PIMCO - Investment Outlook- June/July 2006 "Mission Impossible?

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Investment Outlook
Bill Gross | June/July 2006

Mission Impossible?

Good morning Secular Forum participants. The global economy appears strong with low inflation. Equity
markets and commodities are soaring. Still, your self-described “stable disequilibrium” appears vulnerable to
policy transitions attempting to rectify growing global imbalances. Your mission, should you choose to accept it,
is to forecast economic and then financial trends for the next three to five years and outperform the competition
with less volatility. This tape (and maybe the markets) will self-destruct in 10 seconds.

Dah dah da-dah, dah dah da-dah…da-da-dah-dah…DA-DAH!

I’m prone to exaggeration and always looking for a good theme for an Investment Outlook, but that’s
actually sort of how I remember the beginning of PIMCO’s most recent Secular Forum held in our
Newport Beach home office in early May. We didn’t pipe in the “Mission Impossible” theme song and
there were no Tom Cruise cameos, but still, after accepting the assignment, all 275 of us recognized
that the next few years might present challenges bordering on the impossible. Guest speakers
including Charles Gave, Clyde Prestowitz, Mark Gertler, and Alan Krueger alerted us to the changing
policies of global central banks and the huge question marks surrounding the pace and final
destination of monetary tightening. Our own internal research totaling nearly 900 graphs and
weighing, in “term paper” parlance, almost three pounds, pointed to demographic, geopolitical, and
populist currents which almost certainly would affect global economies and their financial markets –
but how and in what magnitude? See what I mean? This Secular Forum was no easy assignment,
nor is its summary. Not to worry though. Sit back in that cushy theater seat of yours, start munching
on some popcorn, and prepare to enjoy and hopefully profit from PIMCO’s 2006 production. As you
can see, I’m lighting the fuse…our mission is about to begin.

Secular Review and Current Update

PIMCO’s secular economic forecasts in recent years have emphasized globalization, technological
innovation, and what we chose to label as a lack of global aggregate demand. In combination, these
three forces we claimed would produce moderate disinflationary growth that would lead to benign
and ultimately bullish movements in global bond markets. 3 - 4½% was our future range for 10-year
Treasuries with slightly lower yields on Euroland bonds due to their structural unemployment
problems and growth-inhibiting demographics. Improvement in the Japanese economy was
somewhere way off on the horizon, playing on another screen I suppose, and therefore their
overnight rates would remain near 0%. Well, something funny happened on the way to the Forum or
perhaps the theater in metaphorical terms. Global inflation has remained low, but the combination of
U.S. consumption propelled by a multi-year housing boom, Chinese reciprocation in the form of
massive investment spending, and the positive knock on effects in Japan and numerous “emerging”
economies produced surging global growth that has caused central banks and indeed private
investors to enforce higher real yields as recompense. 5.20% 10-year Treasuries are sort of outside
of our forecasted range, wouldn’t you say? “My bad” – to use Generation Y jargon.

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Our benign forecast, as previously mentioned was predicated on the maintenance of a global “stable
disequilibrium” which seemed somewhat securely balanced due to a dearth of global aggregate
demand and the compensating mechanism of what was labeled Bretton Woods II – a recycling of
BRIC and OPEC reserves into global bond markets as a safe haven insurance policy against
another late 1990s Asian currency crisis. Whew! This scriptwriter needs to think about shorter
sentences or else the audience will head for the exits.

The thought was this: the center of global production was drifting towards a high savings rate region
– Asia. The resultant “savings glut,” to use Bernanke’s term, would be recirculated into U.S. and
Euroland bond markets to build up “insurance” reserves but also to place a ceiling on domestic
currency appreciation. China was seen as the main culprit but even Japan was involved in this game
of competitive “real” devaluation. The deal was a win-win for all parties. Asia got to grow their
domestic economies, Japan got to emerge from years of deflation, and the U.S. got to import cheap
goods and cheap money in order to stoke their housing/asset markets. Euroland prospered as well.

Although the “stability” produced many inherent disequilibriums including the U.S. consuming 80% of
the world’s excess savings reflected in an $800 billion current account deficit, there seemed nothing
impossible about this mission, I suppose. And there’s nothing improbable about its continuing either
until China/Japan are in closer proximity to their destinations – China to eventually have a self-
sustaining, internally demand balanced economy and Japan to have permanently exorcised the D
word from its lexicon.

Still, the strong growth that this cozy arrangement has engendered is by itself threatening its own
sustainability in current form. Having encountered mild but accelerating inflation, Japan, the ECB,
and perhaps still our own Fed are embarked on a path of uncertain interest rate hikes, which
pressure U.S. yields, which threaten the housing boom, which augurs for slowing consumption,
which more than likely will then negatively impact Asia and Euroland economies. Talk about
dominoes! In addition, as Alan Greenspan warned us just a few months ago, BRIC and BRIC-like
nations at some point will reach saturation or perhaps satisfaction levels in terms of their U.S.
Treasury and even global bond holdings. Real asset purchases or internal investment may then
dominate at the margin. China’s recently announced 5-year internal growth plan and the past few
months’ accelerating commodity prices at the hands of unknown buyers may be a reflection of such
saturation. So Asia’s strong growth and the U.S.’s, Euroland’s, and Japan’s cheap money are not
perpetual givens. Bretton Woods II may be morphing into Bretton Woods III. In addition, global
corporate savings excesses, themselves a potential factor in last year’s conundrum of lower bond
yields are likely to diminish at the margin as capitalism’s animal spirits are rejuvenated and
investment spending absorbs some excess.

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For now though, the strong global growth and the break in Bretton Woods II reserve flows have
primarily been responsible for a half reversal of the “conundrum” which perhaps artificially lowered
yields by as much as 100 basis points after 2002. This giveback has left us with 5.20% 10-year
Treasuries, 4.10% 10-year Bunds, and JGBs heading north towards a 2 handle. In addition, risk
markets dependent on robust, nay “steadily” robust global growth have prospered. Risk spreads and
volatility levels inherent in those spreads are in many cases near historic lows and financial leverage
is at historic highs. It appears that these markets expect that we will not only have strong growth but
benignly strong growth for as far as the eye can see. Perhaps Mr. Cruise can relax and take a seat
with the rest of you viewers and enjoy the rest of his own movie.

What’s New?
Well not so fast Tom, or you Forum Cruise “act-alikes” (I use the term figuratively – we don’t allow
tantrums and sofa stomping on the premises): this mission you have accepted has only just begun.
The fact is that this mild reversal of yields embodied in 2005’s “conundrum” is just one of many
changes that may threaten the current stable disequilibrium that appears so attractive to investors
and capitalistic interests. One of the dominant features of stable disequilibrium was in retrospect the
“disequilibrium” of central bank policy rates. The Fed, the ECB, and the BOJ held short rates at
negative real or 0% yields for some time and the stimulative effects on asset prices and
growth are still part of the current environment. To the extent that they are now moving closer
to historical Taylor Rule norms, the move towards equilibrium may in fact be destabilizing if
done too quickly or moved towards restrictive territory. We at PIMCO are of the persuasion that
the “Yen carry trade” embodied in 0% borrowing rates by Japanese individual and global institutional
investors has been a significant factor in the compression of yields and risk spreads in almost all
financial markets. As their 0% rate morphs now into something higher, financial markets will feel the
impact. And as speaker Charles Gave pointed out, an economy dependent on asset appreciation
which in turn is dependent on low yields, is more vulnerable than one based on income. That
certainly is descriptive of the U.S. asset based “pump” economy described in last year’s Secular
Outlook review which embodies increasing amounts of leverage primarily in the household and
financial sectors of the economy. Gave went further to suggest that changes in any one of the
following five areas have historically had long-term influences on asset prices: 1) monetary policy, 2)
protectionism, 3) taxes, 4) regulation, and 5) war.

If the first of Gave’s five policy changes is now in play as described in preceding paragraphs, there is
little doubt that the second – protectionism – may be influencing current events as well. Recent U.S.
government decisions involving Dubai “ports” and the attempted purchase of Unocal by Chinese
interests may be just sparklers preceding the primary fireworks embodied in Congressional bills
advanced by Charles Schumer among others. And for those that suggest the U.S. is the potential
villain in a protectionist stampede, reflect on the fact that foreign central banks via their currency
“manipulations” have for years now been engaged in protectionist policies of their own. Long

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standing Treasury attempts to nudge the Chinese off their RMB peg are now evolving into attempts
to include the G7 and IMF as policy influencing bodies reminiscent of the Plaza and Louvre accords
in the 80s.

Those seminal decisions set the U.S. dollar in motion, to say the least, and in recent weeks, we have
experienced some of the same. Our point is that protectionism and reactions to perceived threats of
it are potentially destabilizing events that threaten the current status quo. Yes, the world needs a
cheaper dollar to help rectify the U.S. current account deficit and the excesses of American
consumption. Yes, a cheaper dollar will allow for a decrease in Asian imports and a rebalancing of
our current “disequilibrium.” But prior currency protectionism followed by too swift of a policy reversal
by public policymakers or the inevitable invisible hand of the market, risks asset volatility that is
potentially destabilizing. The outcome depends importantly on decisions made by the Chinese
themselves with regard to their RMB revaluation. In plainer English, watch the pace of dollar
depreciation or periodic re-appreciation if that be the case. Currency volatility can ruin the
global economy’s day, week, or year(s) for that matter.

While space doesn’t permit a detailed elaboration of Gave’s points 3-5, it is important to
acknowledge that risks abound in policy reversals related to existing and future wars, government
regulation, and yes, tax policies. Iraq/Iran with their influence on oil prices is the most obvious
example. In addition, we continue to believe that the next few years will increasingly be affected at
the margin by what Paul McCulley describes as the iron fist of government policies rather than the
invisible hand of a dynamic free enterprise economy. Certainly Bush tax cut policies seem secure
until 2008, but they are at risk thereafter as a potential Democratic Administration and Congress
attempt to rectify existing inequalities with more populist measures. Populist movements are
underway in South America as well reflected in government moves towards energy production
nationalization in Venezuela, Bolivia, and Ecuador. Again, the pace and volatility of geopolitical
disagreements, wars, and reversals of government regulations and policies will potentially be
destabilizing. Movements towards equilibrium in other words, must be telegraphed as much as
possible lest the markets themselves become unstable.

Investment Implications
As our mission statement at the head of this Outlook pointed out, our goal is not just to analyze the
complexities of stable disequilibrium, but to forecast financial markets and outperform the
competition with less volatility. While the preceding analysis was fundamentally necessary, the
following dialogue represents the objective.

It is critical at the outset to acknowledge (perhaps a little too concisely due to brevity
requirements) that we have not shifted our secular forecast from a disinflationary to a
reflationary scenario just yet. The U.S., Europe, and Japan’s potentially inflationary policies
to balance unfunded health and pension liabilities are perhaps a dominant topic for 2008’s
Secular Forum. For now, the continuing influences of globalization, technology advances

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furthering productivity, and asset destabilization policies spoken to in prior paragraphs,

probably will allow global inflation to remain in moderate range bound territory between 1-3%
for most economies. Inflation targeting lies ahead for the U.S. and perhaps Japan which in
combination with those old bond market vigilantes (yours truly for sure) should enforce a non-
threatening tint to overall inflation. We believe as well that sometime within the next several years, a
U.S. recession is likely, due to currency, commodity, and housing related influences. If so, and if the
global economy slows in reaction, then moderate inflation is the most reasonable forecast.

Get the inflation forecast correct, put it together with an accurate real rate analysis, and you’ve got
the basis for a successful portfolio strategy mission, as readers would acknowledge. It’s in the area
of real global rates where we have the most uncertainty, however. Having already acknowledged the
partial reversal of the recent year’s conundrum, it is tempting to go all the way and forecast a return
to real rate normalization. We are reluctant to do so however in the face of a still existing global
savings excess, diminished as it is. Additionally, central banks have been/will likely remain cautious
in their tightening cycles. We have observed that inclination with the sixteen successive 25 basis
point hikes in the U.S. and in the ECB’s still turtle-like approach to higher yields. An aggressive
central bank is likely to strengthen its region’s currency excessively, which is just the opposite of
competitive real devaluation policies now in place. Global real yields then, whether expressed in
spot, or forward curves should stay reasonably low – perhaps 2% on average (lower in Japan)
with an increasingly positive slope over our secular horizon, although curves may be flatter
than normal if central banks remain continually “transparent.” Substituting Bernanke for
Greenspan, however, lends caution to this last thought if only because he has not yet been tested in
a crisis. We shall see.

Combining inflation, real interest rate, and term premium considerations mentioned above we come
to the following range forecasts for the secular timeframe from 2006 until 2010.

As a continuing theme from last year’s forecast, the inherent leverage throughout the global financial
system will at some point pose a danger to risk oriented markets (stocks, high yield and emerging
market debt, CDO structures, and housing prices). Charles Gave claimed that interest rates do not
discipline a financial system – financial crises do. We’re not sure about the first part of that statement
if only to observe that prior financial crises have been correlated to monetary policy tightening, but
there’s little doubt as to the need for some monetary discipline at this point in time. Historically low
risk spreads in all segments of the marketplace reflect a belief that this newly flattened global
economy (tilted now towards Asia as speaker Clyde Prestowitz pointed out) can grow at consistently
high rates without a hitch. The history of capitalism would suggest caution if only because a normally
balanced “creative destruction” environment can tilt as well when over-investment, excessive
leverage, and the emotional responses of market makers and investors accelerate deteriorating
fundamentals. PIMCO in 2006 manages assets across a broad spectrum of risk categories, and
we will continue to do so. To not flavor each of them with a relatively high quality
composition, however, would be irresponsible in light of the low reward/higher risk character
of the global markets, especially those in the United States.

To single out the U.S. in terms of relative overvaluation may seem a year late and perhaps a 25-cent
piece short if we’re talking currencies. Perhaps, although PIMCO has been on the weak dollar
bandwagon for several years now and clients have been amply rewarded. We continue to believe
that the process of rebalancing the disequilibrium observed in excessive U.S. consumption and near
negative savings will require higher incentives to reverse both conditions. Those “incentives,” even if
externally imposed, speak to a weaker dollar and lower relative asset prices in comparison to the
rest of the world. When not countered by cyclical considerations, PIMCO portfolios will likely feature

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increasing international diversification in foreign currency terms.

We recommend as well that clients and other readers continue to diversify their asset mix with a
percentage of commodities. Aren’t they the epitome of the same risk assets we so gravely warned
about a few paragraphs ago? Of course, and a global slowdown/financial unwind will not likely treat
them kindly. Still, we are enveloped in a global dynamic characterized by resource shortages and
resource wars of the civilized and even uncivilized kind. “Buy what China wants to buy before China
buys it” – has been a profitable adage for some time now and commodities still head the list,
although perhaps not on a cyclical short-term basis.

Well, Tom is beaming and has his arms around the girl, so that must mean his mission has
overcome the impossible for the third time now. With PIMCO, of course, we can’t be sure. Our
ratings and perhaps our box office will only become clear over the next several years. Still, what is
not impossible or even improbable is that we at PIMCO will continue to recognize we are most
fortunate to be entrusted with the management of your assets. The responsibility, while heavy, is the
reason we are in business. Thank you. And as to the tape that supposedly self-destructs in 10
seconds? Well, that’s for the movies and cute little Tom to fantasize with. Our tapes and our data
keep goin’ on for years and years and hopefully our relationship with you will as well. For now
though, this movie’s over. See if you can make it to the parking lot to beat the rest of the crowd. Talk
about mission impossible!

Secular Forum Conclusions for the Next 3-5 Years

1) Global growth currently strong, but vulnerable to policy reversals.

2) Global inflation remains benign averaging 1-3%.

3) Global interest rates return partially to “Taylor Rule” norms as the “conundrum” reverses. Still,
government yields remain relatively low, 4-5½% for 10-year Treasuries.

4) Risk assets are at risk due to narrow spreads and the withdrawal of global liquidity. Watch the
BOJ.

5) Dollar based assets and the dollar itself should underperform global alternatives.

William H. Gross
Managing Director

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