s debt ratio was forecast around 90%, indicating a steady decline since the early 1990s, when it was around 125%. Germany’s debt ratio in 2004 is projected to be about 50%, compared with 60% in the late 1990s and 40% in 1990. The U.S. was projected to have the lowest level of public sector debt of the four countries in 2004, at around 35% of GDP, down from its peak of around 65% in the mid 1990s.

Figure 7
 Source: IMF

My point in all of this is not to make an explicit forecast but to point out vulnerabilities which in turn lead to simple themes. Remember those simple themes and their ultimate success throughout the 70s, 80s, and 90s that I’ve mentioned previously? Well, I’ve indicated in the previous 15 minutes or so that the 1990s economic themes of globalization, technological innovation, and demographics remain on track to promote a 1-3% inflationary world and a 4 1/4 - 6 1/2% U.S. long bond. It’s in the finance arena, though, where the changes may present the most opportunities with perhaps the simplest themes. Because of the U.S. private sector excesses in debt, and in fact the surpluses now being generated by the Treasury, it would seem a time to emphasize Treasury debt and go light on corporate debt. The facts presented in the previous charts suggest the U.S. is not necessarily the island paradise reflected in the NASDAQ or even the S&P. There’s a volcano of debt on this island as well as that of Japan that threatens to erupt at some future date. The PIMCO supertanker must at the least make preparations to leave this port of deteriorating corporate debt – which, in normal English, means upgrading the quality of our portfolios.

On the international front, because of the Japanese debt levels and the difficulty of rectifying their situation short of another Japanese “miracle,” it would seem appropriate to not only not own JGB’s but to aggressively short them where possible in order to take advantage of either credit deterioration, or perhaps an ultimate return to normality where its yields resemble more closely that of the rest of its G-10 neighbors. Either way, it’s hard to conceive of a situation continuing for much longer where Japanese yields persist under 2%.

These and other simple themes centered around changing secular structures in the world of global finance promise to provide opportunities for bond investors in the foreseeable future.

I thank you for your time and wish you all the best personally in future years. Herr Strumple, I’m sure, does as well despite his inability to be here today. He’s simply too busy trying to fulfill my needs and provide himself with just the smallest amount of satisfaction.

William H. Gross

Managing Director

The above speech was presented on March 6, 2000


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