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Economic and Market Commentary

Rotor Tilling Behind Bill's Tractor

Ijust got back over the weekend from a two-week sojourn through (ex-Japan) Asia, visiting with PIMCO clients. It was my fourteenth whirlwind through the region since 1993 - twice a year during my days on the sell side of Wall Street, and once a year since coming home to PIMCO in 1999. It is always a delight to spend time with long-time (not old!) friends, who love to think out loud about global macroeconomic themes. Making new friends who like doing the same thing is wonderful.

And when the talk is not just talk, but a discussion of the fundamental foundation for PIMCO's positioning of portfolios, including their own, conversations take on a particular poignancy. On the sell-side, the skin in the game was bragging rights about the forecast. On the buy side, the skin in the game is winning the game, defined as consistently adding value - alpha! - to clients' portfolios. I like it better on this side.

The cornerstone of PIMCO's approach to winning the game for our clients is a long-term, or secular orientation. Indeed, we schedule this Asia trip right after PIMCO's annual Secular Economic Forum in early May, so as to brief our clients on PIMCO's evolving thoughts. This year's Forum was a "biggie," in that PIMCO declared a major secular turning point: America's twenty-year journey toward more unfettered capitalism, fueled by a shifting of power over resources from the public to the private sector, is over.

The years ahead will involve a remixing of America's mixed economy - indeed the global mixed economy - toward greater public sector power over resources. Accordingly, secular investment themes founded on America's celebration of capitalism need to be reassessed; and changed. We did this at our Secular Forum, as Bill Gross delightfully detailed in his May/June Investment Outlook. 1 My mission in Asia was to run a customized rotor tiller over the ground that Bill had plowed with his big tractor.

Democratic Capitalism Is Not An Oxymoron
For me, secular analysis starts with the proposition that a mixed economy is the natural order of things: neither the public sector nor the private sector is inherently good or bad. Yes, they compete for power over resources, with long secular shifts in power between the two. But most fundamentally, the public sector and the private sector need each other.

Property rights are the nexus between the two: only the public sector, through the political process, can define and enforce property rights, and without property rights, the private sector could not pursue capitalism. The most valuable asset that "we the people" own is our collective decision, through the political process, to govern ourselves through the "rule of law." It cannot be privatized. Yes, private sector tribunals of all sorts can exist. But the "rule of law" itself cannot be privatized. Its value as an organizing tenet of capitalism depends elementally on our collective, political decision to function as "we the people" in defining property rights, the quintessence of the "rule of law."

Time For CEOs To Issue Rich Stock To Paydown Dear Debt
Figure 1 is a line graph that shows the spreads of S&P 500 earnings yield and BBB corporate bonds to the 10-year U.S. Treasury bond, from 1990 to early 2002. Spreads of BBB corporates over Treasuries, scaled on the left-hand vertical axis, trend upward to their highest peak on the graph by early 2002, at around 275 basis points, up from a chart-low of around 75 in mid 1997. The chart shows those spreads trading since 2000 above their average of 144, shown by a solid horizontal blue line. By contrast, spreads of equity yields over Treasuries, scaled on the right, are around negative 300 basis points in early 2002, down from a recent peak of around negative 100 in early 2001. The two sets of spreads, when superimposed, show they tend to trade inversely to one another. When one is low the other is high, and vice versa.
Figure 1
Source: Bloomberg, Lehman Brothers Index Group

Here in the United States, the political process we chose for ourselves, as "we the people," is democracy, founded on the principle of one person, one vote. In contrast, capitalism is founded on the principle of one dollar (monetary unit), one vote. Thus, democracy and capitalism are in inherent conflict, with the conflict resolved via the "rule of law." It's a messy co-existence of systems, which Churchill mused was the worst possible arrangement, except for all others! Churchill was right.

Democracy and capitalism need each other, and the competing needs of the two systems set the stage for secular shifts in the power relationship between the two. Democracy celebrates the power of the individual, giving each the same vote, which begets populist, re-distributive proclivities. Capitalism celebrates the power of money, which is not distributed equally, begetting anti-populist, boom-bust pathologies. Put differently, democracy promotes fairness in the distribution of the economic pie, while capitalism promotes growth in the economic pie. The interaction between the public and private sectors in a framework of "democratic capitalism" is about the pursuit of the fairest, biggest pie.

President Bush calls that pursuit "compassionate conservatism," which could also be nicely, and alliteratively called "compassionate capitalism." I call the same pursuit "principled populism," which could also be called "populist capitalism." 2 Regardless of the label, a never-ending power struggle between the private sector and the public sector is an inherent feature of capitalism in a democracy. Secular forecasting demands anticipating structural change in that power struggle.

Capitalism's Ascendancy
For the last twenty years, and particularly for the last ten years, capitalism has been winning the power struggle.

  • Monetary authorities solidified their political independence, adopting implicit and explicit inflation targets, while tuning their cyclical reaction functions to "market signals." Put differently, central banks, notably the Fed, surrendered a portion of their autonomy to the bond and currency market "vigilantes," who celebrate falling inflation and "demand" monetary tightening on risk of rising inflation, so as to preempt rising inflation itself. It was all a bit disingenuous, of course, as markets "demanding" Fed tightening may not be demanding anything at all, but rather simply "discounting" Fed tightening. But the illusion of the Fed being led 'round by the nose by market "vigilantes" reinforced the ethos of a power shift from the public sector to the private sector.

  • Fiscal authorities surrendered responsibility for cyclical aggregate demand stabilization to the monetary authority, shifting their focus to increasing secular aggregate supply "potential." Keynesian-style levering of the public sector balance sheet in periods of weak aggregate demand became a sin, while Gordon Gecko-style levering of the private sector balance sheet became a virtue. Public deficits would no longer "crowd out" private sector investment, presumed to be always more productivity-enhancing than public investment; public surpluses would be pursued to "crowd in" private sector investment!

  • Regulatory authorities surrendered much of their autonomy to the power and putative wisdom of markets, including the presumed ability of market participants to police themselves from self-dealing and avarice. Explicit deregulation was the cause celebre in domestic markets, and reduction of both tariff and non-tariff barriers to exploiting the "law" of comparative advantage became the cause celebre in global markets. Markets, not bureaucrats, would be the grease lubricating economic progress.

Making Money On Capitalism's Ascendancy
The secular investment implications of this three-pronged shift in power from the public sector to the private sector were really quite straightforward. First and foremost, a celebration of capitalism was inherently a disinflationary force, because capitalism is about creative destruction: extraordinary profits through technology and pricing power are but transitory, as falling barriers to competition (entry) attract entrepreneurial capital that competes away extraordinary profits. Put differently, entrepreneurial capitalism has a nasty (or is that delicious?) habit of "commoditizing" all manner of economic activity, and history teaches that commodities secularly deflate. Thus, a party in celebration of capitalism, which post-Cold War America in the 1990s was all about, was inherently disinflationary, particularly when reinforced by a Federal Reserve listening to the private sector's capital market "vigilantes."

At the highest level, the associated investment theme for asset allocation was to sell tangible assets into financial assets, as falling inflation would lift valuation for all things financial. At the next level down, the investment theme was to overweight stocks versus bonds. Falling inflation would be good for both assets, but since stocks are a call option on capitalism's upside, while bonds are an upside-limited legal contract between borrowers and lenders, stocks would be the drink of choice at the here-comes-capitalism party.

At the level of investment themes for bond portfolios, the associated implications were to run neutral-to-long duration versus benchmarks, and neutral-to-short credit risk versus benchmarks. The long-duration risk call was obvious; of course, as inflation would, like gravity, pull down nominal (default-free) interest rates and yields. The short-credit risk call was less obvious to most (but not here at PIMCO!), as "crowding in" of capitalism would inevitably involve "crowding in" of private sector default risk, as the public sector de-levered and the private sector levered up.

In the most extreme case, capitalists running on hubris were issuing debt to retire stock, so as to gear the upside to remaining stock holders (or themselves, in the case of capitalist leaders feeding at the call option trough). It was not a time to take credit risk greater than benchmark, but less, on the simple proposition that bad loans are made in good times, particularly when good times are fueled by the hubris of capitalists.

A related global investment theme under the let's-celebrate-capitalism secular umbrella was to be neutral-to-long the dollar versus benchmarks: if the capitalist party was originating in America and stocks were going to be the drink of choice, then global investors would have to pay the cover charge in dollars to enter the saloon. Yet another related investment theme for the 1990s was to expect that the party would end not with a whimper but a bubble, and then a bust. Secular shifts in the power relationship between the public sector and the private sector tend to reverse only when the sector in ascendancy has overplayed its hand, setting the stage for the sector in decline to reassert its power.

The Invisible Hand Collides With The Visible Hand
As Bill cogently explained in his Investment Outlook (why is it that he can say in one word what always takes me two!?!), PIMCO's investment professionals concluded at our Forum that just such a secular hand-off in power lies on the horizon: the invisible hand of capitalism will be re-fettered with the visible hand of government power.

  • The Fed is no longer listening to the bond and currency market vigilantes, who congenitally applaud disinflationary/deflation monetary policy, bullishly flattening the yield curve and taking up the dollar. Rather, the Fed is sitting at an "accommodative" 1-3/4% Fed funds rate, notwithstanding a sharp increase in intermediate and long-term yields since last fall, and a sharp fall for the dollar this year. The Fed is doing what only it has the power to do, because it owns a printing press, while the private sector doesn't: the Fed is truncating deflation risk by printing money, a quintessential and necessary function of the Fed on behalf of "we the people."

  • The White House and Congress not only have rediscovered Keynesian aggregate demand management, but are openly practicing it by pro-actively running fiscal deficits. The notion of paying down government debt so as to "crowd in" more private investment via private sector debt creation has been chucked. The increased post-September 11th need for government to spend more for the physical defense of the country is part of the reason, of course, and a very justifiable one: capitalism can make the armaments for defense, but only "we the people" can decide to pay to buy more of them. We have. We also are choosing to devote more private resources to increased security.

    And away from that, fiscal authorities have thrown off the hair shirts that capitalists urged (forced!) upon them during the 1990s, as evidenced by the passage of tax cuts for corporations and a huge bill of subsidies for agriculture A bigger government is no longer deemed to be a problem to be solved, but a solution to the problem of capitalism's hubris and overreach, notably in excess - unprofitable! - business investment.

  • Regulatory authorities are rediscovering the joy of ferreting out capitalism's "market failures" and doing something about them. That is, after all, what regulators do. And capitalism has unfortunately provided a buffet for feasting: lax corporate governance that offends democratic sensibilities. Enron is the company on the post office's "wanted" wall, but not the only one; indeed, more "wanted" pictures are posted daily, and some of the crooks might just go to jail.

    What democracy does best is to celebrate the individual - remember, one person, one vote! - and when capitalism tramples the individual, "we the people" respond by demanding that our government punish capitalists and their "greed is good" ethos. The compassion in President Bush's compassionate conservatism has become re-regulation and protection from the deflationary ravages of "commoditization" and corporate avarice. And the move to re-regulation extends beyond the nation's shores, as evidenced by Mr. Bush's embrace of tariffs - protection from global deflation! - for the U.S. steel industry. Globalization is now playing defense, and nationalism has got the ball.

Making Money On Democracy's Renaissance
If we are right in our identification of a secular turn (return) of power toward the public sector, and incoming evidence is cumulating mightily in that direction, the core investment themes of the 1990s are no longer "operative," as they used to say in the Nixon White House. Most important, secular disinflation is rapidly approaching its sell-by date. Thus, financial asset returns will no longer be riding a tide of rising valuation.

Earnings and dividends will be what matter for total returns in stocks, and coupons/spreads will be what matter for total returns in bonds. Stocks face a particular challenge, of course, because if stocks were a call option on capitalism's ascendancy, they have become calls on yesterday, not tomorrow; meanwhile, dividend yields - the dominant historical driver of equity total returns - are close to being an oxymoron. Bonds look better as an asset class, but they, too, face a valuation challenge, as a secular turn to rising inflation will ineluctably beget a rise in risk-free yields.

Within the bond asset class, however, euthanasia of crony capitalism in America will be a constructive force for corporate bonds. Once cowboy corporate leaders have reached the cusp of bankruptcy risk, as many have, they must surrender control of the corporation to bond holders - either explicitly in bankruptcy, or implicitly by diluting the stuffing out of shareholders with the issuance of more shares. Either way, corporate leaders must now put the interest of the creditors ahead of shareholders, not because they want to, but because they have no choice. Good loans are indeed made in bad times, because in bad times, contractual obligations legally trump capitalists' hopes, dreams and prayers. On this score, our cover graph showing the relative valuation of corporate equity and corporate debt is the picture that paints a thousand words.

Accordingly, the right secular themes for bond portfolios in the years ahead will be neutral-to-short benchmark duration, and neutral-to-overweight benchmark credit risk. Yes, that's a dramatic reversal of the 1990s, but then, that's what secular turning points are all about. Finally, if the dollar was the cover charge for non-U.S. investors to celebrate capitalism in America, and the cult-of-equity party is over, the dollar is now set for a secular decline. For portfolios, that implies a neutral-to-short dollar position versus benchmarks, the opposite of the 1990s.

Bottom Line
None of these secular shifts in investment themes necessarily imply that investors do anything today, or tomorrow. Secular shifts by definition occur in the context of cyclical exigencies, which shape the prices for secularly oriented portfolio shifts. That said, sometimes it is important to buy and sell at the right price, and sometimes it is important to buy and sell. So, dear reader, if you are still lifting your glass in celebration of the ascendancy of capitalism in our mixed economy, don't just stand there: do something!

Paul A. McCulley
Managing Director
June 6, 2002


1 See "Episode II," Investment Outlook, May/June 2002
2 "Principled Populism," Fed Focus, September 7, 1999.


Past performance is no guarantee of future results. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. The credit quality of the investment in the portfolio does not apply to the stability or safety of the portfolio. Duration is a measure of the portfolios price sensitivity expressed in years. Stocks represent a share in the ownership of a particular company. If the company does well, the value of each share generally goes up. Although common stocks have a history of long-term growth, their prices fluctuate based on changes in a company's financial condition and on the overall market and economic conditions. The value of stocks are more volatile than other types of investments shown and therefore may entail greater risk. Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity.

This article contains the current opinions of the author but not necessarily Pacific Investment Management Company LLC. This article is distributed for educational purposes only and does not represent a recommendation of any particular security, strategy, or investment product. The author's opinions are subject to change without notice.

Pacific Investment Management Company LLC (PIMCO). Copyright 2002 PIMCO.

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