Don't Sweat Rate Hikes
By Kate Welling

“The markets are volatile, the economy is at a secular and cyclical turning point; New York is still in shock and it is the holidays—but other than that, everything is very normal.” On that cheery note began a rapid-fire conversation Wednesday with PIMCO’s always disarmingly incisive economics guru, Paul McCulley. Disarming, especially for a dismal scientist, because his insights come cloaked at least as often in earthy Southern locutions as in economic jargon.

I’d instigated the call because of the last line in Paul’s latest Fed Focus piece for PIMCO, a sentence startingly free of the wiggle room endemic to econspeak: “With secular victory over inflation achieved, and with secular productivity promises to be pursued, Greenspan has tightened for the last time in his career.” What? The Fed has just lowered (for the 11 th time in a year) its fed funds target to 1.75%. Arithmetic alone says it has lots more room to raise, rather than lower, short-term rates. The stock market has spent much of the last three months celebrating a recovery from a recession it refused to recognize until September 11th. Meanwhile bond investors, anticipating upward pressure on rates as the economy picks up steam, have beaten an unceremonious retreat. Either the LA smog has finally gotten to Paul or he’s saying the markets have been—if you’ll excuse the expression—mistaken.
			Kate and Paul I’ve talked to many journalists over the years, some good and some not so good. One of the very best is Kate Welling, formerly Senior Editor at Barron’s and now founder and proprietor at welling@weeden, a research service of Weeden & Co. LP. I recently re-read her July 19, 1995 Barron's interview with me, and I was struck by how she presciently drew out of me the secular themes that dominated PIMCO’s investment strategies over the ensuing 3-5 years. She interviewed Paul a couple weeks ago, and I think you’ll enjoy the free thinking she elicited from him. - William H. Gross

Which is not to say, as a practical matter, that he’s about to disparage the bull case that lifted stocks and cratered bonds of late. “The bottom line is that Greenspan has been printing $20 bills, and if he prints enough, the stock market goes up.” Especially in a recession, when the Fed has thrown all caution to the wind. That’s the Greenspan put. He’s been underwriting the downside to spur risk-taking—and the bonditos are in agony over the prospect his put will work.

Historical experience, Paul observes, entirely explains stocks’ dramatic outperformance vs. bonds in November. But it’s telling investors almost nothing useful about what’s likely to happen in the future.

Simply because we’ve arrived at a long-term inflection point in the economy. The Fed’s 20-plus-year war against inflation has been won. Price stability is now. But few investors have any memory of what it was like when the Fed’s overriding secular concern wasn’t fighting inflation. Indeed, they’ve become so attuned to the rhythms of the Fed’s anti-inflation strategy that they can’t conceive of dancing to any other beat. Opportunistic disinflation, Paul explains, is econo-speak for the Volcker-hatched strategy of “not getting wrapped around the axle about it” when the economy sinks into one of its inevitable cyclical recessions, but instead taking advantage of the resulting disinflationary dividend. “You take your disinflationary dividend in each recession and then as soon as the economy recovers, you slap it upside the head with pre-emptive tightening so as to keep inflation from cyclically rising. That was the essence of the Fed’s whole long-term strategy to catch the price stability bus. And it worked.”

The trouble is, adds Paul, “I don’t think either the Fed or the marketplace ever figured it would catch the bus. But now that it has, the whole notion of opportunistic disinflation becomes an oxymoron. You can’t have a disinflationary dividend from a starting point of long-term price stability. There is no place lower that you want to go. Effectively, once Greenspan catches the bus, he doesn’t want to get sucked into the exhaust pipe and come out the other end with something like Japan effectively becoming his legacy.”

In other words, more opportunistic disinflation is no longer a dividend. More disinflation opens a Pandora’s Box of potentially deflationary defaults, shocks to the system that risk knocking it out of the price stability sweet spot [vast and helpful data on which is available in a just-issued Leuthold Group special study on the relationship between market performance and inflation/deflation rates] and into a nasty and decidedly un-virtuous deflationary spiral.

Notes Paul: “Greenspan has always talked about price stability as an inflation rate so low that it has no impact in long-term decision making. But once you get there, you have to think in terms of avoiding going below it, because then long-term decision making is impacted by a deflationary bias. Japan’s last 10 years in the economic wilderness should have taught us that a deflationary bias in long-term decision making leads people to sit on their ass.” Not to mention their assets.

What worries Paul is that he doesn’t think the Fed has grappled yet with the implications of reaching price stability. “You could see that earlier this year when they talked about taking back their easing very quickly, if they decided they’d overdone it. Because that would expose the system to a shock that, at price stability, could push you into deflation land. It’s one thing to have a double-dip recession when you’re running double-digit inflation and interest rates, or even 8% or 6%, because the second dip simply gives you second disinflationary dividend. But once you get here, there ain’t no damn dividend.”

Nor have investors, distracted by the immediate gratification of playing the cyclical Greenspan put, come to grips yet with this changed secular paradigm, Paul observes. They by and large haven’t grasped yet that declining interest and inflation rates, in this highly leveraged economy, are axiomatically dangerous, sending default rates soaring, instead of being the axiomatic blessings they were over the last 20 years. “Despite 10 years of data points in Japan that underscore that proposition.”

Don’t get the idea, though, that Paul is bent on playing the Grinch. He’s a glass-half-full soul, even if he works for a ( the) bond house. His argument isn’t Armageddon, it’s “get real.” Yet even making fairly generous assumptions about economic growth and productivity gains going forward, Paul can’t see the equity markets doing anything but disappointing investors expecting a quick return of the double-digit returns they enjoyed in the 1990s. Corporate profits as a share of GDP essentially doubled in the decade between 1988 and ’98, but probably hit their secular peak three years ago, he notes, because we’ve since discovered that a lot of reported profits in ’99 and ’00 were “but blue smoke wrapped in an enigma.” And that means that the time to be a huge bull on the growth of corporate profits as a percentage of GDP (or, put another way, on the intrinsic rate of return on capital) was in the late ’80s, “when we had a shortage of capital and a surplus of labor. Because from that starting point, we could have share of GDP shift from labor to capital.”

And we did, in spades. The decade of the supply side revolution, “in which CEOs operated on the concept of return to vision instead of return to capital,” produced an old-fashioned business investment boom that Paul describes as “not dissimilar to the railroads over 100 years ago, but with a technology turbocharger. So we have beautiful capital stock right now. It’s just that ain’t nobody making any money on it.”

In contrast, the supply of labor is relatively tight, vs. 10 years ago, even if the unemployment rate has obviously jumped of late. What this implies from here, says Paul, slipping into econo lingo, is that “share of GDP should accrue to the factor input that is in relative scarcity.” In other words, it’s labor’s turn for a bigger slice of the economic pie, an inflationary impulse not generally perceived as good news for corporate profits. Or stock prices.

Paul expresses it in a bit more measured tones: “The reality is that corporate profits as a share of GDP ain’t going up secularly anymore. You could get any kind of a bounce cyclically, assuming that we’re a going-concern economy, but shares of national income (GDP) are going to be moving, effectively, in the direction of labor. Which simply says the corporate profits can’t really grow faster than nominal GDP. So expecting double-digit growth in profits is lunacy. The arithmetic simply doesn’t work, even if nominal GDP is going to grow at maybe 5% or 6%.” A forecast which, he acknowledges, is fairly optimistic. “With inflation at 2% or less, you have to be drinking a bit of new age productivity Kool-Aid to add 3% or 3.5% real growth on a normalized basis to get to a nominal GDP path of 5%-6%. In which case, if profits as a share of GDP aren’t going up, when you look at where the P/E is on the S&P or the Wilshire 500, you don’t see a secularly rosy outlook for stocks. It really is that simple.”

The surprise, considering the bias inherent in Paul’s vantage point on the markets, is that he doesn’t think “things are going to be all that hunky-dory for bonds, either.” Not with the five-year Treasury “on a normalized basis, within a pitching wedge of nominal GDP.” In other words, bonds—true to type—will be boring. As Paul puts it, “you can probably expect mid-single digit returns on bonds and sleep at night. Or you can expect mid-single digit returns on stocks— if things go right—and live with a lot of volatility.”

If those sorts of returns sound, at best, unexciting in the extreme, consider that to get to them, Paul has to assume 3%-3.5% real GDP growth, which is anything but Armageddon. Indeed, it’s a forecast that as noted requires imbibing some of Greenspan’s new age productivity Kool-Aid, an activity generally looked askance on by his colleagues at PIMCO, who are professionally skeptical of all such economic miracles. And neither does Paul swallow it whole, suspecting that the sort of measured improvement in productivity statistics that we were seeing in the late ’90s “didn’t reflect long-term productivity gains from gee-whiz technologies as much as the fact that the very act of investing in them gave us a booming economy while they were being built.”

But more germane at the moment, Paul says, than proving or disproving the productivity miracle, is that Greenpan believes in it. “The guy who is sitting at the controls does believe and has a huge vested stake in trying to maneuver so there’s at least a sporting chance that it will look like he is right. For the entire last year, and especially since September 11th, he’s been saying that all the stuff going on in the economy is—like they said in Monty Python and the Holy Grail—just a flesh wound. He wants to see business investment get a grip on itself. He wants the type of recovery that supports the notion that what has been ailing the economy is nothing mortal. So he has a double incentive to sit on his backside once he finishes the easing process.”

Which is why Paul predicts flatly that Greenspan isn’t about to raise rates, indeed, won’t raise them as long as he heads the Fed. The markets, clearly, have been betting to the contrary, as noted. It could well be, as Paul theorizes, that equity investors have simply responded, as Pavlov’s dogs, to the Greenspan put. And that the bond market’s swoon, rather than predicting a tightening, merely reflects what happened when investors dumped “Armageddon assets” to buy risk assets when they sensed the Fed head putting his put in play. In which case, says Paul, “It’s hugely important for the Fed to communicate in word and deed that they do not subscribe to and will not validate the implied tightening scenario imbedded in the forward curve.” The Fed did that, to some extent, in their Tuesday statement, when for the first time in this whole easing cycle, they made an explicit cyclical forecast for inflation, saying that they expect inflation to come down next year. “To my mind, that is just one step away from saying that we expect inflation to come down next year, we’re at price stability, what the heck are you guys thinking about betting that we’ll need to tighten?” Paul is convinced, in other words, that the Fed is trying to shift market attention from how low rates go to how long they’ll stay low. And he’s convinced that’ll be quite a while.

Like I said, Paul is an optimist. And, in this season of good will to man, let’s hope he’s right. The alternatives, real deflation or stagflation, we wouldn’t wish on even Osama.

Kathryn M. Welling
December 14, 2001
welling.weedenco.com

Reprinted with permission from
welling@weeden, a research service
of Weeden & Co. LP