pimco's bill gross february 2014 investment outook: most "medieval"

8/13/2019 PIMCO's Bill Gross February 2014 Investment Outook: Most "Medieval"

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Your Global Investment Authority

Investment OutlookFebruary 2014

Bill Gross

Most Medieval

In days of oldwhen knights were boldand ladies most beholdenstraw seemed like silkand water, milk

and silver almost goldenNot so sure about thatlimerick it was probably a cruel world those days of old.Yet much of it was fascinating and in some cases surreal.Te relationship of man and God, for instance. Or betteryet man, animals and God. Unlike today, when mostbelieve that animals were put on this Earth for humanityspleasure or utility, most people in the Middle Ages believedthat God granted free will to Adam, Eve and all of His

creatures. Animals were responsible in some strangeway for their own actions and therefore should be heldaccountable for them.

Accountable? Well yes, animals were actually put on trial for their

misdeeds. They might actually be considered evil. Beetles that munched

on church pews, pigs that dined off of late evening drunkards, locusts

that ravaged harvest wheat all were viewed in a similar fashion much

like their human counterparts thieves, adulterers and murderers alike.

Sometimes the animal would be brought before an actual court,

sometimes (as with insects) tried in absentia. In the case of ravagingpigs, for instance, there might be a full judicial hearing with a prosecutor,

defense and a robed judge who could order a range of punishments,

including probation or even excommunication. No bad little piggies

went to heaven, it seems. Often, there would be an actual execution with

a hog being hanged by the neck until it was dead. The pork chops

followed shortly thereafter, I assume. There was no Humane Society in

1500. Somehow I thought those medieval times needed a more

reality-based ditty than the one cited above, so heres a modern-day

Chaucers attempt:


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2 FEBRUARY 2014 | INVESTMENT OUTLOOK

In days of old when pigs were bold

and people very prayerful

a locust might be canonized

and drunkards had to be careful.

Now on to the world of investing, me Lords and Ladies,

which by the way is full of little piggies feeding at the

trough, scaredy cats afraid of their own shadow, and

ostriches sticking their heads in the sand. And too, history

will record that capitalism and its markets are a dog-eat-

dog world. If so, weve currently got a menagerie to rival

anything in those days of old. But lets stick with the

piggies for the following Investment Outlook. Hopefully

the prose will be better than the previous poetry.

I find it fascinating the number of ways that investors

approach the value of securities and other investments

such as commercial real estate or homes. Many of them are

legitimate and form a solid foundation in academic

research or even common sense. Natural interest rates,

P/E ratios, cap rates, risk and liquidity premiums, and even

real estates location, location, location are ways to

fundamentally price an asset. Add to that the emotional

influence of human nature and you have a pretty good idea

as to why prices go up and down; not necessarily a pretty

good idea as to when they will go up and down, but at

least the why part is partially visible.

But lost in this rather complex maze of why is the function

of credit and credit expansion in a modern, financial-based

economy that it dominates. Asset prices are dependent

on credit expansion or in some cases credit

contraction, and as credit goes, so go the markets,one might legitimately say, and I do most

emphatically say that!What exactly do I mean by

credit? Well, money in all its multiple forms. Cash is a

form of credit in my definition because you can use it to

buy things. Bonds are credit. Stocks are credit. Houses and

real estate can be considered credit when they are

securitized and sold to investors in mortgage pools. In our

modern financial economy, credit is anything that can be

transferred on a wire or a computer from one account to

another and ultimately be used as the basis for spending

money on things such as groceries or airplane tickets.

And so when an investor tries to think about prices for

these various forms of credit, it is necessary to get behind

the winds of credit itself, to see what causes credit to

behave like a mild South Seas breeze or a destructive

typhoon in the China Sea. Credit creation or creditdestruction is really the fundamental force that changes

P/Es, risk premiums, natural interest rates, etc. For most

investors that may be hard to understand, but that is

where the little piggies come in.

Imagine you are on that South Sea island with only two

people. Each of you owns half of the island, grows your

own food and has four little piggies for bacon and chops

and all of the good stuff that people like to eat. Things are

copasetic; the local economy is doing fine, but one day

your other buddy figures out a way to make a new cropthat you dont have. Shes the islands entrepreneur, so to

speak. Well, being jealous and perhaps a tad greedy, your

previous buddy refuses to share the secret. But she will

offer you a future share of her harvest for one of your little

pigs there being no money, credit or anything of the sort

on the island. You love that bacon, but the lady is living

higher on the hog, so to speak, with that new crop, so

you agree on a deal one pig for one years harvest of her

future crop. Despite the lack of a stock market,

crops are now trading at a P/E of 1 X pigs. One pig

equals one future years worth of your ex-buddys

bountiful harvest. Well the months roll by and one thing

leads to another, and for some reason you want some

more of your neighbors crop. Maybe its marijuana and

the island has just legalized it for medicinal purposes. Lets

just say. And lets say youre willing to part with another

pig for another share of medicinal weed. Neighbor,


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INVESTMENT OUTLOOK | FEBRUARY 2014 3

sensing enthusiasm, says, No, itll cost you three pigs,

which is all you have, but youre feeling high and certainly

very hungry so you say OK. This funny smelling grass

now sells at 3 X pigs, or a pigs-to-grass P/E ratio of 3/1

and everybodys happy. Until well to get back to the

real world, those piggies have really been credit or cash

substitutes all along, and now in order to keep this system

going you need more pigs or more credit in order to

continue. But youre out of pigs. A funny thing now

happens in this capitalistic South Sea island and mainly to

the price of marijuana. It traded last year at 3 pigs to 1,

but since youre out of pigs and credit, the price collapses.

Grass goes to zero because there is no more credit; you

have no more pigs to pay for it.

So for those of you who dont live in Washington State or

Colorado or others who are a little miffed at this example,

lets just put it this way. P/Es of 3 or P/Es of 15 or

P/Es of 0 are intimately connected to the amount of

available credit. So are interest rates. If there was

only one dollar to lend and someone was desperate

to have it, the interest rate would be usurious. If

there was one trillion dollars of credit and no one

was eager to borrow for some reason or another,

then the rate would be .01% like it is today and for

the past five years in my personal money market

account.The amount of credit and its growth rate are

critical to asset prices, and of course asset prices in our

modern economy are critical to growth and job creation

and future prospects for investment. We have a fiat/credit/

debt-based economy that depends on the continuous

creation of more and more credit in order to thrive andsome would say even survive. We need those pigs and

more of them. And they need to circulate and be traded

what some would call velocity in order to keep the

economy growing. Our South Sea island economy never

did change until the new crop was discovered, but

concurrently, not until the pigs started to be traded for it.

And so? Well, to use the U.S. as an example, we officially

have 57 trillion dollars worth of credit (stocks not being

part of the Feds official definition) and probably 20

trillion more in what has come to be known as the

shadow system. But call it 57 trillion because the

Fed and Chart 1 do.

OINK!

Source: Federal Reserve Board/Haver Analytics

U.S. Credit

45 50 55 60 65 70 75 80 85 90 95 00 05 10

60,000

50,000

40,000

30,000

20,000

10,000

0

Chart 1

US$

(Billions)

It used to grow pre-Lehman at 810% a year, but now it

only grows at 34%. Part of that growth is due to the

government itself with recent deficit spending. A deficit of

one trillion dollars in 20092010 equaled a 2% growth

rate of credit by itself. But despite that, other borrowers

such as households/businesses/local and foreign

governments/financial institutions have been less than

eager to pick up the slack. With the deficit now down

to $600 billion or so, the Treasury is fading as a

source of credit growth.Many consider that as a goodthing but short term, the ability of the economy to expand

and P/Es to grow is actually negatively impacted, unless

the private sector steps up to the plate to borrow/invest/

buy new houses, etc. Credit over the past 12 months has

grown at a snails 3.5% pace, barely enough to sustain

nominal GDP growth of the same amount.


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4 FEBRUARY 2014 | INVESTMENT OUTLOOK

Is there a one-for-one relationship between credit growth

and GDP? Certainly not. That is where velocity complicates

the picture and velocity is influenced by interest rates and

the price of credit. But with QE beginning its taper, and

interest/mortgage rates 150 basis points higher than they

were in July of 2012, velocity may now negatively impact

the equation. MV=PT or money X velocity = GDP is how

economists explain it in old model textbooks. Actually the

new model should read CV=PT or credit X velocity = GDP

but most economists are classically trained to the Friedman

model, which viewed money in a much narrower sense.

So our PIMCO word of the month is to be careful.

Bull markets are either caused by or accompanied by

credit expansion. With credit growth slowing due in

part to lower government deficits, and QE now

tapering which will slow velocity, the U.S. and other

similarly credit-based economies may find that future

growth is not as robust as the IMF and other model-

driven forecasters might assume. Perhaps the

whisper word of deflation at Davos these past few

weeks was a reflection of that. If so, high quality

bonds will continue to be well bid and risk assets

may lose some luster. In any case, dont be a pig in

todays or any days future asset markets. The days of

getting rich quickly are over, and the days of getting rich

slowly may be as well. Most medieval, perhaps.

And too, stick with PIMCO. Believe me when I say,

we are a better team at this moment than we were

before.I/we take the future challenge faced by all asset

managers with close to a sacred trust. Not the one that

the ancients granted to animals, but a more modern one

embraced by the relationship of client/fiduciary and the

need to be held accountable, sort of like the pigs and

locusts in days of old when knights were bold.

Most Medieval Speed Read

1) Asset prices depend on credit creation and expansion.

2) The U.S. and other countries create less credit from

the public standpoint as their deficits decline.

3) 34% credit expansion in the U.S. may not be enough

to maintain 3% growth, especially if asset prices go

down and velocity is affected.

4) Dont be a pig in a highly levered global marketplace.

There is risk out there.

William H. GrossManaging Director


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pimco's bill gross february 2014 investment outook: most "medieval"

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