Your Global Investment Authority

Investment Outlook
May 2014
Bill Gross
ACHOO !
Teres nothing like a good sneeze;
maybe a hot shower or an ice cream
sandwich, but no nothing else
even comes close. A sneeze is, to be
candid, sort of half erotic, a release
of pressure that feels oh so good
either before or just afer the Achoo!
Te air, along with 100,000 germs, comes shooting out
of your nose faster than a race car at the Indy 500. It feels
sooooo good that people used to sneeze on purpose. Teyd
use snuf and stick it up their nose; the tobacco high and
the resultant nasal explosion being the fashion of the times.
Healthier than some of the stuf people stick up their nose
these days I suppose, but then thats a generational thing.
My generation is closer to the snuf than that other stuf.
One of the problems with sneezing though is that there can be an
embarrassing aftermath. People in the old days used to carry around
handkerchiefs for just that purpose, but now nobody carries a handkerchief.
As a substitute you could walk around all day with toilet paper in your pocket,
but then youd stand accused of being a bumpkin and people would probably
be right. So usually sneezers just let it rip, cover with their hand, and pray
theres nothing visible behind it. If there is, there might be a pocket to wipe
away the evidence, at least for guys like me. Ladies? Their outts are
obviously less sneeze proof. So they need to pray harder.
Speaking of praying, theres just no stopping people from saying God bless
you or bless you for short. If youre in a crowded room with more than
50, the God bless yous sort of create a rather constant cacophony like the
communion line at a Catholic church. The shorter and more frequently used
bless you though, may take the religion out of it somewhat and make it ok
for atheists to sneeze and still get noticed. Actually, way back when, there
was a legitimate purpose for the God bless you part. Lots of people died
from inuenza and associated epidemics and Gods blessing would certainly
2 MAY 2014 | INVESTMENT OUTLOOK
have come in handy. My wife Sue though, is just a bless
you person like many of you readers. I am not, which I hope
is ok, except that it sort of makes it awkward when we both
sneeze at the same time. I get blessed and she doesnt. Not
quite fair I suppose, so sometimes I play along and squeeze
her hand after the Achoo and tell her Im blessed to have
her sneeze or no sneeze. Dont even need a pinch of snuff
to know thats a good move.
The old saying goes that when the U.S. economy sneezes,
the world catches cold. That still seems to be true enough,
although Chinese inuenza is gaining in importance. If both
sneezed at the same time then instead of God bless you
perhaps someone would cry out God have mercy. Were
not there yet, although in this period of high leverage
its important to realize that the price of money and the
servicing cost of that leverage are critical for a healthy
economy. The Great Recession occurred signicantly as a
result of central banks raising the price of credit too high in
the face of households and levered speculators who
eventually could not afford to pay the increasing interest
rate tab. As defaults on U.S. subprime mortgages and high
yield bonds began to mount, lenders not only refused to lend
more but were forced to liquidate levered holdings, producing
a literal run on the Bank of Credit which in the U.S. now
totals an estimated 75-85 trillion dollars.
As the Fed raised short-term rates to 5% in 2004/2006
they were following a historically standard model that
followed the thesis of attening the yield curve, making
credit more expensive, and slowing the economy in order
to moderate ination. The 5% destination was in part
determined by what was and still is known as the Taylor Rule
as well as a rather practical assumption that short-term rates
approaching the rate of nominal GDP growth had usually
been the ultimate destination in a tightening cycle. What the
Fed failed to factor in was the increasing amount of leverage
in the system that could no longer tolerate standard Taylor/
nominal GDP rules of monetary policy.
I bring up this history to illustrate the problem that not only
the Fed but all central banks face in this new epoch of high
leverage. High debt levels dont necessarily change the rules
of nance (you gotta pay to play), but the models upon
which they are based. Interest rates have to be lower in
a levered economy so that debtors can survive, debt
can be reduced as a % of GDP, and economies can avoid
recessions/depressions! In a levered landscape, what is the
magical neutral policy rate that can do all of that? Hard to
know. No wonder the Fed and other central banks stumble
along with QEs and Twists, extended periods of time, magical
blue dots, and other potions and elixirs to try and produce a
favorable outcome.
Despite the uncertainty and the recent importance of
historical models using unemployment as a practical guide,
there has been research that might point to a proximate
neutral fed funds rate. Thomas Laubach and John Williams
working for the Fed Board of governors wrote an early 2003
piece titled Measuring the Natural Rate of Interest. Their
updated model from the San Francisco Fed website suggests
the neutral nominal fed funds rate might be as low as
50 basis points currently and 150 basis points assuming
2% PCE ination in the future. Others, such as Bill Dudley,
President of the New York Fed, gave an important speech in
May of 2012 suggesting a neutral real rate close to 0%
which would imply a 200-basis-point nominal rate if the
Feds ination target was hit. PIMCOs Saumil Parikh in a
March 2013 Asset Allocation Focus concluded that a
100-basis-point or a 1% nominal fed funds rate was long-
term neutral stabilizing ination at 2% and nominal GDP
growth close to 5%.
These estimates are just that approximations of a neutral
policy rate in a New Normal economy burdened by high debt
leverage and other structural headwinds such as
globalization, aging demographic inuences, and technology.
But I suspect these estimates which average less than 2%, are
much closer to nancial reality than the average, 4% blue
dot estimates of Fed participants, dismissed somewhat by
INVESTMENT OUTLOOK | MAY 2014 3
Fed Chair Janet Yellen herself last month. Why is this
academic Fed Fight important to markets? Well, if a bond
investor knew whether 4% or 2% was the long term
neutral policy rate, he/she would literally have the key
to the kingdom. Forward markets now anticipate a 4%
nominal policy rate sometime out in 2020. If the neutral
policy rate was 2% instead of 4% then bonds instead
of being articially priced, would be attractively priced.
Instead of facing a nearly 100% certain bear market currently
forecast by market mavens, bond investors could draw some
comfort from a low returning yet less volatile future. Bonds
would shed the certicates of conscation label for yet
another decade or so, as this 2% neutral policy rate delevered
the economy without igniting inationary fears.
At PIMCO, we believe that this focus on the future
neutral policy rate is the critical key to unlocking
value in all asset markets. If future cash returns are
2% (our belief) instead of 4%, then other assets such
as stocks and real estate must be assumed to be more
fairly priced as well. Current fears of asset bubbles
would be unfounded. A 2% neutral policy rate,
however, is not a win/win for investors. It comes at
a price the cost being a nancial future where asset
returns are much lower than historical levels. When you
think about it, savers would much prefer to receive a 4%
yield on their savings than a 2% rate. No-brainer there. But
the journey to 4% would be much bumpier and bear
market would be an apt description of the next half-decade.
That is what the Fed is trying to avoid, but in the process they
nancially repress markets, offering a Yellen put but
distributing low asset returns as a result. Potentially 2%
instead of 4% for cash; maybe 3% instead of 5% yields for
10-year Treasury bonds; 4% returns instead of 57% for
stocks; nancial repression ultimately is not an investors
friend, because it lowers returns on cash and all other
nancial assets.
So you say you need more? Join the club. Most pension funds
assume 78% total returns in order to fund future retirement
liabilities. Investors want their cake, priced at current
market prices, but they want to eat future returns of near
double-digits. That wont happen with a 2% neutral policy
rate. Still there are ways to ght back most of which involve
taking different risks than you may be commonly used to
taking: alternative assets, hedge funds, levered closed-end
funds, a higher proportion of stocks vs. bonds in a personal
portfolio. Portfolio managers at PIMCO who understand this
can also transform a total return bond portfolio into a higher
returning asset. All of these alternatives are potentially higher
returning assets in a world of 2% policy rates where cash is a
poor performing asset, but likewise a cheap liability that can
be borrowed to an investors advantage. Look to PIMCO for
your common cold solution. If you sneeze, well just squeeze
your hand and tell you we are blessed to have you. Hopefully
vice versa. Dont need a pinch of snuff to know that.
Achoo Speed Read
1) Future neutral policy rate is critical for all asset values.
2) Current Fed participants believe 4% is the neutral rate.
3) PIMCO believes 2% neutral is closer to the mark.
4) If so, asset markets are not bubbly, just low returning.
5) Look to different areas of risk taking if you need
higher returns.
6) Bring a handkerchief in any case.
Achoooooo!
William H. Gross
Managing Director
Newport Beach
840 Newport Center Drive
Newport Beach, CA 92660
+1 949.720.6000
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