Bill Gross Investment Outlook Jun_08

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Investment OutlookBill Gross | June 2008

Hmmmmm?

You can fool some of the people all of the time,and all of the people some of the time,

but you cannot fool all of the people all of the time. Abraham Lincoln

What this country needs is either a good 5 cigar or the reincarnation of an Illinois rail-splitter willing to tell theAmerican people what up what really up. We have for so long now been willing to be entertained ratherthan informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, atface value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that acandidates preacher Democrat or Republican should be a significant factor in how we vote. We care moreabout whos going to be eliminated from this weeks American Idol than the deteriorating quality of ourhealthcare system. Alternative energy discussion takes a bleachers seat to the latest foibles of Lindsay Lohanor Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have

we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcoreideological debate.

Its Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headedfor modern day Rome better educated, harder working, and willing to sacrifice today for a better tomorrow.Can it be any wonder that an estimated 1% of Americas wealth migrates into foreign hands every year? We, asa people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on ageopolitical scale, that our allies are dropping like flies. Yes we can? Well, if so, then the we is the criticalelement, not the leader that will be chosen in November. Lets get off the couch and shape up physically,intellectually, and institutionally and begin to make some informed choices about our future. Lincoln didnt sayit, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, weve beendoing a pretty good job of that for a long time now.

Ill tell you another area where weve been foolin ourselves and thats the belief that inflation is under control. Ilaid out the case three years ago in an Investment Outlook titled, Haute Con Job. I wasnt an inflationary PaulRevere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at thecheckout counter. In the ensuing four years, the debate has been joined by the press and astute authors suchas Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy andhow we got here as an informed American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs one showing the ups and downs of year-over-year price changes for 24 representative foreigncountries, and the other, the same time period for the U.S. An observers immediate take is that there areglaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. Theserepresentative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for thepast decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% numberfor the world but a closer 4% in the U.S.

Page 1 of 5PIMCO - IO June 2008

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The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1)hedonic quality adjustments, 2) calculations of housing costs via owners equivalent rent, and 3) geometricweighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have takenplace over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. Itwas claimed that a measure based on what an owner might get for renting his house would more accuratelyreflect the real world a dubious assumption belied by the experience of the past 10 years during which theaverage cost of homes has appreciated at 3x the annual pace of the substituted owners equivalent rent (OER),and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same

degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflationrate. Product substitution and geometric weighting both presumed that more expensive goods and serviceswould be used less and substituted with their less costly alternatives: more hamburger/less filet mignon whenbeef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s pavingthe way for huge price declines in the cost of computers and other durables. As your new model MAC or PCwas going up in price by a hundred bucks or so, it was actually going down according to CPI calculationsbecause it was twice as powerful. Hmmmmm? Bet your wallet didnt really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually andtherefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI thatwould have been based on the good old fashioned way of calculation. The results are not pretty, but areundisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI chartsare startling, arent they? This in spite of a decade of financed-based, securitized, reflationary policies in theU.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on core as opposed to headline inflation, a concept actuallyinitiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For afew decades the logic of inflations mean reversion drew a fairly tight fit between the two measures, but now in achart shared frequently with PIMCOs Investment Committee by Mohamed El-Erian, the divergence is beginningto raise questions as to whether headline will ever drop below core for a sufficiently long period of time torebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Eriansrecent Secular Outlook summary suggest otherwise.




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The correct measure of inflation matters in a number of areas, not the least of which are social security

payments and wage bargaining adjustments. There is no doubt that an artificially low number favorsgovernment and corporations as opposed to ordinary citizens. But the number is also critical in anyestimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation werereally 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today,because bond investors would require more compensation. And although the Gordon model for thevaluation of stocks and real estate would stress real as opposed to nominal inflation additive yields, todaysacceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields including TIPS are 1% lower than believed. If real yields move higher to compensate, with a constant equityrisk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuationof all three of these investment categories bonds, stocks, and real estate would mean a downwardadjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial realestate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLSwas ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of theworld during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to beentertained with the notion of artificially low inflation than to be seriously informed. But just as many in theglobal economy are refusing to mimic the American-style fixation with superficialities in favor of hard work andlegitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact iscloser to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets areincreasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new globalinvestment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest:1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS,while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On theother hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPIand nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn bedenominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at leastare credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, andthen begin to reorient portfolios for a changing world. Todays world, including its inflation rate, is changing.Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying forchange in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook ) the markets assumptionof low relative U.S. inflation in comparison to our global competitors.

William H. GrossManaging Director




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Bill Gross Investment Outlook Jun_08