When one of the world's best fixed-income investors suddenly switches from bearish to bullish, we have to take note. But has Bill Gross been turned upside down by listening to too many bad economists?
Pythia, the oracle of Delphi, used to answer all the questions put to her in deliberately ambiguous termsand so has the adjective delphic' passed into our language. There was a good reason.This is because the most dangerous thing a prophet can ever do is actually to prophesy, a temptation we manfully try to resist whenever we are asked to do so. This lesson has, perhaps, been reinforced by the latest commentary from Bill Grossthe estimable head of Pimco's bond operations and one of the savviest and most forthright fixed income investors around. First, a little context.
Back in September of last year, Mr. Gross entered into something of a contretemps with the powers-that-be when he openly challenged the methodology officially employed in the US to calculate the likes of the consumer price index, going so far as to call it an "haute con job" and opining that it understated "true inflation" by at least 1%. Around the same time, he characterized 10-year Treasury note yieldsthen, as now, around 4.1%as "excessively low" and, by January of this year, he was confident enough in his estimation to tell Barron's that 10-year US Treasury yields were headed to "4 3/4 to 5%".
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This was a view he clearly still espoused in February when, with yields again touching 4% dead, he echoed the Fed Chairman's just-expressed puzzlement, telling Bloomberg news that the latter's use of the word conundrum' mean that: "Greenspan's a little befuddled so are we!"With yields back up to 4.56% a month later, he announced that "half the conundrum has been erased" (implying his earlier 5% ceiling was still in place), though, as it transpired, this was a mere 8 basis points away from the beginning of the rather counter-intuitive rally which has since taken yields all the way back down to the vicinity of 4%, once more.
With the haute conned' CPI numbers climbing, in the meanwhile, to 3.5% (and thus reducing the difference between note yields and the ostensible fall in money's value to their slimmest in a quarter-century) one might have expected Mr. Gross to have registered another forcible protest.
Not a bit of it, however, for it seems our guru has since been traveling that lightning-afflicted road to Damascus. As he wrote in his latest monthly newsletter:"If we had to forecast (and we do), we believe a range of 3 - 41/2% for 10-year nominal Treasuries will prevail during most of our secular timeframe [of 3-5 years] and that yields on euroland bonds will be slightly lower"
Reaction was instant, if lurid, and the newswire headlines screamed: "Pimco's Gross says 10-year yields may fall as low as 3%." Now, we are all entitled to change our opinions when we have digested new data, or when a more compelling chain of reasoningwhether our own or that of anotherhas caused us to revise our original outlook: Mr. Gross cannot be blamed for undergoing such a shift. But we are entitled to ask what triggered such a stunning turnaround in outlook, being suspicious that even an intellect as powerful as Mr. Gross' might have succumbed to the classic New Era delusion that "it's different this time".
Working through his missive, the truth is that Mr. Gross seems to have been seduced by the council of despair to which he was subjected at a recent company forum. It also apparent that his own confused reading of economics made him all the more susceptible to the gloomy prognostications voiced therein. We say this last because it is plain that Mr. Gross hews to the idea that the world faces something called a lack of aggregate demand'a Keynesian fallacy long since given the lie by proper economists.
To take just one phrase from Mr. Gross' monthly newsletter as evidence, we shuddered when we saw the world's foremost bond investor blithely state that "the global economy needs more consumers." Gross also seems implicitly to believe in ex-Fed Governor Bernanke's fantastical "global savings glut" hypothesis; a fundamental error of reasoning which rests on a basic confusion between money (especially today's unanchored, funny money) and claims on real, productive resources.
All this led Mr. Gross (who is normally impeccable on ethical matters) to fall so far under the influence of his company's own Chancellor Palpatine that he even went on to follow the undeniable observation that:"in recent years, America's growth has been stitched together more from the iron fist of government policies than the invisible hand of a dynamic free enterprise economy"with a wholly insupportable and illiberal deduction; namely, that:" in a world deficient in aggregate demand, the case for free markets and the invisible hand grows weaker as PIMCO's Paul McCulley has pointed out"This is a case of what we have facetiously called the "IN CASE OF EMERGENCY BREAK HEADS" school of New Deal, therapeutic fascism.
We can only wish Mr. Gross a speedy recovery from his mental infection with the diseased and circular doctrine that failures induced in the free market by bad money and interfering governments can only be remedied by the vigorous application of more of the same!In essence, what Mr. Gross has now come to argue in justification of his surprising bullishness on fixed income is that the growth-inhibiting demo-graphics of the West' will combine with an imminent attenuation of the ability of policy-induced, asset-price inflation to stimulate wasteful spending and that this will limit our aggregate demand', while China's legions of cheap workers will continue to increase global supply.
As Mr. Gross puts it:"if 3% inflation is all [sic] we can get from the past 5 years' asset reflation, it's hard to believe we can get more from what's left Continued disinflation will rule our fragile future king-dom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy."
Faced with this tangle, it is hard to know where to begin to unpick the weave of economic misperceptions so that we can stitch a more durable fabric from it, but we shall certainly try (though demographics' is such a mare's nest of futurology that we shall deny it any treatment, for now). In the first place, a 3% rise in an index which Mr. Gross himself knows is an understated, unrepresentative "haute con job" should be little enough cause for complacency.
Secondly, there is plenty of evidence that, even though short-term interest rates have risen some-what in nominal terms, the artificial boom has been sustained because they have lagged many actual price rises (rates have fallen in real' terms, as economists put it). Additionally, the fact that lenders are falling over themselves to grant credit, both to consumers and businesses, on ever less onerous terms (as the latest Federal Reserve Loan Officers Survey makes clear), has also conspired to offset any minimal restraints imposed by Greenspan, et al.
In other words, there is absolutely no evidence yet that some form of generalized credit exhaustion on the part of Western consumers has manifested itselfwhich is, of course, not to deny it might emerge one day, or to claim that there are not pockets (such as in the UK) where its possible inception can be discerned now.
Overall, however, there is nothing to suggest that Mr. Gross' Asset Pump' (of credit pushing up assets on which to extend further credit) might have reached the limits of its capacity. Norif this were to come aboutshould we neglect to consider whether there might be other means ready to take up the slack left behind by its saturation. For example, when Americans can no longer borrow and spend sums equivalent to around 6% of their income, simply by cashing in their notional housing gains each year, the nation's strip malls might still not be automatically emptied overnight.
Suppose instead that 3% more Americans each year find jobs and all enjoy 3% higher wages (not far from where we are today): it should be obvious that the effect on expenditure could be just the same. Fundamentally, there is nothing to preclude the present, ongoing, monetary inflation from delivering such an outcome. Indeed, there are tantalising signs that the US labor market is already tightening a touch, even if the real benefits accruing to the wage earners are proving more elusive to pin down.
Moreover, if Americans do come to spend less as individuals, we can be sure that their government will not hesitate to flex its "iron fist" once more and so spend on their behalf. If nowhere else, this spending will find its outlet in the accumulation of yet more expensive and sophisticated war materiel, to the benefit of a Military-Industrial complex which has already seen its members' share prices quintuple in the last five years.
Further, why does Mr. Gross discount the possibility that, even if we Occidentals falter, our foreign creditors will not instead start to spend some of their growing surpluses on their own gratification? This is not as far-fetched as it sounds. For one, governmentsfrom Latin America, throughout the Gulf, in Russia, and among the Asians at largeare talking about spending their dollar receipts on large-scale infrastructure projects.
For another, the increasingly urbanized Orient is beginning to discover the pleasures of personal consumptionconspicuous or otherwiseeven before Citigroup and GE Capital really get to work to foster a true buy now-pay later' mentality among the masses, by tempting them with easy-term credit cards, as they have in so many other emerging nations already. All of these trends may be further amplified by a renewed fall in the US dollar, driving up those already soaring import prices which now impact a much greater fraction of the US economy than ever before (imports now amount to the equivalent of more than one-fifth of officially calculated personal consumption outlays).
This will especially be the case if the US Treasury and the economic illiterates in Congress have their way and the dollar is devalued against the Chinese renminbi, but it may happen anyway if Brazilians prefer to trade with Bahrainis, not Bostonians; and if Moscow does business first with Macao, not Minneapolis a state of affairs which much active diplomacy is currently attempting to promote.
Incidentally, we should pause here to rout notions of a ghost army of the "hundreds of millions of unemployed [Chinese] workers requiring only 5-10 cents per US wage dollar" and so perennially suppressing world prices. This is because wages, per se, tell us nothing about whether these unskilled hordes can out-compete other suppliers of goods. If they did, the Marxian nonsense of the iron law of wages' would hold good and all of us over-paid Westerners would be thrown forthwith on the dole as African peasants and Amazon Indians supplanted us wholesale in the factories and offices of the world.
The reason this does not occur is that it is not these peoples' pay scales, but their value productivitytheir revenue-to-cost ratiowhich is what counts in determining whether they have jobs or we do.
That, in turn, depends upon, say, the Chinese urban immigrant possessing some combination of (a) sufficient skill and (b) sufficient capital means to match up to the previously superior ratios achieved by us. No-one can deny that nation is clearly making great strides at reducing its traditional deficits hereto a great extent with the aid of our own know-how and using our manufacturing equipment, but also partly because they save so much.
Notwithstanding this, there are also anecdotes galore about how worker inefficiencies and skill shortages are beginning to bite, even in China, and how, for example, Shanghai manufacturers are already having to pay through the nose for key workers wherever they can find them, eroding their own competitiveness as they do. Pace, Mr. Gross, but all these factors may well provide some temporary relief for American industry, for US exporters will initially be helped and, in similar fashion, those competing with importers will also derive a momentary advantage, if matters come to such a pass.
But, make no mistake: this will come at a high cost both to American consumers as a whole, espe-cially to consumers of those goods for which a hollowed-out US can no longer supply reasonable substitutes to more pricey foreign originals. It will also come at a high cost to holders of US fixed income securitiesboth external owners (be-cause of the losses related to any decline in the dollar) and internal ones (like Mr. Gross' clients), thanks to the damaging effects of higher domestic prices.
Mr. Gross is certainly entitled to his opinion and his fund's subscribers have certainly been well enough served by him in the past for him to merit their indulgence while his forecasts are put to the test of experience. But for our part, we will only point out that bond yields are only as low as they are todayas paradoxical as it soundsbecause inflation (properly understood as a surfeit of money) is too high and not becauseas wrongly defined by those who see it as a rise in a government price basketit is somehow too low.
The time may not be too far away when inflation'measured according to the latter, misleading usagebegins more faithfully to reflect the workings of inflation' under the former, strictly correct construction. If so, Mr. Gross may well wish he'd stuck to his original ideas about 5%, rather than backing his new-found fancy for 3%.
By Sean CorrigaFor Sage CapitaFor more, visit: www.sagecapital.com
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