Good morning Secular Forum participants. The global economy appears strong with low inflation. Equity markets and commodities are soaring. Still, your self-described “stable disequilibrium” appears vulnerable to policy transitions attempting to rectify growing global imbalances. Your mission, should you choose to accept it, is to forecast economic and then financial trends for the next three to five years and outperform the competition with less volatility. This tape (and maybe the markets) will self-destruct in 10 seconds.
Dah dah da-dah, dah dah da-dah…da-da-dah-dah…DA-DAH!
I’m prone to exaggeration and always looking for a good theme for an Investment Outlook, but that’s actually sort of how I remember the beginning of PIMCO’s most recent Secular Forum held in our Newport Beach home office in early May. We didn’t pipe in the “Mission Impossible” theme song and there were no Tom Cruise cameos, but still, after accepting the assignment, all 275 of us recognized that the next few years might present challenges bordering on the impossible. Guest speakers including Charles Gave, Clyde Prestowitz, Mark Gertler, and Alan Krueger alerted us to the changing policies of global central banks and the huge question marks surrounding the pace and final destination of monetary tightening. Our own internal research totaling nearly 900 graphs and weighing, in “term paper” parlance, almost three pounds, pointed to demographic, geopolitical, and populist currents which almost certainly would affect global economies and their financial markets – but how and in what magnitude? See what I mean? This Secular Forum was no easy assignment, nor is its summary. Not to worry though. Sit back in that cushy theater seat of yours, start munching on some popcorn, and prepare to enjoy and hopefully profit from PIMCO’s 2006 production. As you can see, I’m lighting the fuse…our mission is about to begin.
Secular Review and Current Update
PIMCO’s secular economic forecasts in recent years have emphasized globalization, technological innovation, and what we chose to label as a lack of global aggregate demand. In combination, these three forces we claimed would produce moderate disinflationary growth that would lead to benign and ultimately bullish movements in global bond markets. 3 - 4½% was our future range for 10-year Treasuries with slightly lower yields on Euroland bonds due to their structural unemployment problems and growth-inhibiting demographics. Improvement in the Japanese economy was somewhere way off on the horizon, playing on another screen I suppose, and therefore their overnight rates would remain near 0%. Well, something funny happened on the way to the Forum or perhaps the theater in metaphorical terms. Global inflation has remained low, but the combination of U.S. consumption propelled by a multi-year housing boom, Chinese reciprocation in the form of massive investment spending, and the positive knock on effects in Japan and numerous “emerging” economies produced surging global growth that has caused central banks and indeed private investors to enforce higher real yields as recompense. 5.20% 10-year Treasuries are sort of outside of our forecasted range, wouldn’t you say? “My bad” – to use Generation Y jargon.
Our benign forecast, as previously mentioned was predicated on the maintenance of a global “stable disequilibrium” which seemed somewhat securely balanced due to a dearth of global aggregate demand and the compensating mechanism of what was labeled Bretton Woods II – a recycling of BRIC and OPEC reserves into global bond markets as a safe haven insurance policy against another late 1990s Asian currency crisis. Whew! This scriptwriter needs to think about shorter sentences or else the audience will head for the exits.
The thought was this: the center of global production was drifting towards a high savings rate region – Asia. The resultant “savings glut,” to use Bernanke’s term, would be recirculated into U.S. and Euroland bond markets to build up “insurance” reserves but also to place a ceiling on domestic currency appreciation. China was seen as the main culprit but even Japan was involved in this game of competitive “real” devaluation. The deal was a win-win for all parties. Asia got to grow their domestic economies, Japan got to emerge from years of deflation, and the U.S. got to import cheap goods and cheap money in order to stoke their housing/asset markets. Euroland prospered as well.
Although the “stability” produced many inherent disequilibriums including the U.S. consuming 80% of the world’s excess savings reflected in an $800 billion current account deficit, there seemed nothing impossible about this mission, I suppose. And there’s nothing improbable about its continuing either until China/Japan are in closer proximity to their destinations – China to eventually have a self-sustaining, internally demand balanced economy and Japan to have permanently exorcised the D word from its lexicon.
Still, the strong growth that this cozy arrangement has engendered is by itself threatening its own sustainability in current form. Having encountered mild but accelerating inflation, Japan, the ECB, and perhaps still our own Fed are embarked on a path of uncertain interest rate hikes, which pressure U.S. yields, which threaten the housing boom, which augurs for slowing consumption, which more than likely will then negatively impact Asia and Euroland economies. Talk about dominoes! In addition, as Alan Greenspan warned us just a few months ago, BRIC and BRIC-like nations at some point will reach saturation or perhaps satisfaction levels in terms of their U.S. Treasury and even global bond holdings. Real asset purchases or internal investment may then dominate at the margin. China’s recently announced 5-year internal growth plan and the past few months’ accelerating commodity prices at the hands of unknown buyers may be a reflection of such saturation. So Asia’s strong growth and the U.S.’s, Euroland’s, and Japan’s cheap money are not perpetual givens. Bretton Woods II may be morphing into Bretton Woods III. In addition, global corporate savings excesses, themselves a potential factor in last year’s conundrum of lower bond yields are likely to diminish at the margin as capitalism’s animal spirits are rejuvenated and investment spending absorbs some excess.
For now though, the strong global growth and the break in Bretton Woods II reserve flows have primarily been responsible for a half reversal of the “conundrum” which perhaps artificially lowered yields by as much as 100 basis points after 2002. This giveback has left us with 5.20% 10-year Treasuries, 4.10% 10-year Bunds, and JGBs heading north towards a 2 handle. In addition, risk markets dependent on robust, nay “steadily” robust global growth have prospered. Risk spreads and volatility levels inherent in those spreads are in many cases near historic lows and financial leverage is at historic highs. It appears that these markets expect that we will not only have strong growth but benignly strong growth for as far as the eye can see. Perhaps Mr. Cruise can relax and take a seat with the rest of you viewers and enjoy the rest of his own movie.
Well not so fast Tom, or you Forum Cruise “act-alikes” (I use the term figuratively – we don’t allow tantrums and sofa stomping on the premises): this mission you have accepted has only just begun. The fact is that this mild reversal of yields embodied in 2005’s “conundrum” is just one of many changes that may threaten the current stable disequilibrium that appears so attractive to investors and capitalistic interests. One of the dominant features of stable disequilibrium was in retrospect the “disequilibrium” of central bank policy rates. The Fed, the ECB, and the BOJ held short rates at negative real or 0% yields for some time and the stimulative effects on asset prices and growth are still part of the current environment. To the extent that they are now moving closer to historical Taylor Rule norms, the move towards equilibrium may in fact be destabilizing if done too quickly or moved towards restrictive territory. We at PIMCO are of the persuasion that the “Yen carry trade” embodied in 0% borrowing rates by Japanese individual and global institutional investors has been a significant factor in the compression of yields and risk spreads in almost all financial markets. As their 0% rate morphs now into something higher, financial markets will feel the impact. And as speaker Charles Gave pointed out, an economy dependent on asset appreciation which in turn is dependent on low yields, is more vulnerable than one based on income. That certainly is descriptive of the U.S. asset based “pump” economy described in last year’s Secular Outlook review which embodies increasing amounts of leverage primarily in the household and financial sectors of the economy. Gave went further to suggest that changes in any one of the following five areas have historically had long-term influences on asset prices: 1) monetary policy, 2) protectionism, 3) taxes, 4) regulation, and 5) war.
If the first of Gave’s five policy changes is now in play as described in preceding paragraphs, there is little doubt that the second – protectionism – may be influencing current events as well. Recent U.S. government decisions involving Dubai “ports” and the attempted purchase of Unocal by Chinese interests may be just sparklers preceding the primary fireworks embodied in Congressional bills advanced by Charles Schumer among others. And for those that suggest the U.S. is the potential villain in a protectionist stampede, reflect on the fact that foreign central banks via their currency “manipulations” have for years now been engaged in protectionist policies of their own. Long standing Treasury attempts to nudge the Chinese off their RMB peg are now evolving into attempts to include the G7 and IMF as policy influencing bodies reminiscent of the Plaza and Louvre accords in the 80s.
Those seminal decisions set the U.S. dollar in motion, to say the least, and in recent weeks, we have experienced some of the same. Our point is that protectionism and reactions to perceived threats of it are potentially destabilizing events that threaten the current status quo. Yes, the world needs a cheaper dollar to help rectify the U.S. current account deficit and the excesses of American consumption. Yes, a cheaper dollar will allow for a decrease in Asian imports and a rebalancing of our current “disequilibrium.” But prior currency protectionism followed by too swift of a policy reversal by public policymakers or the inevitable invisible hand of the market, risks asset volatility that is potentially destabilizing. The outcome depends importantly on decisions made by the Chinese themselves with regard to their RMB revaluation. In plainer English, watch the pace of dollar depreciation or periodic re-appreciation if that be the case. Currency volatility can ruin the global economy’s day, week, or year(s) for that matter.
While space doesn’t permit a detailed elaboration of Gave’s points 3-5, it is important to acknowledge that risks abound in policy reversals related to existing and future wars, government regulation, and yes, tax policies. Iraq/Iran with their influence on oil prices is the most obvious example. In addition, we continue to believe that the next few years will increasingly be affected at the margin by what Paul McCulley describes as the iron fist of government policies rather than the invisible hand of a dynamic free enterprise economy. Certainly Bush tax cut policies seem secure until 2008, but they are at risk thereafter as a potential Democratic Administration and Congress attempt to rectify existing inequalities with more populist measures. Populist movements are underway in South America as well reflected in government moves towards energy production nationalization in Venezuela, Bolivia, and Ecuador. Again, the pace and volatility of geopolitical disagreements, wars, and reversals of government regulations and policies will potentially be destabilizing. Movements towards equilibrium in other words, must be telegraphed as much as possible lest the markets themselves become unstable.
As our mission statement at the head of this Outlook pointed out, our goal is not just to analyze the complexities of stable disequilibrium, but to forecast financial markets and outperform the competition with less volatility. While the preceding analysis was fundamentally necessary, the following dialogue represents the objective.
It is critical at the outset to acknowledge (perhaps a little too concisely due to brevity requirements) that we have not shifted our secular forecast from a disinflationary to a reflationary scenario just yet. The U.S., Europe, and Japan’s potentially inflationary policies to balance unfunded health and pension liabilities are perhaps a dominant topic for 2008’s Secular Forum. For now, the continuing influences of globalization, technology advances furthering productivity, and asset destabilization policies spoken to in prior paragraphs, probably will allow global inflation to remain in moderate range bound territory between 1-3% for most economies. Inflation targeting lies ahead for the U.S. and perhaps Japan which in combination with those old bond market vigilantes (yours truly for sure) should enforce a non-threatening tint to overall inflation. We believe as well that sometime within the next several years, a U.S. recession is likely, due to currency, commodity, and housing related influences. If so, and if the global economy slows in reaction, then moderate inflation is the most reasonable forecast.
Get the inflation forecast correct, put it together with an accurate real rate analysis, and you’ve got the basis for a successful portfolio strategy mission, as readers would acknowledge. It’s in the area of real global rates where we have the most uncertainty, however. Having already acknowledged the partial reversal of the recent year’s conundrum, it is tempting to go all the way and forecast a return to real rate normalization. We are reluctant to do so however in the face of a still existing global savings excess, diminished as it is. Additionally, central banks have been/will likely remain cautious in their tightening cycles. We have observed that inclination with the sixteen successive 25 basis point hikes in the U.S. and in the ECB’s still turtle-like approach to higher yields. An aggressive central bank is likely to strengthen its region’s currency excessively, which is just the opposite of competitive real devaluation policies now in place. Global real yields then, whether expressed in spot, or forward curves should stay reasonably low – perhaps 2% on average (lower in Japan) with an increasingly positive slope over our secular horizon, although curves may be flatter than normal if central banks remain continually “transparent.” Substituting Bernanke for Greenspan, however, lends caution to this last thought if only because he has not yet been tested in a crisis. We shall see.
Combining inflation, real interest rate, and term premium considerations mentioned above we come to the following range forecasts for the secular timeframe from 2006 until 2010.
As a continuing theme from last year’s forecast, the inherent leverage throughout the global financial system will at some point pose a danger to risk oriented markets (stocks, high yield and emerging market debt, CDO structures, and housing prices). Charles Gave claimed that interest rates do not discipline a financial system – financial crises do. We’re not sure about the first part of that statement if only to observe that prior financial crises have been correlated to monetary policy tightening, but there’s little doubt as to the need for some monetary discipline at this point in time. Historically low risk spreads in all segments of the marketplace reflect a belief that this newly flattened global economy (tilted now towards Asia as speaker Clyde Prestowitz pointed out) can grow at consistently high rates without a hitch. The history of capitalism would suggest caution if only because a normally balanced “creative destruction” environment can tilt as well when over-investment, excessive leverage, and the emotional responses of market makers and investors accelerate deteriorating fundamentals. PIMCO in 2006 manages assets across a broad spectrum of risk categories, and we will continue to do so. To not flavor each of them with a relatively high quality composition, however, would be irresponsible in light of the low reward/higher risk character of the global markets, especially those in the United States.
To single out the U.S. in terms of relative overvaluation may seem a year late and perhaps a 25-cent piece short if we’re talking currencies. Perhaps, although PIMCO has been on the weak dollar bandwagon for several years now and clients have been amply rewarded. We continue to believe that the process of rebalancing the disequilibrium observed in excessive U.S. consumption and near negative savings will require higher incentives to reverse both conditions. Those “incentives,” even if externally imposed, speak to a weaker dollar and lower relative asset prices in comparison to the rest of the world. When not countered by cyclical considerations, PIMCO portfolios will likely feature increasing international diversification in foreign currency terms.
We recommend as well that clients and other readers continue to diversify their asset mix with a percentage of commodities. Aren’t they the epitome of the same risk assets we so gravely warned about a few paragraphs ago? Of course, and a global slowdown/financial unwind will not likely treat them kindly. Still, we are enveloped in a global dynamic characterized by resource shortages and resource wars of the civilized and even uncivilized kind. “Buy what China wants to buy before China buys it” – has been a profitable adage for some time now and commodities still head the list, although perhaps not on a cyclical short-term basis.
Well, Tom is beaming and has his arms around the girl, so that must mean his mission has overcome the impossible for the third time now. With PIMCO, of course, we can’t be sure. Our ratings and perhaps our box office will only become clear over the next several years. Still, what is not impossible or even improbable is that we at PIMCO will continue to recognize we are most fortunate to be entrusted with the management of your assets. The responsibility, while heavy, is the reason we are in business. Thank you. And as to the tape that supposedly self-destructs in 10 seconds? Well, that’s for the movies and cute little Tom to fantasize with. Our tapes and our data keep goin’ on for years and years and hopefully our relationship with you will as well. For now though, this movie’s over. See if you can make it to the parking lot to beat the rest of the crowd. Talk about mission impossible!
Secular Forum Conclusions for the Next 3-5 Years
Global growth currently strong, but vulnerable to policy reversals.
- Global inflation remains benign averaging 1-3%.
- Global interest rates return partially to “Taylor Rule” norms as the “conundrum” reverses. Still, government yields remain relatively low, 4-5½% for 10-year Treasuries.
- Risk assets are at risk due to narrow spreads and the withdrawal of global liquidity. Watch the BOJ.
- Dollar based assets and the dollar itself should underperform global alternatives.
William H. Gross