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After the Flood: Surviving in a Sea of Debt
Since 2009, developed country governments have run fiscal deficits unprecedented outside of wartime, and their debt levels have reached epic heights. Investors accustomed to considering only the interest rate risk associated with their developed government bond holdings have been shocked to find that credit risk has become dominant in many cases. For investors in government bonds, inflation and currency debasement have the potential to be just as costly as outright default. Investors should consider focusing on GDP, or national income, as a measure of a countrys ability to service its debt.
Waiting for All In
by Mark R. Kiesel of PIMCO,
Without a more forceful and coordinated policy response, Europe now faces an increasing risk of a hard landing. In this uncertain environment, volatility will likely remain high, liquidity poor, risk premiums wide and the global economy fragile as financial and credit conditions tighten. Easier monetary policy as well as the potential for more balance sheet support from a larger consortium of global central banks is now needed over our cyclical horizon. If these actions are coordinated and timely, investors and risk takers would be more likely to move off the sidelines.
Life Finds a Way
by Neel Kashkari of PIMCO,
Even the most sophisticated risk management models can't protect against scenarios we've never even contemplated. In this New Normal economic environment of slow economic growth, high volatility and enormous macro risks we don't believe ignoring major downside risks is prudent for equity investors.
We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios to hedge against the risks they can see, and equally importantly, the risks they can't see.
Eurozone Leaders Need to Agree on a Plan for Deeper Fiscal Union
by Andrew Balls of PIMCO,
One of the many worrying aspects of the European debt crisis, even after more than two years of worsening financial and economic conditions, is that there still appears to be no shared understanding and analysis of the problems facing the monetary union. Therefore, with yet another summit of leaders scheduled for December 9, it is very hard to be confident that European political leaders and the European Central Bank are close to agreeing on a credible and comprehensive plan.
Evaluating Optimum Currency Areas: The U.S. versus Europe
While economic integration has progressed materially since the inception of the EMU, the U.S. scores much higher in terms of labor productivity, labor mobility and wage flexibility. Research shows that wage rigidity-defined as wage freezes or cuts as a fraction of total workers-is much lower in the U.S. than the eurozone. Eliminating these rigidities is crucial for the eurozones growth as an optimum currency area. Albeit painful, the intensity of the debt crisis in Europe may force a quicker progress of reform implementation, which could be a competitive advantage for the EMU in the future.
Prepare for a Different Financial Landscape
by Mohamed A. El-Erian of PIMCO,
With the European crisis continuing to dominate the news, many people now realize that todays global economy faces an unusually uncertain outlook. Indeed, Europes turmoil is but one of the multiple global re-alignments in play today. What may be less well recognized is the extent to which specific sectors are already changing in a consequential and permanent manner. This is particularly true for global finance where volatility has increased, liquidity is evaporating, and the role of government is pronounced but inconsistent.
Beware the Falling Euro
by Bill Gross of PIMCO,
Neither the U.S. economy nor U.S. stock indexes will benefit from the euros decline. A declining euro means a rising dollar in relative terms, so our exports will necessarily become less competitive. During the Great Depression, the country that devalued its currency the quickest and the most was the country that was least affected by depression and that recovered the fastest. This truism will aid Euroland, and hinder the U.S. recovery.
Family Feud
by Bill Gross of PIMCO,
Investors should recognize that Eurolands problems are global and secular in nature; it will be years before Euroland and developed nations in total can constructively escape from their straitjacket of debt. Global growth will likely remain stunted, interest rates artificially low and investors continually disenchanted with returns that fail to match expectations. Investors should consider risk assets in emerging economies, and bonds in the strongest developed economies, where the steep yield curve may offer opportunities for capital gains and potentially higher total returns.
Playing 'What If?' with Oil Prices and a Potential Strike on Iranian Nuclear Facilities
by Greg E. Sharenow of PIMCO,
The impact of a major disruption in the supply of oil from Iran would depend on the IEAs intervention, the duration and the degree to which any attack might be a surprise. The market has less cushion than it did earlier this year due to production outages and relatively strong non-OECD demand, leading to sharp draws on inventories. Excess capacity is virtually exhausted and we doubt other OPEC nations would be able to compensate for a reduction in Iranian oil production. In light of these possible price spikes, investors should evaluate how their portfolios might be affected by inflation.
3 Things to Watch This Week
by Mohamed A. El-Erian of PIMCO,
The business sections of this weekend's newspapers understandably focus on last week's disappointing stock market performance (the worst in two months for the S&P) and another round of credit downgrades for European sovereigns (Belgium, Hungary and Portugal). Yet, these are essentially lagging indicators. The stories that may well materialize in the next few weeks will be more heavily influenced by what happens this week to Europe's latest yield curve inversion, core bond rates, and policy announcements.
Whether the U.K. is in the Euro or Not, We Are All in This Together
Can the U.K. economy withstand a further sharp deterioration in the European debt crisis? The prospect of European recession, coupled with the U.K.'s program of tight fiscal policy, points to a challenging economic outlook for the U.K. A weak eurozone means weak export prospects at a time when the U.K. is trying to rebalance its economy towards greater exports. The U.K. economy has made great strides in stabilizing its banking system, but it is not yet in a position where it can withstand a systemic European crisis involving multiple defaults.
Ben Bernanke: The Decider
by Tony Crescenzi of PIMCO,
Amid great economic stress, policymakers have missed many opportunities to improve the situation and better the lives of people.
The leadership void in the U.S. was illustrated by the dismal display of policy dysfunction that led the country to lose its AAA credit rating. European leaders have fared no better.
Ben Bernanke and the Fed, however, have demonstrated leadership. What is both remarkable and instructive for the outlook for monetary policy is how active the Fed remains even though it has reached the zero-bound for interest rates.
QE2 and Its Impact on Sterling Credit Markets
The removal of government bond supply combined with the likely suppression of yields may encourage investors to seek out greater yield via investment grade bonds in the credit markets. The BoEs new round of QE could exacerbate the imbalance between supply and demand and leave a hole in supply that is highly unlikely to be filled by sterling credit issuance. The lack of issuance in the case of non-financials is generally due to strong corporate balance sheets, undrawn credit lines at banks and the rebirth of the loan market.
Act and Learn Versus Debate and Wait
Signs of disappointing policy outcomes are, unfortunately, all around us. Over the last two years, American policymakers have failed miserably to lower persistently high unemployment despite a series of stimulus measures, fiscal and monetary, conventional and unconventional. In Europe, the debt crisis has spread despite numerous summits, declarations, policy actions and political changes. In both cases, policymakers identified and sometimes mis-identified the problems and took highly publicized steps to solve them. Yet to no avail. The identified problems not only persisted, they deepened.
Is Now the Right Time to Hedge Tail Risk?
Not all hedges have equally increased in value, giving investors the option to reduce the cost of their hedges by considering both direct and indirect hedges.
Tail risk hedging may allow certain investors to maintain an allocation to risk assets where they might otherwise deem the position to be too risky and it can also help stabilize portfolios on a mark-to-market basis. Investors may decide to either start implementing hedges now, phase the tail risk strategy in over a period of time, or put the infrastructure in place now and defer implementation until market conditions change.
Known Unknowns
by Neel Kashkari of PIMCO,
We believe investment managers can analyze numerous data sources and apply lessons learned from past economic cycles to make assessments about the global economic outlook. These managers can make reasonable judgments about asset classes over the long term and, through rigorous bottom-up research, develop an edge regarding the outlook for individual companies. However, the market is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be. Hence predictions are likely to be wrong.
Could America Turn Out Worse than Japan?
by Mohamed A. El-Erian of PIMCO,
There was a time when America looked down on Japan for the latters inability to deal with its economic problems. No more. Like Japan, America is now realizing how difficult a post bubble economy can be. The fear is that it will also find out that that it lacks some of Japans attributes needed to cope with long years of economic stagnation. The US has no time to waste to build on the important, albeit small progress that has been made in recent weeks. If it does not, there is a risk that the countrys economic fate could end up being even worse than what Japan has experienced.
Pennies from Heaven
by Bill Gross of PIMCO,
Growth is the commodity that the world is short of at the moment.
Once interest rates inch close to zero and discounted future cash flows are elevated in price, it's difficult to generate much more return if economic growth doesn't follow.
Equity markets should be dominated by dividend yields and the return of capital via share buybacks, as opposed to growth.
In fixed income assets, we suggest that portfolios should avoid longer dated issues where inflation premiums dominate performance.
Eyes on the Prize
by Richard Clarida of PIMCO,
Before Nobel laureates Tom Sargent and Chris Sims developed their methods, economists and policymakers had no rigorous way to incorporate expectations into their statistical models.
There is a limit to forward guidances effectiveness, which is why the Fed has pursued other policy options since hitting the zero lower bound.
An uncanny correlation exists between the Feds preferred measure of the publics long-term inflation expectations and the timing or initial announcement of a quantitative easing or twist program.
Asia-Pacific Portfolio Committee Discusses Cyclical Outlook for Globe and Region
China will likely focus more on rebalancing of the investment-focused domestic economy this time, rather than on reflating of the economy to engineer higher growth as it has done in 2008 to 2009.
Japans fiscal policy will need to be expansionary to facilitate reconstruction efforts.
We believe Australian government bonds have the potential to outperform U.S. Treasuries on a local currency basis, particularly in a left-tail global economic scenario.
Salami Tactics
by Andrew Bosomworth of PIMCO,
Repeated attempts to solve the eurozone's sovereign crisis have failed, reflecting a coordination problem among its fiscal authorities and between the ECB and governments.
Markets will not return to supporting the eurozone as it stands, signaling the EMU's leaders to choose one of two solutions: downsize to a smaller, stronger group of countries or adopt a federation with political and fiscal union.
A comprehensive solution not only needs the right tools in place, but also requires a credible commitment with regard to sequencing and executing the long-term plan.
All That Glitters Is Not a Cash Equivalent
by Jerome M. Schneider of PIMCO,
The latest volatility has investors asking questions about the securities they own, in particular probing any exposures to European issuers.
Cash investors often over-allocate to money market and bank investment vehicles, while the most attractive risk-adjusted opportunities might fall just outside of this space.
We currently see opportunities in short-dated, non-financial BBB-rated corporate bonds, along with dollar-hedged bonds and bills issued by sovereigns with solid balance sheets.
Prediction? Pain
by James Moore of PIMCO,
?Recent Federal Reserve activity has pushed down the long end of the yield curve, spiking the present value of plan liabilities and widening the funding chasm.
The pain of the pension community shows up most obviously in funded status estimates.
High and increasing levels of implied equity risk premium in pension plans suggest sponsors expectations are increasingly optimistic about future contributions from risk assets.
?Repeating the Future
by Neel Kashkari of PIMCO,
For long-term investors, meaning those prepared to stay invested for three, five and even 10 years, who can endure volatility, we believe equities can offer attractive returns.
In an extended period of slow economic growth and deleveraging, interest rates are likely to remain low. Actual income generation from investments is important.
Hopefully society can institutionalize the lessons from this crisis so that future generations dont repeat it: Individuals, corporations and countries should only borrow to fund long-term investment, not current consumption.?
The Markets for Contagion
by Mohamed A. El-Erian of PIMCO,
Markets are in the unusual and very uncomfortable position of being wholly dependent on policymakers and politicians. The investment relevance of company analysis, no matter how good, pales in comparison to the importance of getting the policy calls correct. Faced with this, investors should also remain cautious. Yes there are already opportunities but they will be even more attractive down the road given that the world is now subject to both a synchronized slowdown and de-leveraging.
Six Pac(k)in'
by Bill Gross of PIMCO,
Long-term profits cannot ultimately grow unless they are partnered with near equal benefits for labor.
There is only a New Normal economy at best and a global recession at worst to look forward to in future years.
If global policymakers could focus on structural as opposed to cyclical financial solutions, New Normal growth as opposed to recession might be possible.
Why Good Companies May Get Even Cheaper for Awhile
by Mohamed A. El-Erian of PIMCO,
Should investors buy good companies trading at historically attractive prices? According to conventional wisdom, this simple question has an equally simple answer - "of course" - that is supported by the vast majority of historical cases. But before acting on conventional wisdom, investors should ask themselves why so many unthinkables have turned into reality over the last few months. By doing so, they would be forced to consider important qualifiers arising from historic structural changes buffeting the global economy and, therefore, financial markets.
The Fed's 'Twist' Turns into a Problem for Pensions, Insurers and Households?
by James Moore of PIMCO,
In its attempt to stimulate borrowing by making long-term money cheap, the Fed has harmed large swaths of savers. A look at three groups in particular proves instructive: pension plans, life insurance companies, and households saving both inside and out of 401(k)s.
PIMCO Cyclical Outlook: Growth Risks, Policy Polarization and Rethinking Returns
by Saumil H. Parikh of PIMCO,
Over the next 12 to 18 months, we expect the global economy to expand at a very modest real rate of 1% to 1.5%
Global imbalances have continued to rise in the post financial crisis environment, global leaders continue to fail in their policy coordination efforts, and deleveraging and reregulation continue to be critical over the course of our cyclical horizon.
We are transitioning into a world where we believe the incentives of policymakers and the divisiveness of politics will become the predominant drivers of investment returns and economics.
Chinas Escalation up the Value Chain: From Low-Cost Manufacturers to World Leaders?
As labour demographics change, China could suffer a double whammy of a falling savings rate and a diminishing labour force.
The size of its domestic market allows China to spend more on research and development (R&D) and so potentially build technology and scale more quickly than many foreign competitors.
In particular, we have identified wheel loaders and excavators as two sectors where we expect the Chinese to successfully migrate up the value chain.
Volatility Is With US for Awhile Longer
by Mohamed A. El-Erian of PIMCO,
There were three culprits for last week's market dramatic sell-off: first, yet another downgrading of the outlook for global growth, including in the form of a stark warning from the Federal Reserve on "significant" downside risks (and, for an institution that selects its words very carefully, significant translates to something nearer to horrid); second, recognition that this situation increases the challenges facing policymakers who, for the large part, have been MIA for way too long; and third, a worrisome amplification of the crisis in Europe.
All Eyes on Europe
by Mark Kiesel of PIMCO,
The longer policymakers wait, the more likely Europes financial crisis will deteriorate. The risk of a global liquidity trap has also increased as many healthy balance sheets around the world are also refusing to engage. Germany and other strong sovereign nations in Europe have to make a choice: continue to provide financial assistance to countries with more debt and assist in helping to restructure the debt of some European peripheral countries, or potentially move forward with a smaller, stronger group of countries-or at the extreme walk away from the Euro and the EU all together.
Muni Veterans Discuss Economy, Downgrades and Silver Lining
Many municipal balance sheets are in reasonably good shape and default rates remain a small fraction of the overall market.
The downgrade of Americas AAA rating to AA+ had a knock on effect on municipal bonds. However, we believe of greater consequence to bond issuers, and to the market, is the outcome of federal budget negotiations.
We feel essential service revenue bonds tend to have more consistent revenue streams and lower (or no) pension and medical liabilities than general obligation issues.
Ya Gotta Believe!
Central banks around the world consider easing monetary policy amid concerns of a global economic slowdown.
At least one major central bank, however, appears to be taking an opposite stance: China. Policymakers there are concerned about inflation, excessive credit and property speculation.
In other emerging nations, central bankers are generally poised to ease, but have less ammunition than they did after Lehman collapsed.
Market Preview - What to Look for This Week
by Mohamed A. El-Erian of PIMCO,
Global markets again find themselves in the uncomfortable back seat of a car driven erratically by policymakers. The hope is that policy responses in both America and Europe will enable them to build on last week's solid gains and, thereby, improve the outlook for jobs and economic growth. This can happen if most/all of what follows materializes. Top-down issues are still important drivers of markets. It is not a comfortable place for markets given the recent history of recurrent policy shortfalls and debacles. Yet it is also reality for now.
Time for a Smaller and Stronger Eurozone
by Mohamed A. El-Erian of PIMCO,
The euro should, indeed must, be saved. And it can be saved provided Europe is willing to make hard structural and institutional decisions. The time has come for the eurozone -- Germany and France in particular, but also Austria, Finland and the Netherlands -- to decide how they would like European integration to evolve; and they need to do so quickly. They have two conceptual choices: restore stability to the current, heterogeneous zone; or opt for a smaller but stronger one.
The G-7 Disappoints Again
by Mohamed A. El-Erian of PIMCO,
Unlike recent G-7 meetings of finance ministers and central bankers that were essentially ignored, there was quite a bit of interest in the one held this past weekend in Marseille. That interest turned out to be misplaced, however, as the G-7 delivered little of substance yet again. The G-7 issued a communiqu whose disappointing lack of content contrasts sharply with the deteriorating health of the global economy, the intense risks ahead, and legitimate policy confusion. The G-7 is fortunate that it is not required to justify the expenses of its meetings in terms of what is achieved.
A Powerful Obama Speech
by Mohamed A. El-Erian of PIMCO,
At long last, President Obama did enough this evening to upgrade the quality of the nation's economic debate. He presented a credible program that is focused on the right structural areas. Now he must strengthen it and complement it with a sensible fiscal component; and Congress must discuss it in a cooperative and constructive manner. A lot is at stake, especially for those that have been jobless for too long but also for American society as a whole. Let us hope that Washington is, collectively, able and willing to follow through.
Teaching to the Test
by Neel Kashkari of PIMCO,
Many managers are focused on beating benchmarks, rather than helping clients achieve their investment objectives. Clients save and invest their money for specific reasons, such as for retirement or childrens education and managers should focus on helping them meet those goals. Many managers are really closet indexers masquerading as active managers while charging premium fees for benchmark returns. Many equity managers deviate very little from their benchmark because they are terrified of potentially underperforming it.
The Changing Landscape of Global Investing
by Mohamed A. El-Erian of PIMCO,
National and global realignments are fundamentally and durably changing the global investment landscape.
Investors face the challenge of recalibrating some of the traditional parameters that are key to managing risk and delivering returns.
There are also implications for investment management firms which are yet to be sufficiently reflected in the thinking and actions of the industry as a whole.
Helicopter Ben risks destroying credit creation
by Bill Gross of PIMCO,
The concept of showering money over national economies to combat deflation has been an accepted principle of monetarism for decades. A helicopter, however, is not your average aeroplane, and the usual laws of aerodynamics do not necessarily apply in all cases. Similarly monetary policy at the zero interest rate bound introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.
Tuesday's Market Preview Is Not Pretty: El-Erian
by Mohamed A. El-Erian of PIMCO,
Again, already fragile U.S. markets will be influenced by developments on the other side of the Atlanticand in a week in which there is great anticipation for President Obama's "mission critical" speech on the American economy. Europe's deepening debt and growth crisis amplifies the importance Obama's effort to deal with America's deepening unemployment and growth crisis; and does so by raising both the stakes and the challenges for the President. Tighten those seat belts. It will be a bumpy and volatile week as markets are held hostage to policy developments in both America and Europe.
Austerity is not Enough
by Andrew Balls of PIMCO,
Before the Jackson Hole meetings over the weekend, it was no surprise that all eyes were on central banks. They have demonstrated in recent years that they can act swiftly and decisively when they choose to. While eurozone governments have failed to maintain a united front to deal with a sovereign debt crisis, and American politicians have concocted their own budget crisis, central bankers have retained the moral and operational high ground. Yet, given the problems of growth in the U.S., and of growth, solvency and the coherence of the eurozone, there is a limit to what central banks can do.
New-Fangled Love Songs
by Bill Gross of PIMCO,
Liquidity concerns may affect all European peripheral bond markets unless the European Central Bank counters the rush for the exits with an enlarged daily checkbook.
In the U.S., discord between rich and poor has led to lower, not higher, Treasury yields as approaching recessionary winds force the Fed and private investors to favor bonds.
We prefer investing in the cleaner dirty shirt countries of Canada, Australia, Mexico and Brazil, along with non-dollar currencies that have strong trade ties with the Asian continent.
Why Washington Urgently Needs to Break America's Negative Feedback Loop
by Mohamed A. El-Erian of PIMCO,
It is tempting to dismiss all this market volatility as just irritating "noise" rather than insightful "signals". But, be very careful before you are opt for this seemingly comforting interpretation. There is a lot in play today that requires a bold response out of Washington. This is not just an American phenomenon. Europe is in a much worse situation. And, if policymakers on both sides of the Atlantic don't get their act together, they will run out of tools that have a chance of being effective circuit breakers. Things could get a lot worse before they get better.
?The Case for Tail Risk Hedging in Emerging Market Equities
While our secular outlook for emerging markets is solid, we expect long-term success will be earned by those who can manage cyclical risks.
There is a tradeoff between the cost of establishing a hedge and the downside protection that it imparts to a portfolio.
The best approach to tail hedging is a flexible one; using dynamic rebalancing, diversification and affordable option-like securities.
A diversified macro approach to hedging tail risk actually may be more efficient for EM than it is for developed asset classes.
Developed Market Banks: Why PIMCO Pathfinder Takes a Selective Approach
by Charles Lahr of PIMCO,
The Pathfinder Strategy is currently limited to only a handful of banks that are best characterized by PIMCO as deep value opportunities.
We generally do not see meaningful upside potential in equity positions of developed market banks over the secular horizon.
Our concerns primarily revolve around three factors: loan growth, balance-sheet risk along with capital levels and regulation.
Policy Dithering Will Further Fuel the Crisis
by Mohamed A. El-Erian of PIMCO,
The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilised financial markets. If policymakers do not act boldly, and do so in a globally-coordinated fashion, the world risks tipping into a prolonged recession with worrisome institutional, political and social consequences.
Saying No to Keynes and Fiscal Folly
?Taxpayers have been hoodwinked into believing the cost from profligate government spending is low relative to the benefits.
The Keynesian revolution ignited a decades-long abuse of the core principle of Keynesian economics: for government to increase spending when private sector aggregate demand weakens and stymies job growth.
The central banker is left to shoulder the burden, seeking all the while to pressure the fiscal authority to amend the abuse of Keynesian economics and decades of fiscal folly.
No Turning Back: The ECB Brings Its Balance Sheet to Bear on Italy and Spain
by Andrew Balls of PIMCO,
The European Central Bank has crossed the Rubicon. By buying Italian and Spanish government bonds, it has brought a much-needed and credible external balance sheet to bear. There is thus the potential for an end to damaging games of chicken between the eurozones monetary and fiscal authorities and, therefore, stabilizing the eurozones systemically important government bond markets. But there remains huge uncertainty, together with large technical and political execution risk.
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