Managing bonds, especially at PIMCO, is not all that easy. I refer not necessarily to the 5:00 am to 5:00 pm hours or even the near overwhelming responsibility of overseeing and protecting more than $200 billion. No, perhaps the most difficult part of the job comes immediately following our annual Secular Forum held in late May, a Forum charged with forecasting the global financial and economic outlook for the next 3-5 years. The hardest part is not just coming up with the right ideas, but thinking of a current movie title that will encapsulate the three-day discussion, please a majority of the 120 participants, and intrigue you – dear reader – all at the same time. Comedies have worked sometimes, but usually a somewhat perilous theme is more appropriate and applicable to the world of bonds. Bond managers are, after all, the ghouls of the investment world; our product does best when dusk not dawn configures the horizon; and our senses are more bat-like than heliolithic. How else to explain such perilous recent Forum titles as The Phantom Menance, Too BIG to Fall?(the love song from Godzilla), and Titanic?. And to think, all of these menacing natters of negativism were foisted on an optimistic readership during 1997-99, a period which eventually led to the triumph of capitalism and its markets, despite a few scares along the way: dotcoms doubled overnight, Greenspan’s fear of irrational exuberance turned out to be just a bad dream, and as the digital clock turned to the 21st century, the world’s financial markets, if not its economy had reached a “permanently higher plateau.” (NOT!) There’s Something About PIMCO might have been a better thematic title sometime during those years – at least it would have exposed our bearish genes if not added body to our guys’ Wall Street hairstyles.

But bearish genes aside, PIMCO’s range bound interest rate forecasts have been pretty much on the money these past five years or so, and our strong, cautionary hints at problems in Asia and elsewhere have led to significant profits for our clients. So let’s stick with the Armageddon-like titles for now – they’ve got momentum as the stock pickers would say, and they’re fun to play with. This year I thought we’d shift from the silver screen to the big tube at home and hoist up “Survivor” as our thematic foil. Here we have 16 people on Gilligan’s Island somewhere off Borneo, all competing to be the last chip off the block and win $1,000,000. Now this isn’t a reenactment of Lord of the Flies – they don’t kill each other – they just vote each other off the island, which is certainly a more civilized way to go about it than in Golding’s version: the most popular castaway wins, not the most ruthless. Then again there could be other factors at play. My wife Sue suggested she’d vote thumbs down for any guy that smelled bad. Son Nick, clearly despises the weak and faint hearted. After 62-year-old Sonja Christopher was the first to be expelled for stumbling in a team competition he screamed, “Sonja – start paddlin’ baby, it’s 5,000 miles to San Francisco.” But despite the wide variety of reasons for voting contestants off the island, the overarching theme is the elimination itself – each and every week, someone else goes until at last there’s just a single solitary survivor. Definitely a New Age Economy concept, and worthy of further exploration, so to speak. But no more hints, let’s hit the beach and start looking for firewood or that fresh water that the CBS camera crew stashed somewhere in the jungle. Let’s see what it takes to be a SURVIVOR.

Secular review
First, though, let’s rehash how the global economy got to this island paradise in the first place. After setting sail well over 10 years ago into the turbulent seas of free trade and intensified competition, our economies and financial markets found smoother waters in 1999. Accelerating corporate profits in Europe and the United States were perhaps the most obvious indications of a powerful capitalistic dynamic based on higher levels of productivity, accelerating rates of technology investment, and ample credit supplied by the world’s central banks. While that liquidity might normally have been threatening to fixed income investors (and indeed yields have risen substantially for most of the past 18 months), there remained a New Age feeling that accelerating inflation was a phenomena of the 70s and had no place on this magnificent capitalistic schooner of the 90s and beyond. Bond market – indeed we called them Capital Market – vigilantes were in full command to enforce their requirements for low inflation, strong currencies, and balanced budgets, and governments as well as central banks altered their historic policies in somewhat slavish concurrence. The most striking example, as pointed out by guest speaker Paul Romer from Stanford University, was the acceptance and promulgation by a myriad of the world’s central banks of policies geared towards “inflation targeting.” While the U.S. was still a somewhat non-conforming outlier – being theoretically forced by Humphrey/Hawkins to favor the economy as opposed to inflation – most of the major central banks (surreptitiously including the Fed) have an inflation target centered somewhere around 2%. Not too high, mind you, to suggest any semblance of reflation. Not too low to come anywhere close to repeating the Japanese deflationary example of the past 10 years. It has been these targets, as well as the fiscal surpluses experienced in North America and the reduced deficits in continental Europe, that have allowed the private sector of the global economy to work its magic. Most of the developed and indeed the emerging economies were in full bloom at the time our Secular Forum convened in mid-May 2000. Our magnificent schooner had weathered the Asian tidal wave, steered clear of the LTCM hedge fund rocks and had innocently sailed into port on this island paradise with the solitary problem of deciding which one of its passengers would take home $1,000,000. This sounds less like an ordeal and more like a pleasure cruise the further along we sail. Ah, but the tide inevitably turns, as all sailors and astute investors know. The fact is that while the world’s strong growth rate of the past few years – especially that in the United States – has been at least partially due to a rapid cyclical productivity surge, it has also benefited from an infusion of central bank liquidity. That monetary push has resulted in a decline in the pool of available labor that cannot continue indefinitely. In addition, superior growth in the U.S. has been aided by the exhaustion of over 60% of annual world savings reflected in our $300 billion trade deficit. After reaching near historic depths as shown in the graph below, a logical conclusion suggests that this cruise cannot continue at the same speed or perhaps even the same direction for long.

U.S. Trade Balance as % of GDP
 
Figure 1
Source: Bridgewater

What's new
Our domestic economy should therefore slow to maximum real growth rates of 2-3% if for no other reason than we’ve run out of labor to man the lookouts and clean up the bilges. Only productivity growth can take us towards the 3% theoretical target that maximizes growth without an inflationary threat. In addition, instead of liquidity injections from central bankers, the global economy is now experiencing a reversal of fortunes, an ebb tide of money that raises short-term interest rates and inhibits inflationary economic growth. Europe is on the upward march and even Japan is contemplating the unthinkable – eliminating their 0% interest rate policy. Likewise, as our dollar falls in lockstep with a declining trade deficit, it will be our investment sector that bears the brunt of the damage. So 3% domestic growth, and 3% global growth as well, is a maximum expectation, despite those Internet and biotech sugarplums that dance and tease us in our sweetest of dreams.

Growth, however, will dip even lower if we get some unexpected storms, but what else would you expect in a tropical paradise? The fact is, as we’ve learned from previous experience, that capitalism is subject to over and underreach even in Shangri-La’s. Recession is not just a four-letter word 5. It’s an inevitable outgrowth of Keynesian “animal spirits.” Let’s check out the forecast, then, and speculate about the survivors, should we hear the thunder of the “R” word over the next few years.

There are five realistic lightening bolts that could individually or in concert produce a recession that the markets do not now expect:

1) Central Bank Overreach
Central banks, including the Fed, may be fighting the last generation’s war in their fixation on inflation. No one really knows the rules of the New Economy yet, and the staying power of higher rates of productivity shown below.

A Productivity Miracle?

Figure 2
Source: BLS

Are we truly in a New Age or is this productivity push a cyclical phenomenon brought on by Internet frenzied investment and an exuberant trade balance? How does the wealth effect fit in and how quickly do global economies react to monetary tightening given excessive levels of leverage – especially in the U.S.? No one is even close to being sure, and so as central banks gingerly feel their way in 25-50 basis point increments, they could possibly pull a Wile E. Coyote – looking down from the interest rate peak and discovering there’s only thin air to support them. Beep Beep!

Not only is there a possible threat of overreach on the upside but also perhaps a greater danger of overstaying their hand once we get to the mountaintop of higher yields. Stock market exuberance almost precludes the Fed from lowering interest rates absent a catastrophe. Inflation targeting regimes around the world would force other central banks to do the same. If so, the big R might be lingering closer to shore than most assume.

2) Emerging Market Contagion
Our EM specialist, Mohamed El-Erian, reports that his parts of the world are in better shape than two years ago – higher international reserves, less short-term debt, needed reforms underway – but there are still problems. Higher global interest rates will not help, and those countries remaining on fixed currency regimes – Argentina, in specific – are vulnerable. A big EM headache could present the contagion threat once more.

3) Japan Slides Back Into Its Sink Hole
There’s not enough space here to elaborate on the Japanese problem. Suffice to say that Japan is fighting demographic and cultural headwinds with 10% GDP fiscal deficits, grudging political and economic reforms, and limited success. It constitutes 15% of world GDP, though, and is still the economic center of Asia. If its Nikkei falls further, undermining banks and corporations alike, then the world may have a problem, not just the Japanese.

4) Popping the U.S. Equity Bubble
Our suggestion in last year’s Secular Forum that the real economy does not determine the level of today’s financial markets but vice versa remains true. The primary prop to global consumption and perhaps investment as well appears to be the financial markets themselves, as the temporary wealth effect allows stockholders and businesses to transform paper profits and IPOs into high-end consumer sales and high-tech investments as shown in the chart below. With markets now off their peaks, consumption and investment downturns may follow. We shall have to observe this one closely.

Technology Investment
How Much Is Too Much?

Figure 3
Source: U.S. Department of Commerce - BEA

5) Significant Reversal of the Dollar
While a lower dollar would imply increasingly competitive U.S. exports, a dollar debacle would affect foreign investment even more. Although there are few signs yet of global exodus, an unstable dollar could reverberate worldwide and send investors scurrying to safer havens even in their own local markets.

The probability of one or more of these events combining to produce a global recession over the next few years is now greater than 50%. Admittedly the problems are primarily endemic to the U.S. and Japan, and Europe should balance more evenly in the middle of our survivor’s life raft, but no nation or continent is an island in this global economy. John Doanne is definitely not the last survivor.

Investment conclusion
Should we experience a recessionary downturn or even a period of very slow growth, financial markets will face an entirely different horizon than what they’ve grown used to. Up until the Russian crisis, banks and other institutional investors were akin to the proverbial sailor facing a red sky at night – “sailor’s delight.” If catastrophe were to strike – the U.S. in 1987, Mexico in 1994, even Brazil in early 1999 – central banks, the IMF and any other supranational agency in existence would come roaring to the rescue with life rings, inflatable rafts, and even a gourmet breakfast fixed to order – “Bacon or sausage, Mr. & Ms. International Investor? Do you want your money back in 10s or hundreds or millions? Sorry about the waves.”

Twelve hours later, however, after the Russian night and the realization that “bailing out” is not conducive to long-term global health, that same red sky appears in the morning of the 21st century. “Red sky in the morning – sailor take warning.” We shall. No less a friendly Samaritan than Alan Greenspan has recently prophesized that, “Accordingly, the monetary and supervisory authorities would doubtless endeavor to manage an orderly liquidation of any (significant) failed entity, including the unwinding of its positions. But shareholders would not be protected, and I would anticipate appropriate discounts or ‘haircuts’ for other than federally guaranteed liabilities.” If so, then what has come to be known as the “new financial architecture” will resemble a bamboo hut with a leaky banana leaf roof as far as investors are concerned. Instead of “bailing out,” we now have “bailing in,” a rather innocuous sounding phrase that means there are no guaranteed survivors except the mighty sovereigns. Emerging markets? No. Daimler/Chrysler circa 2000? No. FNMA or FHLMC? No. Are the odds really that high, Captain, that any of these stalwarts would falter in a New Age of technological plenty? No, of course not, but even the thought of the chance raises the cost of capital to all but Aaa sovereign credits and that, dear reader, is a critical point. A second observation is that our forward-looking secular horizon may have many survivors along with its growing list of losers, but the castaways will not be rescued with bacon and sausage on a fine chinaware plate. Sector yield spreads, therefore, will continue to widen to reflect increasing risk even if the global economy continues to prosper. There is indeed the possibility, as outlined in Outlooks earlier this year, that corporate bonds suffer spread erosion in a prosperous, Goldilocks secular environment. Winner take all, “Amazon.com” internet strategies point towards the erosion of profits in the economy’s base – retailers, paper producers, parts wholesalers, grocery stores, print media/music, etc. If so, then corporate spread products may lose both ways – if Goldilocks survives, or if she’s voted off the island. Start paddlin’ baby. The fixed income investor who fixates correctly on quality spreads, not interest rate direction, will be the ultimate $1,000,000 winner.

As alluded to at the beginning of this Outlook, we at PIMCO expect an economic slowdown and/or recession in the next few years and believe that such a growth downturn will gradually lower high quality interest rates by capping inflation at levels near 3% in the U.S. and closer to 2% in Europe. We at PIMCO expect to take advantage of these increasingly attractive yields at cyclical inflation peaks by extending duration and maturities at some point during the next six months. We expect above all, however, to protect principal and create excess relative performance in the process. Our domestic economy is laden with debt and is entering a New Age in which “winner take all” attitudes may negatively affect corporate profits and probabilities of solvency. An increasing percentage of corporations and even a few emerging sovereigns may soon be voted off this global island paradise and the new financial architecture promises fewer life rafts to get back to San Francisco than in previous years. The ultimate “survivor” among investment management companies should be that firm that recognizes this transition and structures portfolios accordingly, based on new levels of risk and higher levels of yields for non-sovereign debt. We at PIMCO intend to be that survivor. We are young, fresh, and energetic, yet with enough moxie and experience to survive a financial storm. But even if the sun should keep shining for the next five years running, I’ll wager you PIMCO will still be near the head of the line, allowing you, dear clients, to enjoy that bacon and sausage on your fine china plates. Until next year’s secular journey – a cautious but confident “bon voyage!”

William H. Gross
Managing Director