o eleven!” If you’ve ever rolled the bones at a Las Vegas craps table you know just how great that sound is. Happens only once in 18 rolls because that’s the mathematical chance of a 6 and a 5 coming together at the same time, but when it does it’s a big deal, with big odds and lots of money for the fools who believe in 18-1 shots that only pay off at 16-1. Sort of like the bond and stock markets, I guess: bonds are elevens and stocks are everything else. Once in a random eighteenth year or so bonds will kick the daylights out of stocks, and bond managers can inwardly pretend they’re masters of the investment universe even though they know their reign will be shorter than George Dubya’s. Still, why not enjoy it while we can I guess. Just don’t gloat. Humble pie is the best dessert for bond managers. We know our place, and it’s a distant second in this modern day investment universe, despite this year’s double-digit returns in high quality bond portfolios.
There’s another Las Vegas banter that dice players may be familiar with. It’d take too long to explain to those of you that enjoy other more refined games such as cribbage, canasta, or croquet, but after a 5/3 or 4/2 combination of the dice is rolled, a good croupier will always yell, “It came easy, now bet it hard.”
That, my fellow craps players is the perfect description for our current economic outlook. Not that PIMCO’s May long term secular warning encapsulated in “Survivor,” or Ed Hyman’s apt description of the “Perfect Storm” are not right on as well, but I like this one just as much. It’s good because it has a sort of “cause and effect” to it and it emanates from the bowels of the casino which is a fair description of the market environment that our equity, high yield, and New Age Economy have been operating in for some time now. “It came easy, now bet it hard.”
The fact is, it did come easy. Billions upon billions - make that trillions - of dollars being thrown at the solitary notion that it was much different this time. Because, like that first sexual encounter when you conned yourself into believing you were experiencing something that had never, ever happened before in world history, investors delusionally assumed that the New Age Economy could never experience a downturn anywhere close to a recession, and subsequently threw not only caution, but common sense to the wind. The notion of a perpetually higher level of productivity based upon New Age technology had a certain ring to it that even wise old owls such as Alan Greenspan began to swallow. PIMCO, to be fair, as well as yours truly, believed there was something going on during the past five years that was different this time: globalization, technology, favorable demographics all allowing for higher secular levels of productivity and therefore economic growth. But perpetual? No, they haven’t invented those machines or economies yet. And as we’ve warned for much of the past twelve months, something out there was just not right. It all seemed too easy. Stocks moving up at 20-30% a year on average, the NASDAQ doubling in 1999; corporate debt growing at rates not seen for decades with much of it being used to buy back stock; individual savings rates moving to negative territory under the assumption that you could make the mortgage or car payment by selling off a few shares of Dr.Koop.com; growth in corporate and individual debt soaring at unprecedented levels as seen in the chart below; a U.S. dollar escalating 30% in 15 months against its major competitor – The Euro – under the assumption that America would always grow 2% faster than those overregulated, non-risk oriented Germans; a trade deficit approaching third world levels of 5% of GDP on the belief that no one or no country would ever ask for their money back because U.S. growth would never stop; IPOs, net stocks, junk bonds, hedge funds, Pentium II, Pentium III… I feel like Billy Joel here singing, “We didn’t start the fire.” There has been simply an endless list of folly, all reflecting the belief that the magic wheel would never stop, and the dice would never be passed. It came, as the croupier said, “ Easy .”
U.S. Private Debt
4 Quarter Average $ Change
Source: ISI Group
Now it may come “ hard.” And one doesn’t have to go nuclear, become Grinchy or even believe in Armageddon to think that a hard landing or a near recession has odds greater then a “yo eleven” of showing up. Because capitalism by its very nature leads to excesses that eventually must be corrected if an economy is to move forward. And we’ve had our share of excesses – all of those “easy” things outlined above – and more. So excesses will be corrected and the economy’s growth rate will slow, perhaps even reverse. The description of the landing, whether it be hard or soft and for how long essentially depends on the extent of the excesses and the policy responses that follow. “Will the Fed ease rates and by how much?” is a good question. “Will George Dubya’s stimulative fiscal policies be too little, too late?” is another. Is the global economy healthy enough to ward off a case of American flu? And even if all of these questions can be answered optimistically, there remains the equally perplexing query of whether risk capital can be enticed back into the equity, bond, and bank loan markets to allow for the financing of not only a soft landing, but a gradual recovery soon thereafter.
It’s this question of risk capital availability that looms most ominously on the current investment horizon. Cyclical investors assume that a few good Fed cuts should be enough to bring the customers back into the casino, and undoubtedly that would help. But I have my doubts as to the potency of interest rate policy in a New Age Economy. 150 basis points of rate hikes were surely not enough to stop the technology juggernaut in its tracks. Six months ago, common wisdom was talking 30-40% growth rates for much of the industry. 6 1/2% Fed funds hardly factored into anyone’s equation or DotCom business plans and financing was primarily venture capital or IPO related in any case. What went wrong was that the industry got ahead of itself, projecting demand for new products and indeed concepts that were beyond the ability of the real economy to use, assimilate, and pay for. Many ideas, which formed the basis of new companies and fledgling attempts to grab a share of New Age wealth, were not much more than snake oil when all was said and done. So Alan Greenspan’s expected policy ease will help, especially portions of the Old Economy such as housing and manufacturing which depend more heavily on the fuel of low interest rates. But risk capital may remain in hibernation for some time. “Once burned – twice shy,” and this has been the New Age Economy’s first real fire. I continue to suspect, as I have outlined in Outlooks all year, that the New Age Economy and corporate bonds do not mix especially well. Without the oil provided by lower quality and high yield junk bond financings, growth rates may sputter.
So how should one play this game of economic and investment dice? Well betting man that I am, I would put my chips on what the croupier would call the 4/4 or 3/3. It came easy, now I’d bet it hard. I would bet on the New Age Economy’s first recession. Sometime later in 2001, though, I’d lay odds on its second recovery, although this time a less vigorous one than what we’ve experienced over the prior few years. The next upturn will be a chastened recovery, a cautious one filled with recent memories of DotComs gone bad and junk bonds turned sour. It will be a recovery colored by a new shade of exuberance – less irrational, more mature and worldly wise.
Twixt now and then, though, the investment casino will continue to resonate with a cacophony of “yo 11’s.” Bonds will continue to reign supreme, at least for a precious few more months, as destruction takes precedence over creation. The secret for bond market success will continue to be portfolios of longer than average duration and higher quality. Government bonds both here and abroad in Europe will be in increasing demand and decreasing supply. Those 18-1 shots don’t come by too often, but when they do, their safety and consistency of cash flow outshine almost all other investment alternatives.
Whatever the future outcome, let me use this occasion to wish you all a happy holiday season and a healthy and at least somewhat prosperous New Year. We at PIMCO thank you for your faith in us and your continuing confidence. And as Tiny Tim was heard to say,
“God bless us all.”
God look down on us – every one.
William H. Gross