Man, I’m hungry. Here I sit at home, having fasted for the last 24 hours for this afternoon’s "it’s more than you want to know" medical test, and all I can think about is a good old-fashioned peanut butter sandwich. Slab that Skippy real thick on two pieces of "nutritious" white bread and scarf it down with a cold glass of milk – now that’s livin’. Up until this very instant, though, food for me has been purely a functional necessity. Fine dining? Nah, just shove it in the front-end, get my daily caloric quota and get back into the pool – to hell with waiting an hour. My idea of fine dining with my infinitely understanding wife, Sue, is a 45-minute sit-down between 5:30pm and 6:15pm then home for some weekend TV. What a guy! What a date! Somehow Sue says I’m lots of fun. Go figure. But back to this food thing and how much I miss it at this very moment. I went through this same fasting procedure accompanied by "internally cleansing" castor oil almost seven years ago when I was ten pounds heavier and had more fat cells to sustain me. Now I’m so weak it’s all I can do to lift this little ol’ pencil off this humongous pad of paper. I’m skinnier these days because I decided to kick the sugar habit six months ago. No more red licorice after Investment Committee meetings at work. No more pigging out on cookies at home. But all of that has left me weak and frail and terribly unprepared for this fast. I’m HUNGRY! I’d sneak out to the kitchen right now for some of those cookies, but the doctor would find out and make me swallow the castor oil all over again. Oh man, now I love food – and not that awful green Jell-O® that I’ve been swallowing since I got up this morning. J-E-L-L-O sucks. Just give me a peanut butter sandwich will ya please.
I suppose I’ve prejudiced my case for what’s about to follow in the ensuing paragraphs. You’ll assume I’m so weak that I’ve sort of lost it, but then that may not be front-page news. What has been front-page recently is talk of a housing bubble and the effect that a bubble "popping" would have on the economy and interest rates. Even Greenspan has now jumped into the debate with his Jackson Hole monologue on lowered risk premiums, rising asset prices (homes) and their stimulative effect on consumer purchasing power. In the same breath he mentions that "history has not dealt kindly with the aftermath of protracted periods of low risk premiums," the implication being of course that the economy’s future may not resemble its stellar past, and that investment returns may take on the same trajectory. The Chairman’s parting warning shot reminded me of Eisenhower’s farewell admonition on the industrial/military complex. Somehow, standing behind the rostrum for the last time might have then and might now have provided the audience with their first smog-free glimpse into what a leader’s really worried about instead of having to hide behind the rah-rah of productivity gains and hedonically adjusted "core" inflation rates.
I have a few more rostrums and nostrums in my future, but I’ll be glad to tell you what I’m worried about nonetheless. Yes, history will prove that both Eisenhower and Greenspan were right to sound the alarm, although with securities, as opposed to a military/industrial complex feeding and being fed by modern day capitalism, timing is a critical issue. Portfolio managers hired for their performance guns cannot afford to wait for the validation of historians. Having said that, I have a strong sense that most of our risk asset markets (and therefore our domestic and global economies as well since they are so asset-appreciation dependent) are substantially past high noon. Oh, I know I’m paid and paid well to shroud the Outlook with pessimism whereas equity, hedge fund, and these days private equity managers are paid and paid well to cast a perpetual glow of hope on tomorrow’s dawning. But in determining whether or not the sun is rising or beginning to set on our economy and its markets, perhaps it is best to return to the maestro himself for a hint on the timing of this affair. "Any onset of increased investor caution," he wrote at Jackson Hole, "elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums." The secret for successful future strategies, therefore, may be to decipher what precipitates that increased investor caution and when.
To state that the level of prices themselves and therefore the skimpiness of risk premiums should at some level induce investor caution seems axiomatic. It seems most logical to an experienced old hand such as yours truly, and it is enough to induce caution, but it is not always a great timing tool. The NASDAQ was bubbly at 2, but it went to 5-thousand and it took the failing and in some cases fraudulent results of the dotcoms to caution investors that the end of the road was in sight. Perhaps an increase or two in the cost of money played a part as well and if so its parallel to today’s environment is compelling. With the Fed on the march from 1% to perhaps 4% Fed Funds, the price of borrowing to finance our asset-based economy has increased substantially. If Greenspan is targeting the housing bubble and I believe he is, then he holds investor caution in the palm of his hands, at least for six more months. Is 4% enough, especially with the yield curve flattening and bending down? An early answer is that today’s 3½% short-term rate already seems to be having an effect on housing; so 50 basis points more would be "cautionary" still. We have recent examples from Australian and UK housing markets as well where even smaller absolute increases of 150 basis points in short rates were enough to stop prices going up. Of course their mortgage markets are not rife with what I call "funny money" paper that has provided an additional boost in the U.S. Imagine lending money at 100%, 110%, 120% of estimated market value and on terms with borrower’s options to pay or not to pay. No caution there, that’s for sure. Still the Fed and other regulatory agencies have for the past few months been exerting increasing scrutiny on lending standards that when combined with higher short rates, may be just enough to "caution" prospective home buyers. The increase in home equity loans has been dropping rapidly as shown in Chart I, which may be a telltale sign of the froth coming off the top of this bier stein.
Additionally, because prospective homebuyers become increasingly optimistic, as employment and real wages turn higher, it stands to reason that they should become cautious if their income gains falter instead. The fact is that job growth is almost anemic in comparison to prior business cycles, as is wage growth for the important first-buyer segment of the population. Granted, this cycle’s employment and wage anemia hasn’t seemed to have had much of an effect up to now, but the housing market’s own momentum has been responsible for a goodly portion of job growth and income generation in the past few years. Take a gander at the remarkable Chart II displayed below. It shows that real estate, not manufacturing, has been the economic impetus in recent years in terms of net growth. Once price momentum slows or ceases for home prices, job growth will slow or disappear in the sector as well. How many more mortgage brokers or real estate agents do we really need or can we legitimately support? At least one more than our total of portfolio managers and investment bankers you might say, and to that I’d say "touché," but it only reinforces my point! Once the cautionary momentum begins, job and wage growth will not support a continuing housing boom, leading to further caution and an economic slowdown at the minimum.
If the home asset bubble stops expanding, deflates, or pops any time soon (and I suspect we are only a few short months from at least the first of these three) then the potential for Greenspan’s "debt liquidation" follow-on is something that investors must begin to prepare for. Debt liquidation, as opposed to loan growth, slows an economy or sinks it into recession, generating the higher risk premiums that the Chairman warns us lie ahead. What should an anticipatory bond manager do with the possibility of such circumstances drawing closer by the day? Cut the fat from his portfolio that’s what. Swallow the castor oil, go on a temporary fast and prepare for the system to eliminate its waste. (Sorry folks, but I had to tie it in somewhere.) That means a focus on high-quality investments with anticipation for an eventual Fed easing at some point in 2006. I believe that 4% will cap this Fed Chairman’s last bear market tightening and that his successor will quickly be confronted with the necessity to lower rates once again. A bullish orientation towards the front-end of the curve therefore should begin to dominate bond strategies, combined with an avoidance of anything that carries those low-risk premiums that Greenspan finally diagnosed. Those assets include real estate, equities, high yield, corporate, and some areas of emerging market debt. They also include, by the way, long-term Treasuries or any longer-dated government paper that has been lowered in yield in the past by Greenspan’s own "measured" transparency over the past 16 months. That is not to say that long government bonds won’t go up in price if the "system" suffers some elimination, slower growth, or to be frank, a recession in 2006. It’s just to acknowledge that the better duration-weighted paper lies at the front-end of the curve, especially now that it provides similar yields to longer maturities. Get ready for Greenspan’s "lunch" time and –
William H. Gross
P.S. This Outlook was written pre-Katrina. Katrina’s aftermath only adds to the potential for "caution" mentioned above and reinforces the strategies underlined on this page. More details in a few weeks.
Next month, look for the IO available as a "podcast" on both pimco.com and on itunes.com. Now I must be honest, for someone who has written every IO, including this one, using pencil and paper, the thought of "podcasting" baffles me…I mean, why would you spend time listening to me instead of the new U2 album? But my son, Nick, insists "it’ll be cool Dad." So I told him I’d give it "a try."