Bill Gross, co-founder and co-CIO of PIMCO, is to my mind one of the shrewdest money men around. His monthly newsletter, this month entitled “The Ring of Fire”, therefore always makes for thought-provoking reading.
The following are a few excerpts from the report:
“In this New Normal environment it is instructive to observe that the operative word is ‘new’ and that the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive. When leveraging and deregulating not only slow down, but move into reverse gear encompassing deleveraging and reregulating, then it pays to look at historical examples where those conditions have prevailed. Two excellent studies provide assistance in that regard – the first, a study of eight centuries of financial crisis by Carmen Reinhart and Kenneth Rogoff titled This Time is Different, and the second, a study by the McKinsey Global Institute speaking to ‘Debt and deleveraging: The global credit bubble and its economic consequences.’
“… banking crises are followed by a deleveraging of the private sector accompanied by a substitution and escalation of government debt, which in turn slows economic growth and (PIMCO’s thesis) lowers returns on investment and financial assets. The most vulnerable countries in 2010 are shown in PIMCO’s chart ‘The Ring of Fire’. These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth.
“What then is an investor to do? If, instead of econometric models founded on the past 30-40 years, an analysis must depend on centuries-old examples of deleveraging economies in the aftermath of a financial crisis, how does one select and then time an investment theme that can be expected to generate outperformance, or what professionals label “alpha?” Carefully and cautiously with regard to timing, I suppose, but rather aggressively in the selection process under the assumption that it’s never “different this time” and that history repeats as well as rhymes. Reinhart and Rogoff’s book, if anything, points to the inescapable conclusion that human nature is the one defining constant in history and that the cycles of greed, fear and their economic consequences paint an indelible landscape for investors to observe. If so, then investors should focus on the following 30,000-foot observations in the selection of global assets:
1. Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy.
2. Invest less risky, fixed income assets in many of these same countries if possible. Because of their reduced liquidity and less developed financial markets, however, most bond money must still look to the ‘old’ as opposed to the new world for returns. It is true as well, that the ‘old’ offer a more favorable environment from the standpoint of property rights and ‘willingness’ to make interest payments under duress. Therefore, see #3 below.
3. Interest rate trends in developed markets may not follow the same historical conditions observed during the recent Great Moderation. The downward path of yields for many G-7 economies was remarkably similar over the past several decades with exception for the West German/East German amalgamation and the Japanese experience which still places their yields in relative isolation. Should an investor expect a similarly correlated upward wave in future years? Not as much. Not only have credit default expectations begun to widen sovereign spreads, but initial condition debt levels … will be important as they influence inflation and real interest rates in respective countries in future years. Each of several distinct developed economy bond markets presents interesting aspects that bear watching: 1) Japan with its aging demographics and need for external financing, 2) the US with its large deficits and exploding entitlements, 3) Euroland with its disparate members – Germany the extreme saver and productive producer, Spain and Greece with their excessive reliance on debt and 4) the UK, with the highest debt levels and a finance-oriented economy – exposed like London to the cold dark winter nights of deleveraging.
“The last decade – the ‘aughts’ – were remarkable in a number of areas: jobless recoveries in major economies, negative equity returns in US and other developed markets, and of course the financial crisis and its aftermath. If an investment manager and an investment management firm proved to be good stewards of capital markets during the turbulent but vapid ‘aughts’, they may be granted a license to navigate the rapids of the “teens,” a decade likely to be fed by the melting snows of debt deleveraging, offering life for unlevered emerging and developed economies, but risk and uncertainty for those overfed on a diet of financed-based consumption. Beware the ring of fire!”
Click here for the full article.
Source: Bill Gross, PIMCO – Investment Outlook, February 2010.
