Bill Gross Investment Outlook Mar_05

8/14/2019 Bill Gross Investment Outlook Mar_05

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InvestmentOutlook BillGross

March 20

Ive Got to Admit Its Getting BetterGetting Better All the Time

I have been since early childhood, andremained, through most of my maturingadulthood, a boy who could do betterthan that. My mother, whose soul nowrests, dreamed things for me that allmothers dream except she was not somuch a dreamer as a dream weaver andas events eventually unfolded, a Bond-King maker, whose demands for excel-lence pointed me in the direction of myultimate career. The Gross goslings wereexpected to perform at the peak of theircapabilities, and when they did not, wewould hear some very loud honks fromMother Goose. I can remember enduringher criticism even into my late 20s whenpolitely asking her to dance at a localdinner club. After only a few steps on the

oor she counseled, Bill, you can do bet-ter than that. She was right but I had nointention of mimicking Arthur Murrayso we quickly sat down to our salads inorder to control my frustration. I was herson who was going to do very, very well, but not so well it seemed that I couldntdo better than that.

Looking back on those years it is truethat I wish there had been a little moresugar in my childhood Kool-Aid butthen, how could I possibly complainabout the nal brew. As a matter of fact, todays parents (including myself)could learn a lesson or two from hergenerations style of both psychic andmaterial deprivation. I view her de-manding demeanor now as but a smallexpense that returned a much largerreward. If the price be that emotionallyI sometimes continue to view my own behavior critically, the blessing comesmost certainly from my family and theopportunities I can afford them andothers outside my family circle, as wellas a now intellectual acceptance that Ihave done what I set out to do. I recallan early visit by my parents to SouthernCalifornia after just having started a jobat the edgling Paci c Investment Man-agement Company in 1972. Mom, Itold her, someday Im going to becomethe best bond manager in the world. Eyebrows were raised without a return


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comment of encouragement, but thenwhile she didnt know a thing about bonds, she knew a lot about me, and Inow suspect she thought I had a chance

whatever it was that bond managersdid. A few years ago when I returnedto the Mausoleum where both of myparents are interred I had a one-wayghostly conversation with them, and atsome point during my silent soliloquy I

nally broke the decadesold emotionalumbilical cord by saying, you know

Mom, I cant do any better than this.I think instead of raised eyebrows shemust have been nodding in mutualagreement. While not at the end of theline, I had reached a destination fromwhich I could go no further or do bet-ter than that.

Who would have thought the bondmarket could have done better thanthat better, that is, than what ittypically does during periods of risingshort-term rates? Not yours truly, norAlan Greenspan who calls it a conun-drum a word with less impact thanirrational exuberance but fraughtwith signi cance nonetheless if only because it acknowledges mysti cation by a man who is supposed to have a lotof the answers. The fact is that since theFed has raised the overnight rate from

1% to 2 % (with market expectationsfor more), the 5-year Treasury (a proxyfor the market as a whole) has declined by 15 basis points. Long bonds and 10-

years have done even better, dropping75 and 50 basis points, respectively.Greenspan and Gross as well as theentire A-Z list of bond managers knowthat while typically the yield curve

attens as the Fed marches upward, itdoes so by intermediate and long yieldsgoing up less than short rates. What

they call bull atteners (long rates go-ing down) are as rare as Ahi tuna thatnever hits the grill. How then to explainit, and is there an irrationality to thismarket that speaks to overvaluation orperhaps even a bubble?

I must tell you that we at PIMCO

have been talking about this topic formonths. We, too, have been befuddledand have been forced to readjust expec-tations and examine new evidence inlight of a transformed global economy.Our conclusions, reached some days before Greenspans testimony, are out-lined in a summary memo I addressedto our Investment Committee on Febru-ary 17th. I submit it to you in its entirety with only minor modi cations andadditions (primarily in the graphs that follow).


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To: Investment CommitteeFrom: Bill GrossSent: Thursday, February 17, 2005 12:29 PMSubject: macro/portfolio management thoughts

Speci c to recent discussions which have been spiced by Greenspans testi-mony I believe our Committee believes that the conundrum is due in part toa recycling of the U.S. trade de cit back into the U.S. bond market whether itbe Treasuries, Agencies, mortgages, or corporates. In effect, U.S. overcon-sumption is being recycled nearly one for one back into the bond market asopposed to direct investment or investments in stocks, producing arti ciallylow yields of indeterminate magnitude perhaps 50-100 basis points butunclear. Chart 1 graphically demonstrates the growing shortage of Treasuriesavailable to domestic investors despite the burgeoning budget de cit. It isthis shortage, as well as similarly reduced supplies of other mortgage andcorporate bonds that have lowered yields when they normally move the other way. Due to global arbitrage and currency/portfolio diversi cation require-ments by Asian central banks, other markets in Euroland, and selective EMGmarkets are in a similar conundrum. In effect, a lack of global investmentopportunities due to a shortfall of global aggregate demand has resulted ina surfeit of savings, which is ooding the global bond markets. The attemptby Asian Central Banks to suppress their own currencies is but a part of thislarger secular phenomenon. A FRENZY TO CAPTURE CARRY HAS BEENTHE INEVITABLE RESULT, PRODUCING ARTIFICIALLY LOW YIELDSOUT THE CURVE, ARTIFICIALLY LOW SPREADS, AND ARTIFICIALLY

LOW VOLATILITY AS PARTICIPANTS ANTICIPATE A CONTINUATIONOF CURRENT TRENDS. In addition, the assumption of a measured Fed,together with an assumed low level for real short rates in future years hasfurther dampened volatility which in turn has helped to atten the curve, ashave changes involving GSEs and the mortgage market. Recently enactedand proposed accounting changes as well as cash ow speci c contributionsfrom the PBGC and others have focused interest at the long end of the curveas well as both here and in Europe.

How to structure portfolios in such an environment which belies the commonbusiness and interest rate cycle?

My proposal, consistent with many others in the IC (although certainly not

unanimous) is as follows:1) In general, do not own nominal notes in 2-10 year paper in countries withaverage or vibrant demographic conditions which are able to in ate their wayout of the global aggregate demand predicament, and which currently price in


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a continuation of todays high savings, low interest rate conundrum. The U.S.is the primary culprit in terms of what we can/do own and its market yieldscurrently qualify as a mispricing. It is also most vulnerable to foreign centralbank diversi cation or buyers strike even if probabilities of the latter are low.

2) Focus on bond market economies that are decaying demographically andthat are de ation pronethus maximizing real returns over time and provid-ing relative price protection as well as comparable carry if possible. Eurolandis the primary candidate, qualifying demographically, structurally, and exhibit-ing comparable carry to the U.S. which soon may move to the plus side asshort rate differentials widen. Japans carry is still de cient although it isbecoming more attractive.

3) Invest in the U.S. in TIPS since in ation in demographically stable econo-mies is a natural result of low real interest rates and the asset in ation whichit produces. A continuing declining dollar reinforces this view as a strong

EURO and YEN add to the positives in #2 above.4) Seek cash/low duration as a haven in all markets but in the U.S. speci -cally if and when yields begin to approach the level of the bond marketitself. Eurodollar reds are beginning to qualify even under our low real rateassumptions for the FED.

5) Be mindful of Asset Liability Management (ALM) trends which may forcemoney into markets with limited supply. While Euroland has more exiblesupply conditions, its ALM trends are more advanced and some of the sup-ply may be priced into the current curve. Although U.S. supply is severelyconstrained (20-year TIPS being the only new issue) it is also subject to aTreasury Department policy reversal. Im not clear on which long end is more

attractive but would be open to either.6) Be alert to developments which may reverse this perfect Goldilocksenvironment and anything that would affect the trade de cit or induce volatil-ity back into the marketgeopolitical, LTCM look-alikes, trade legislation,dollar crisis, oil. Analyze too, if the current trend continues, whether existingyield levels could go even lower. I do not believe they will however due to theclimbing level of short rates and their forward curve counterparts which arebecoming increasingly attractive.

The above considerations produce the following portfolio structures:

A) We should lower overall durations to the point of at carry to our bogies.

Where that is Im not sure but the idea re ects the view that while we arenot sure when the conundrum will reverse, we want to protect ourselvesagainst it as long as our portfolios can wait it out without sacri cing yield. Iwouldnt be concerned about a duration as much as 1 year lower than indi-ces if carry equaled the index.

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B) Foreign orientation0.5 to 1.0 years duration, perhaps as much as 30%of typical portfolio holdings.

C) Front-end duration focus if forward yields are attractive compared to 5s

and 10s.D) TIPSoverweight.

E) Slightly lower than index weighting of long duration assets to protectagainst ALM trends.

F) Vol sales at wings even at existing low levels.

G) Long-term Munis at 97%+ of Treasury counterpart yields.

H) Low mortgage and corporate concentrations.

This portfolio is a different one for us so I will need to solicit comments.

WHG

Fewer Treasurysfor Domestic Investors B

i l l i o n s o f D o l l a r s

4000

3000

2000

1000

1985 1990 1995 2000 2005

Outstanding Stock of Treasurys

Less Foreign & Fed Holdings

Source: BCA Research 2005

Bond Market Tsunami

Chart 1


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Net Purchases of All U.S. Securities by All Foreign Countries12 Month Rolling Sum

-100

0

100

200

300

400

500

600

700

800

900

1,000

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

B i l l i o n s o f D o l l a r s

Source: Department of the Treasury International Capital (TIC) Reporting System

Bianco Research, L.L.C. 2005

Chart 2

In light of our rationale, which attemptsto explain the great conundrum, aninterested reader might wonder why ourdurations and overall strategy appearso defensive. After all, if foreign central

banks and others continue to absorb70%+ of the bond markets new supply(900 billion out of an estimated 1.3 tril-lion in 2004), why wouldnt this squeez-ing out of domestic investors continueunabated, with yields continuing tomove lower? The insensitivity to price/yield exhibited by Asian central banks

in an effort to cap their own currenciesmight seem just as illogical 50 basispoints lower as it does right now. And if the lack of global aggregate demand re-

ected in a surfeit of savings is really the

primary cause, the malady is not likelyto improve for years. Point granted. Wemight be at the mercy of a bond markettsunami here, whose rst wave hasstruck and is now receding, only to be

followed by more of the same in a fewshort months. This possibility is part of any interest rate guessing game exceptit is complicated in this new instance by buyers who have non-interest rate con-cerns. Still, there are limits. Why woulda central bank buy 10-year Treasurypaper below 4% if it expected 3-month

Treasury Bills to be yielding 3 % by theend of the year? It could cap its currency just as easily by going the short maturityroute without risking future price losses.And for those institutional foreign bond

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holders, and the hedgies domiciled inthe Caymans, theres no doubt too that ahigher and higher short rate reduces andin some cases eliminates carry, leading

to collapsed positions and ultimatelyhigher yields further out on the curve.

So the road, as most roads do, ultimatelywinds back to the central banker con-trolling the worlds reserve currency Alan Greenspan. While he may havelegitimate questions about why yields

are so low in the face of rising FedFunds, he indeed sits on a throne higherthan his global counterparts. If he wantsthe 10-year Treasury at 4 %, he should just wave that Fed Funds scepter at afew more meetings, and therell be no bull bond market tsunami. Four percent

is the oor for 10-year Treasury notesin my view. Its time to get defensive aslong as your portfolio carries enoughyield to outlast the wave of global

savings and price-insensitive central bankers who have dominated the cycleto this point. Because of them, a bearmarket may not be in the of ng for sometime, but Greenspans Fed Funds sceptershould be enough to stop the current bull market charge. If it doesnt, you canwrite and say I should have known bet-

ter than that, but it wont bother me asmuch as it used to.

William H. GrossManaging Director


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840 Newport Center D

Newport Beach, CA 9

949.720

Past performance is no guarantee of future results. This article contains the current opinions of the author and suchopinions are subject to change without notice. This article has been distributed for informational purposes only and is not arecommendation or offer of any particular security, strategy or investment product. Information contained herein has beenobtained from sources believed to be reliable, but not guaranteed.

Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time.The guarantee on Treasuries, TIPS and Government Bonds is to the timely repayment of principal and interest, shares of aportfolio that invest in them are not guaranteed. Mortgage-backed securities are subject prepayment risk. With corporatebonds there is no assurance that issuers will meet their obligations. Investing in non-U.S. securities may entail risk as aresult of non-U.S. economic and political developments, which may be enhanced when investing in emerging markets.

No part of this article may be reproduced in any form, o r referred to in any other publication, without express writtenpermission of Paci c Investment Management Company LLC. 2005, PIMCO. IO035-022305

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Bill Gross Investment Outlook Mar_05