Well we warned you didn’t we? Last year’s PIMCO Secular Forum that is. Only a month or so after NASDAQ 5000, we came up with this UNBELIEVABLE forecast that maybe over the next few years the U.S. and other global economies might suffer a breakdown of sorts. We suggested a better than 50/50 chance of a recession during our secular timeframe due to a number of “lightning bolts” that individually or in concert could put an end to Goldilocks, if not yank the halo right off of the head of our New Age Economy. The popping of the U.S. equity bubble, central bank overreach and Japanese economic malaise were three prominent precipitating factors that the PIMCO girls and boys believed might lead to the big R, which would in turn cast investors onto a deserted island or the Australian Outback a ’la “Survivor.” We adopted that theme for our Investment Outlook and it influenced our investing style as well – winning lots of immunity challenges by purchasing predominantly high quality bonds and extending duration with the long Treasury bond at 6 1/2%. Instead of a $1 million prize, though, we bagged the Morningstar Portfolio Manager of the Year award for the second time in three years which went a long way towards proving that surviving well can best be accomplished through the use of the PIMCO tribe’s 3-4 year secular outlook.
But hey, who’s counting (besides us) and anyway, Richard and Tina, the winners from Survivor I and II are already has-beens and not even on the talk show circuit anymore. What’s new, what’s hot, what have you done for me lately? Well, we’re still into surviving of course, but for this year’s theme we thought we’d switch networks and feature a reality game show that’s captured the imagination of Americans and the English alike. Let’s play – The WEAKEST LINK! To do so probably involves more wit and indeed sarcasm than yours truly can muster. I’m no match for the dominatrix of London, Anne Robinson, who emcees the TV version. Every so often, PIMCO portfolio managers liken our trading floor to the Tower of London, but that’s another story. The show’s title and theme though, is a great lead-in to our own view of the next 3-4 years that there are more than a few weak links in our global economy that could result in slower growth for years to come, so I thought we’d use it and hope that you dear reader could at least half comprehend what we came up with this year. Admittedly that might be as difficult as using an ashtray on a motorcycle, but give it at least a pathetic go, will you? We’ll even answer some of the questions for you if you promise to BANK SOME OF THE MONEY! Are you the unpopped kernel in our bag of popcorn? Let’s start the clock.
Our current secular stopwatch actually began sometime in the early to mid ’90s with the blossoming of the New Age Economy, fed by visions of endless technological productivity advances and realities of New Age stock markets that ascended to unprecedented heights. You all know the story by now. Computers, the Net, biotech, agritech and countless other breakthrough innovations would lead to a doubling of historical productivity growth rates and therefore double digit, even 30-40% annual increases in some corporate earnings. Cisco, at one point last year the world’s largest corporation in terms of market capitalization, was going to double in size every two years for as long as Strom Thurmond has been a Senator. Yeah, right. But as long as that was the accepted tautology then stock P/Es at 2 or 3 times historical norms made sense, as did that well-worn phrase “it’s different this time.” Turns out perhaps it wasn’t so different after all. Take a look at Forum guest speaker (Mr. Irrational Exuberance himself) Robert Shiller’s chart displayed below.
U.S. Stock Market: A New Era or Irrational Exuberance?
Source: Robert Shiller, Yale University, Morgan Stanley Economic Research
Now there’s a real secular chart with some meat on its bones. Lots of “new eras” are displayed over its 130 years – from the railroads, through the development of the automobile, to national electrification. None of them produced a significant blip in real earnings growth which forms the basis of stock price and P/E expansion. Should we really believe it’s different this time? NASDAQ investors and S&P owners alike (as seen in Shiller’s chart) did – and still do. So did business corporations who invested in an accelerating amount of dot.com, telecom, and high tech equipment, much of which now lies unused or at least underutilized. So did American workers who found jobs down to an astounding 3.8% unemployment rate and spent wages, capital gains, and freely given “in the money” options at an accelerating rate. So did foreign investors who managed to accommodate a near 5% of GDP current account deficit and pump the dollar to unforeseen heights by purchasing U.S. stocks and corporate bonds, reflecting the same belief in New Age miracles.
These were more than likely all bubbles, folks – and still are. But the dream lives on. And all these dreams perhaps somewhat simplistically rest on one singular assumption: the belief in higher than average productivity in our New Age Economy. Greenspan believes it, stock market investors believe it, and corporations chase it like the Holy Grail. It is the link that justifies all these bubbles as well as much of the world’s faith in the American capitalistic model as the economic paragon of the 21st century. But, just how strong of a link is it? As Anne Robinson might query, have we all been IDIOTS to believe in it?
Shiller’s chart would suggest as much, but there is additional theoretical smoke here to be concerned with. The following chart, advanced by Secular Forum guest speaker Stephen Roach, who along with Northwestern’s Robert Gordon ranks at the top of the world’s productivity experts, shows a pronounced disparity between what is known as “labor” and “total factor productivity” or TFP.
Growth in Productivity
Source: Morgan Stanley Dean Witter
It’s the labor productivity that markets and corporations have been focused on, and that productivity measure has indeed accelerated in recent years, rising at a faster rate than at any time since the 1960s. But TFP, which includes not only labor but plant and equipment, has barely produced a ripple – in fact, it has gone down over the past few years. That means that labor productivity is up and corporate profits are up because of “capital deepening” (the amount of capital employed per worker) – not necessarily higher total factor productivity (the efficiency with which both capital and labor are used). It means that Americans have invested in more machines but not necessarily ones that are any more productive than during the past 130 years – to cite Shiller’s example again.
So? Why don’t we just keep on buying more machines? We will, but not as many, and that makes all the difference. Because prior levels of investment have been made possible via increasing amounts of debt as well as IPO, venture capital, and other equity financing which now is much harder to come by, the ability of corporate America to “deepen” capital at anywhere close to recent levels is more than suspect. This link of the New Age Economy’s chain falls under the category of “all good things must end” or at least slow down. Productivity’s recent downturn, based upon serious disruptions in business investment has begun to influence the economy and investment markets alike, suggesting that the peak has been seen, even if the end is not near.
But is it a cyclical or a secular peak you imbecile? Good question, Anne. Because if the Fed can pump up the economy with its 250 basis points of cheaper money, then why not party-hearty for another 10 years. Maybe, but not likely. With private consumer and corporate debt at historically high levels and with investors finally believing that stocks are not just a one-way winning lottery ticket, the next cycle is almost certain to be less exuberant than the last. And there is after all not only business investment but consumer spending that must slow down.
U.S. Private Debt % GDP
2000: 4Q 135.3%
Source: ISI Group
America’s (–1%) personal savings rate must eventually rise to higher levels as suggested in our March Investment Outlook. We look for 2% U.S. GDP growth over the next 3-4 years instead of the 4% growth experienced since 1997, largely due to the return to earth of productivity growth rates, and the need to rebuild consumer savings rates .
If productivity is a fragile link then there most assuredly are others – many of them outside the borders of the U.S. of A. This is a global economy these days and a global chain, even if America has been the strongest link up until now. Japan is a basket case and a valid candidate for the weakest link. It awaits serious structural reform and monetization via a weaker YEN. No believable steps have as yet taken place, although new Prime Minister Koizumi’s mod hairstyle is as heartening as anything we’ve seen in the past few years. We’ll need more than makeovers to fix Japan however. Elsewhere, emerging nations have strengthened their balance sheets and reserves over the past few years of prosperity, yet disasters await in Argentina and Turkey to cite the weakest of the links in the emerging chain. Contagion can likely be isolated if the G-10 is 2% or more growth positive, but it is not there now and may not be for six months or longer. This is a global tender spot and a weakest link possibility.
There is more hope elsewhere. Europe, to point out the obvious, might be a stronger relative link than in the '90s simply because it's been less bubblish. It's had its telecom and MP3 fiascos and its banks are in deeper hock to emerging nations than are ours, but its private market balance sheets are still in better shape and structural reforms are on the way – lower taxes, Sunday shopping in Germany – who knows what’s next? According to Morgan Stanley’s Roach, Europe should become the world’s largest IT buyer over the next 3-4 years, coming close to match our own IT capital stock as a percentage of GDP. Look for Europe’s economic growth rate to match or exceed that of the U.S. for the next few years.
Europe May Catch Up
Source: Morgan Stanley Dean Witter
China too promises to prosper, but its economy is no global engine simply because it’s internally driven and still too small to pull a weakened U.S. back to normal. It prefers to export rather than import just like Japan, just like Korea, just like about every other country with the exception of the United States. This export/import disparity is crucial for analyzing the global outlook for the next 3-4 years. The world’s biggest pool of potential consumers lie in China, India, Mexico and South American nations with demographically younger citizens. Yet getting the goods to these potentially voracious consumers is no easy task what with internal policies geared towards exports. In turn, the financing of internal consumption is still light years away from the U.S. model which utilizes credit cards, individual home mortgages and securitization of assets to keep the spending campfires burning. This weak and almost missing link between the developed world’s savers and the emerging nations’ potential consumers is at best an opportunity lost for global prosperity over the foreseeable future, and at worst a deepening drag on global growth as the G-10 Nations continue to age demographically over the next 3-4 years.
The inability to get the goods and financing to match demographic demand is but one faulty link or transmission mechanism that characterizes the world’s economies today. Back in the U.S., it’s become apparent for years that the banks are not as influential as they used to be in cooling or speeding up the economy. The elimination of Regulation Q in the ’70s was the first in a series of steps that elevated a host of disparate entities such as FNMA, GE Capital and its look alikes, hedge funds, mutual fund investors, vendor financiers, and of course PIMCO and institutional pension funds, towards a pinnacle of influence on interest rates, quality spreads and the availability of finance. The old foundation of bank reserves as the primary influence over the domestic economy is not only hardly debatable, it’s near laughable. The Fed’s and Treasury’s control over the domestic financial balance sheet therefore has been seriously weakened by time, deregulation, and technological progress. There is no significant linkage or control over investment preference other than via the blunt hammer of short-term interest rates and the increasing attempts at moral suasion – some call it cheerleading – by the Federal Reserve. In such an environment the weakest financial link, whether it be LTCM in 1998 or some fresh overaggressive candidate in the future is bound to increase the possibility of major financial accidents and with it the volatility of interest rates and credit spreads.
Fiscal policy was a link that drew close PIMCO inspection as well. The cult of the budget surplus has characterized U.S. and European government behavior for a few years at least. Rarely over a secular time frame have politicians fought to assume the mantle of the “most frugal” but we came close during the U.S. elections and our current $300 billion surplus is proof of this political pudding. Our Forum concluded, however, that this fiscal “tightening” of sorts, in the U.S. and Europe, may in fact have contributed to the existing or upcoming recession more than most realize. Not only was the secular move contractionary by reducing government spending’s influence, but as PIMCO’s Paul McCulley put it, we managed to delever the good credit (the U.S. Treasury with a printing press) and lever the bad credit (the private sector) at the same time. The tipping of the growth scales towards private overexuberance, as we’ve pointed out, resulted in an Austrian School boom of private investment, which is now culminating in an Austrian School bust. Better to have less of a surplus than more at this point we concluded, a direction which seems more than possible given the decline of tax receipts on both a national, state, and local level.
But enough of these discussions of weak economic links. How many readers know what the Austrian School is, Mr. Gross? You, Sir, are the idiot for going on so long. OK. OK. On to the investment conclusions. As I told our 100+ Secular Forum participants from literally the four corners of the globe, we cannot invest in GDP futures or productivity options. When all is said and done, the task of the FORUM is to tell us where to invest our clients’ money – domestically or internationally, long duration or short, high quality or high yield. If we can’t translate an economic outlook into a portfolio of bonds then the three days of discussion could better have been spent on the golf course. So here are some investment nuggets that hopefully will turn into gold for your portfolios:
- Sub par U.S. and global growth will continue to prolong a disinflationary environment in the U.S. and Europe that leaves inflation in a 1-3% range over the next several years – lower in Europe, higher in the U.S. due to the eventual weakening of the dollar and the ultimate strengthening of the Euro. The relative technological “deepening” of Europe should be a factor as well, as their productivity is temporarily raised.
- Interest rates will be range bound but volatile – especially in the U.S. due to our riskier transmission mechanisms. Ten year U.S. Treasuries, now at 5 1/4% should move between 4 1/2 and 6 1/2% from now until 2005. Euroland rates could average 50 to 100 basis points less due to its lower inflation, more attractive currency and ECB focus on inflation as opposed to growth.
- Quality spreads should continue to have a bias towards widening in the early portion of our secular period as sub par economic growth translates into subdued corporate profit growth in the U.S. and Europe. Opportunities for high yield and corporate bonds will be better in 2002 and beyond. PIMCO remains committed for now to higher quality investments with mortgages forming the centerpiece of our yield product despite higher volatility. If 10-year Treasuries remain within our forecasted range, prepayments will ultimately subside and render optionality in mortgages relatively impotent.
- The higher forecasted volatility of yields in the U.S. should impart a steepening bias to the yield curve over time.
- Stock and bond total returns over the secular time period will be fortunate to reach 6% annually. Stocks have a better chance of negative returns than do bonds.
- Emerging market bonds will be more attractive next year than currently. We will opportunistically pick up the pieces and put together the emerging market chain should an opportunity present itself over the next 12 months.
So there you have it. And what is PIMCO going to do differently as a result of our three days of work? Not that much you half-wit! Not just yet at least. Didn’t you know this year’s output was more of the same? PIMCO bearish on the economy. Clowns! Well, yeah maybe Anne, but at least we’re in there pitchin’, trying to figure out secular answers to longer-term questions. In the process we’ve managed to bank a lot of money for our clients. And look at it this way, baby – bond people are supposed to protect principal – you wouldn’t want us to ever bet the farm or get up to that $125,000 question would you? That’s better left for a riskier game called, “stocks for the long run.”
In the meantime, and if you stayed with us this far, aren’t you dying to know which is the weakest secular link? After all, we’ve discussed a bunch – including U.S. productivity, Japan, emerging market contagion, export/import imbalances, faulty financial transmission mechanisms, fiscal surpluses, and, of course, a continued deflating of the U.S. equity bubble. Not even mentioned has been the price of energy and a potential credit crisis in this country’s largest state, California. Which one should we be most concerned with? Well it should be obvious you limping snail that we devoted most of our attention to the existence of the U.S. productivity miracle. Would we have devoted only a few sentences to our choice of the weakest link? Obviously not. If productivity comes back from its current cyclical depths and regains its 1995-2000 heights, then stocks soar, investors’ animal spirits return, and bears go into hibernation. If U.S. productivity has been primarily a cyclical, over-investment mirage, then super-bulls prepare for thy matador. PIMCO sides with the latter not the former. AMERICAN PRODUCTIVITY IS THE WEAKEST LINK! GOODBYE.
William H. Gross