Sunday, March 28, 2010

Bill Gross Says Bonds Have Seen Their Best Days

But First He Recommends Some Bonds

In his April 2010 letter PIMCO’s Bill Gross advised how to select among the bonds of sovereign issuers. Then he turned around and said in a radio interview that bonds have seen their best days. Not only did he advise both for and against bonds, but his bond allocation consisted of nothing more than a set of binary choices dependent on so many unknowns as to make the advice useless. If you’re still interested, here is a summary of what Gross had to say.

Sovereign Debt Classification

Because of the rising risk of default (and related debt problems), Gross says that the main objective in fixed income investing should be capital preservation. Sovereign debt of developed nations is usually a good place to be for preservation, but the problem today is that the governments of developed nations still need to substitute for their private sectors. This means that they will all need to continue creating debt, but not all can do this without falling into a debt crisis. Gross used a series of two sieves to classify countries into tiers according to their capability to take on more debt:

Sieve #1

The first sieve assesses whether a country has the ability to escape a debt crisis by creating even more debt. Gross condensed this issue into three questions:

1. Can a country issue its own currency and is it acceptable in global commerce?

2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?

3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

Not surprisingly, Gross answered all of these questions in the negative for Greece, and he suggested that the answers are mostly negative for the other Southern European debtors. More surprisingly, he answered in the positive for the United Kingdom, which he expects to avoid a debt crisis, despite the nation being on PIMCO’s “don’t invest” list.

Sieve #2

Even if a nation seems likely to avoid a near-term debt crisis and passes the first sieve, it may not necessarily be a good investment candidate, because it may yet issue so much debt as to produce inflation and a depreciating currency. This would obviously reduce the return on the nation’s bonds and could in a severe case cause it to fall into a debt trap. Gross classifies the UK in this group.

In contrast, Gross passed the US on both sieves, albeit only conditionally on the second. He suggested that the US debt load may be manageable because of its favorable demographics and growth potential, but that the situation merits close monitoring. His concern is that Treasury issuance may in the future grow to the point that it overwhelms demand, given that “the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt.”

Where Gross Advises Investing

As his allocation strategy, Gross would restrict investments to the sovereign debt of countries that pass these tests – escape a debt trap, reflate their economies, and suffer no severe consequences like runaway inflation or currency devaluation. He included investments in both the front end and back end of the yield curve (short or long maturity) depending on whether the nation seems likely to experience reflation or debt deflation.

Specifically, he advised front end investments in countries like the US and Brazil that are likely to experience successful reflation, and back end investments in countries like Germany and “core Europe” that can withstand potential debt deflation. Elsewhere, Gross has been recommending the debt of countries such as Germany and Canada that have low deficits.

Another consideration is the risk of rising interest rates as quantitative easing is eventually reversed and the world economy reflates. Whenever this happens (no telling when), Gross believes that the prudent way of boosting yield will be by sacrificing credit quality rather than by extending duration.

So Long and Thanks for All the Fish

Gross added one caveat: The validity of his recommended strategy depends on the continuing stability of the world economic and financial system. “Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.”  (Italics mine.)

In other words, if you buy the recommended foreign securities and the world recovers (save for a few smaller countries, I suppose), you have a chance of surviving with your scalp still attached. If you buy the recommended foreign securities and the world falls apart, that’s just too bad because you should have kept your portfolio exclusively in long Treasuries. How nice of Gross to provide us with a strategy whose execution depends on the binary outcome of an uncertain future event, “global contagion is contained”. Thanks for all the deep insights, Bill.

No wonder the performance of the Total Return Fund was only at the 54-th percentile last year.

Bonds Have Seen Their Best Days

Given that Gross has just written a letter advising a fixed income investing strategy, you might think that he is bullish on bonds. You might also be mistaken, because Gross said in a March 26 Bloomberg radio interview that “bonds have seen their best days.” A rising interest rate environment is an “argument to not own as many” bonds.

He added that the U.S., Japan, and other nations will have to sell record amounts of bonds, which will eventually lead to inflation. Although Gross did not specify the timing, it looks like the three decade long bond bull really is ending -- sometime.

No wonder PIMCO has been moving into equity investing.

PIMCO’s Advice to “De-Risk”

In the April edition of his US Credit Perspectives PIMCO Managing Director Mark Kiesel provided a perspective that somewhat unifies these seemingly disparate viewpoints into a more coherent, near-term strategy: De-risk fixed income portfolios by upgrading credit quality.

The rationale for this advice was a combination of both short-term and long term risks.  In the short term, the current support of the world economy through accommodative fiscal and monetary policies seems  likely to end, as the developed nations unwind their stimulus programs and face the prospect of fiscal tightening.  In the case of the US, for example, policy support of the economy “will likely fade” in the second half of 2010.   The long-term risk is the growing government debt loads of the developed nations.

Because spreads are currently tight between high and low credit quality bonds, this provides an opportunity to upgrade:  “As a result, investors should take advantage of the tighter credit spreads and focus on de-risking their portfolios in order to prepare for the increasing long-term secular headwinds stemming from the growing deterioration in public sector balance sheets in many developed economies.”

At least Kiesel's message lies somewhere in a reasonably risk-sensitive middle ground somewhere between the rhetorical extremes in Gross's various messages.

Sunday, March 14, 2010

Mohammed El Erian on the Likelihood of a Chaotic Outcome

Mohammed El Erian's recent article in the Financial Times, "How to Handle the Sovereign Debt Explosion", may offer us a glimpse into the PIMCO CEO's thinking about the outcome of the debt crisis. He makes six points, which individually seem totally obvious. When you get to the sixth point, however, you get a definite picture of his thinking about the general nature of the outcome.

Point 1. The current financial crisis is best stated as a generalized deteriorization in the balance sheets of nations throughout the developed world.

No surprise here.

Point 2. The deterioration of public finances is reducing the relevance of "conventional classifications," such as the difference between advanced and emerging economies.

No surprise here. A growing number of the former now have poorer economic and financial prospects than a growing number of the latter.

Point 3. The advanced countries will adjust somehow, but the real questions are whether the adjustment will be orderly or disorderly, its timing and collateral impact.

Yes, we really would like to know that! 

The orderly option is a " combination of growth and a willingness on the part of the private sector to maintain and extend holdings of government debt". This will be difficult because of "high unemployment, muted growth dynamics, persistently large deficits and regulatory uncertainty".

He says something else here that seems totally obvious but will become more relevant when we get to Point 6. "Countries will thus be forced to make difficult decisions relating to higher taxation and lower spending. If these do not materialise on a timely basis, the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation."  Italics are mine.

Point 4. Governments will impose solutions by diverting resources internally. Because all advanced countries are in trouble, solutions that depend on other countries will be scarce.

If they can't grow their way out of the crisis, governments have to reduce spending and/or raise taxes. Reducing spending won't be easy, because constituencies will be bitterly disappointed at the loss of entitlements, deteriorating services, long-term unemployment, and other results of austerity. Raising taxes will bring conflict with the rich, put another burden on the middle class, and discourage business.  Given the partisan standoff in Congress, it will not be easy to do any of this in the U.S.

Point 5. For the same reason, any government's attempt at getting its own fiscal house in order will be complicated by the actions of other countries.

El Erian does not elaborate, but examples could be competition in the bond markets, trade barriers, currency devaluation, or stresses in organizations like the EU.

Point 6. The deterioration in the finances of the major advanced countries is "not sufficiently well recognized." Further, "We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors."

I don't know if the problem is really "not sufficiently well recognized." Other than that, it is hard to disagree with him, because governments are hardly accustomed to dealing decisively with novel situations until disaster is upon them.

Even if the problem is recognized in a timely fashion, "history suggests that it is not easy for companies and governments to overcome the tyranny of backward-looking internal commitments." This is another good point, because entitlements, partisanship, special interests, and the complexity of modern society all act to deflect any government actions, let alone one that is sufficiently extreme to be effective.

Uptake. Point 6 seems to be the crux of El Erian's argument. As he said in Point 3, if decisions are not made in a timely fashion, "the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation." Given Point 6, he does not expect timely decisions, which suggests a good chance of a chaotic outcome -- inflating out of debt, default, and confiscation.

If we want to survive the financial crisis and maybe even prosper, we need a mental framework that will help us think about the world realistically and productively. Maybe El Erian's framework seems totally obvious to you, or maybe you disagree with it.  I think that we need to consider strategies to cope with possible chaotic outcomes like inflating out of debt, default, and confiscation.