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Economic and Market Commentary


Recognizing the little boy in a grown man is not always an easy task, although most of us, especially the men and their wives, I suppose, know that he’s always in there somewhere. Despite the ties, the shaving lotion and the false bravado made necessary by our competitive world, snakes, snails, and puppy dog tails are what they’re really made of. My favorite “little boy becoming a man” story has always been about my son Jeff, who is now 27 and long since on his own. He was a five year old in 1977 and being prematurely pushed into Little League by his ambitious and vicariously proud father. Before his first official time at bat and while waiting at the on deck circle, he intently observed the current batter who, as fate would have it, was a lefty, and batted from the right side of the plate. When it came time for Jeff to hit, he used the image and example of the last person he had seen and walked up to the right side of the plate as well. My son, however, was a right-handed batter and by so doing, was now facing the rear of the batting cage instead of the opposing pitcher 45 feet away. For what seemed like an eternity, Jeff continued to face the back of the cage, frozen into inaction by his obvious nervousness and lack of experience in the grown up world of Little League baseball. It was only when his coach came over and picked Jeff up at the waist, turned him 180 degrees in the air and cried “play ball” that the stands let out a sigh of relief and a hearty round of applause. His Dad, of course, was mortified—being the budding example of a worldly raconteur. He hadn’t remembered ever making a mistake like that, even at five and certainly not in 1977, ’87 or ’97 for that matter as the years moved on.

Cut away to June of 1999, for an example of how a man—a sophisticated raconteur—can become a little boy under the same circumstances of anxiety and intense social pressure. Yours truly had been invited along with his wife to visit the home of Bill and Melinda Gates for an evening of cocktails, dinner, and conversation culminating in what would presumably be a check written at a later date to a most worthy philanthropic organization. I mean, come on now, how many of you, aside from the debatable amount of the check, would pass up the opportunity to see that home and gab with the world’s richest and perhaps most interesting couple? Not me. Not us. Down the stairs we strode, perhaps the most impressive entryway to a private residence ever built outside of Buckingham Palace or Versailles. Four stories of descending steps, perhaps a hundred yards in all, flanked by video screens of ever-changing images of art —Monet, Renoir, Picasso—all before you reached the main foyer. Once there, we were enjoined by receptionists to discover the rest of the home—modern in architecture, comfortable in space and style. My favorite was the trampoline room, but the library, displaying Leonardo Da Vinci’s “Codex” as well as a gorgeous Winslow Homer oil was not far behind. Finally we turned the corner of the family room and there they were—Bill and Melinda that is—receiving what appeared to be only one or two couples and having a brief conversation with both. This was our chance for glory. First the house, now them—wow, what an evening!

Ah, but here’s where my story about Jeff and his first at bat come into play. As fate would have it again, the man ahead of us introduced himself as Mike “Something or other” and in my nervousness (I thought I was Mr. Cool) the name stuck in my mind just like the left-handed batter’s position had stuck in Jeff’s. As Mike and his wife moved on and Sue and I moved forward to the Gates, I stuck out my hand and said “Hello, I’m Bill Gross, it’s nice to meet you, Mike .” Well, the look on Bill Gates’ face sort of said it all, I guess, but for what seemed like the same eternity as Jeff facing the back of the batting cage, I mentally stuttered and stammered and said to myself, “How in the hell am I gonna get out of this one?” Thank God for my black tuxedo because my underwear seemed to be turning a distinct shade of brown. Finally I said “I……I mean —Bill.” Like the little league coach, it was Sue who finally saved me, talking effortlessly about the house and golf and the things we shared in common. But the man had become the little boy—of that there could be no doubt. Move over, little Jeff; after 22 years you’ve finally got company.

I’m sure you would have loved to have been a fly on the wall to observe the look on both of our faces during my humbling introduction. I too, would love to see the expression on yours, dear reader, as I suggest that our dynamic U.S. economy may soon be due for a fall as significant as the one my fragile ego took that warm Seattle evening; maybe not down to floor level, which would indicate a recession, but low enough to scare the living daylights out of those who are convinced our nearly nine year economic recovery will never die. It’s hard to believe a forecast like that, I suppose, when it comes on the heels of some of the strongest economic reports of the year—a sizzling employment number, record levels of retail sales, an apparent revival in manufacturing, and an ongoing love affair with technological investment. But most of these economic stars are at the zenith, and there are significant countertrends which should sap the strength of the recovery going forward, allowing interest rates to peak near current levels and eventually move lower.

One of the most obvious trends that should weaken the U.S. economy has been the direction and level of bond yields themselves. Investors are most aware of the behavior of U.S. Treasury notes and bonds. It was only 10 months ago that rates bottomed at 4¾% for long-term Treasuries, but those yields are now 150 basis points higher at 6¼%. If government rates are up by 1½%, however, corporate and mortgage yields have climbed by even more—most by nearly 2%. Today, a potential home buyer is staring an 8% mortgage in the face, instead of a 6% payment less than a year ago. Similarly, even high quality A and AA rated corporations now pay in excess of 7% for their intermediate and long-term debt. The private sector’s cash flow, then, is being absorbed much more quickly than before. Home buyers, and home owners through potential refinancings, will now have a lot less spare change to purchase new cars and discretionary big ticket items which have been the hallmark of this recovery. Corporations, in turn, will be less opportunistic in their ability to invest in new plant and equipment because higher interest rates will soon begin to eat into their profit margins.

The profit analogy leads directly into my second argument for a significantly weaker economy, one which I warned about in recent Investment Outlooks but which now appears to be finally coming true: lower stock prices. Without stock market capital gains and the wealth it has generated in recent years, the economy would only be 2/3 as strong as it currently is. Perhaps as much as $100 billion of annual consumer purchasing power has been made possible by the market’s 20 to 30% annual profits during the decade of the 90s. Investors, consumers, and the economy have come to depend on the market in recent years, and the trend has become habit forming, much like a junkie addicted to heroin. My sense is that the consumer will shortly be forced to start using methadone, and while the withdrawal may possibly be orderly and painless from a recessionary point of view, the old heroin highs are a thing of the past.

Take a look at the following PIMCO chart displaying the correlation between U.S. equity prices and changes in personal consumption. While the correlation is not perfect, it’s high enough to tell me that a downdraft or even a leveling off in stocks will likely be followed by a decline in the growth rates of consumer spending. Notice that the recent climb to 5% real consumption growth has occurred during a period in which stocks spurted to historic year-on-year returns of 35%. During periods of much smaller stock gains, the growth in consumption was a more stable 2–3%. 


Figure 1

If stocks stay at current levels (10–15% off their highs), then consumption and the economy will undoubtedly lose significant steam.

To this list, I would add a third contractionary factor—the recent rise in the consumer price index, particularly oil prices. If motorists are spending more at the pump than they were six months ago (20–30 cents per gallon) then they’ll have less money to splurge at the movies or the mall. With commodity prices up sharply over the past six months and inflation approaching 2½% annually, consumers have got to be feeling a little less flush than they were at the start of the year. The economy should slow.

And last but certainly not least, is Super K, or Y2K as we’ve all come to know and love it. No matter whether it’s a fact or a fantasy, a catastrophe or a chimera, there’s no doubt that businesses and even some consumers have spent a combined fortune trying to avoid a millennium hangover come January 1st, 2000: hundreds of billions, in fact. And almost all of that spending is just about over and done with. Sure your Y2K compliance officer is still reporting to work and answering form letters from other businesses in order to avoid potential lawsuits, but the heavy lifting is over. From now on, those tens of billions of dollars per quarter that have been spent to avoid a technological calamity will just not be there anymore to stimulate the economy. And that says nothing about the potential negative effect on small businesses if Y2K is for real; and so on and so on with a host of other Armageddon-type hypotheses. The sum of them all, is that Super K had been super for the economy but will now extract a payback in the form of weakness, not strength.

For several years now, in fact for much of the decade of the 90s, the U.S. economy has taken on the appearance of a healthy, vibrant, super-sophisticated raconteur—impervious to the foibles of its bumbling economic trading partners. It’s stepped up to the right side of the plate à la Mark McGwire and knocked homer after homer deep into the outfield bleachers. It’s courted the company of billionaires with a swagger and a confidence that screams “I’m the man.” Ah but now there’s a change in the wind. I think Americans are about to meet “Mike Gates” and suffer a bit of a comedown. Boys become men. Men revert to boys. Economies are no different. The slower economy should halt this mini-bear market somewhere close to 6 ½% for long U.S. Treasury bonds, and allow for positive returns for the bond market from the fourth quarter onward.

William H. Gross
Managing Director


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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