Blog Department – January 21, 2011

Blog Department – January 21, 2011

1. Bill Gross' Pessimistic Predictions

Below are excerpts from Bill Gross' January 2011 Investment Outlook found on the PIMCO website.

Americans, unlike their developed world counterparts, have been eating their fill lately, and supping at a dinner table laden with pork and tax breaks for all. The American hegemon knows no limits, it seems, when it comes to spending other people's money for their own consumption. Unlike Euroland or the United Kingdom, which appear to have gone on an extreme fiscal diet, the American answer to a bulging waistline is always "mañana." Debt commission recommendations are tossed in the trashcan, tea party election rhetoric eventually focuses on miniscule and merely symbolic earmarks, and both Democrats and Republicans congratulate each other on their ability to reach a bipartisan agreement for the good of the nation. [a reference to the 2010 Tax Relief Act] The problem is that politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion dollar annual deficit. As long as the stock market pulsates upward and job growth continues, there is an abiding conviction that all is well and that "old normal" norms have returned. Four major factors come to mind:

American wages will lag behind CPI and commodity price gains.
Because policy stimulus is focused on maintaining current consumption as opposed to making the United States more competitive in the global marketplace, American workers' real wages will almost necessarily lag historical norms. Blame it on poor education, blame it on globalization, but an ongoing rebalancing of rich country/poor country wages inevitably will keep U.S. wages compressed as deficit spending serves to reflate commodity and end product prices in future years but not paychecks.

Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets.
Unique amongst almost all other global citizens, Americans are ignorant of the merits (and the negatives) of currency depreciation. Unless they are smacked with the reality of an expensive hotel or a meal in a foreign port of call during summer vacation, we have few concerns when the dollar depreciates against a basket of foreign currencies. If our stock market goes up 10% annually in dollar-denominated terms, we assume we are 10% richer even if the dollar sinks at the same time. If the cost of imported goods and especially gasoline goes up more than our paychecks, we blame it on a political conspiracy. The fact is that annual budget deficits in the trillions of dollars add a like amount to the stock of outstanding dollars, resulting in currency depreciation [and] higher import inflation.

One of the consequences of perpetual trillion dollar deficits is the need to finance them, and at attractively low interest rates for as long as possible.
Currently, the Fed is doing both, holding short term interest rates near zero, and engaging in Ponzi like Quantitative Easing II purchases of longer dated Treasuries in the open market. The combination offers bondholders about as attractive situation as the one facing a male praying mantis: zero percent interest rates if you stay in cash, or probable principal losses if you take durational risk by buying 5 and 10 year maturities.

Trillion dollar annual deficits add up, and eventually produce a stock of debt that can become unmanageable: Witness Greece, Ireland, or a host of Latin American countries of generations past.
According to Carmen Reinhart and Kenneth Rogoff's excellent research in This Time Is Different, once a country's debt approaches 90% of GDP (as the U.S. is now doing), its economic growth slows by up to 1% annually as the interest payments drain resources that should be going for productivity enhancements. Sovereign credit risk increases and yield spreads rise relative to global competitors. Future generations pay the price for their parents' mindless [debt addiction].

Above all, remember that all investors should fear the consequences of mindless U.S. deficit spending as far as the eye can see. Higher inflation, a weaker dollar and the eventual loss of America's AAA sovereign credit rating are the primary consequences.

2. Norm Boone's Arguments for Rational Optimism

Pres' fraternity brother, Norman Boone, recently wrote a thoughtful letter to improve the investment mood of his clients (he's a very bright guy with an MBA from the Stanford of the East and is in the same business as Caves & Associates). He first described today's pessimistic mood:

Largely as a hangover from the near disaster we faced a couple of years ago, there still exists widespread fear and intense pessimism, as many investors feel overwhelmed by problems in the U.S., led by high unemployment, Government deficits, still falling housing prices and anger rather than solutions in Washington. Clearly there are substantial issues that have to be worked through. That said, a key concern is that the positive, optimistic, can-do mindset that has helped fuel so much of the growth and success of the U.S. is being mired down in pessimism.

Norm then points out that "throughout history people have regularly overcome problems of similar and bigger magnitude." He draws from a book by Matt Ridley and a Wall Street Journal review of the book by (the) Bill Gates to identify "constant predictions of a bleak future throughout human history." Indeed, they were "real issues" but ones that "were blown out of proportion." According to Norm, there are "two reasons to be optimistic for the mid term: 1) the role of innovation and 2) some of the incredibly positive things that are happening in emerging economies in Asia, Latin American, Eastern Europe and even Africa." Norm quotes from Bill Gates' review of Ridley's book:

"Pessimism is so often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new development and insights that might alter current trends."

Norm completes this argument by noting record global spending on research and the very positive impact of the internet in rapidly disseminating information about new developments.

Speaking about the stunning growth of emerging markets, Norm states: "You've got a new middle class that wants a better life and you've got a whole new generation of incredibly talented young people who are getting educated, applying a strong work ethic and beginning to make a huge impact as a result." He allows that emerging markets are facing large challenges of their own but sees no reason why they won't work through and overcome them.

Norm finally turns to what this all means for the West, as follows:

…pessimists read about China, India and other developing countries and conclude that they're going to achieve growth at the expense of Western countries, and all those super-bright, super-ambitious young kids are going to eat our lunch. And while this could in theory take place, an alternate scenario seems more likely to happen. Many western companies are well positioned to capitalize on the growing middle class in developing economies. A rising percentage of revenue and profits from top consumer goods firms like BMW, Procter and Gamble, Nike, Apple, Nestle and McDonalds are coming from these emerging countries.

And the good news is that these multinational corporations not only have strong brands but also strong balance sheets. Western consumers and governments may be stretched financially but companies have record levels of cash and are in good shape financially.

As for the argument that these emerging economies are going to win at our expense, this assumes that the size of the wealth pie we're dividing up is fixed. It's NOT – through trade and globalization, those emerging markets are going to dramatically increase the total amount of wealth in the world; as they grow, we will also benefit. [The argument] also assumes that western economies and companies won't adapt.

According to Norm:

The next step is for our belief in the future to return.

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		Blog Department – January 21, 2011

		1. Bill Gross' Pessimistic Predictions Below are excerpts from Bill Gross' January 2011 Investment Outlook found on the PIMCO website. Americans, unlike their developed world counterparts, have been eating their fill lately, and supping at a dinner table laden with pork and tax breaks for all. The American hegemon knows no limits, it seems, when it comes to spending other people's money for their own consumption. Unlike Euroland or the United Kingdom, which appear to have gone on an extreme fiscal diet, the American answer to a bulging waistline is always "mañana." Debt commission recommendations are tossed in the trashcan, tea party election rhetoric eventually focuses on miniscule and merely symbolic earmarks, and both Democrats and Republicans congratulate each other on their ability to reach a bipartisan agreement for the good of the nation. [a reference to the 2010 Tax Relief Act] The problem is that politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion dollar annual deficit. As long as the stock market pulsates upward and job growth continues, there is an abiding conviction that all is well and that "old normal" norms have returned. Four major factors come to mind: American wages will lag behind CPI and commodity price gains. Because policy stimulus is focused on maintaining current consumption as opposed to making the United States more competitive in the global marketplace, American workers' real wages will almost necessarily lag historical norms. Blame it on poor education, blame it on globalization, but an ongoing rebalancing of rich country/poor country wages inevitably will keep U.S. wages compressed as deficit spending serves to reflate commodity and end product prices in future years but not paychecks. Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets. Unique amongst almost all other global citizens, Americans are ignorant of the merits (and the negatives) of currency depreciation. Unless they are smacked with the reality of an expensive hotel or a meal in a foreign port of call during summer vacation, we have few concerns when the dollar depreciates against a basket of foreign currencies. If our stock market goes up 10% annually in dollar-denominated terms, we assume we are 10% richer even if the dollar sinks at the same time. If the cost of imported goods and especially gasoline goes up more than our paychecks, we blame it on a political conspiracy. The fact is that annual budget deficits in the trillions of dollars add a like amount to the stock of outstanding dollars, resulting in currency depreciation [and] higher import inflation. One of the consequences of perpetual trillion dollar deficits is the need to finance them, and at attractively low interest rates for as long as possible. Currently, the Fed is doing both, holding short term interest rates near zero, and engaging in Ponzi like Quantitative Easing II purchases of longer dated Treasuries in the open market. The combination offers bondholders about as attractive situation as the one facing a male praying mantis: zero percent interest rates if you stay in cash, or probable principal losses if you take durational risk by buying 5 and 10 year maturities. Trillion dollar annual deficits add up, and eventually produce a stock of debt that can become unmanageable: Witness Greece, Ireland, or a host of Latin American countries of generations past. According to Carmen Reinhart and Kenneth Rogoff's excellent research in This Time Is Different, once a country's debt approaches 90% of GDP (as the U.S. is now doing), its economic growth slows by up to 1% annually as the interest payments drain resources that should be going for productivity enhancements. Sovereign credit risk increases and yield spreads rise relative to global competitors. Future generations pay the price for their parents' mindless [debt addiction]. Above all, remember that all investors should fear the consequences of mindless U.S. deficit spending as far as the eye can see. Higher inflation, a weaker dollar and the eventual loss of America's AAA sovereign credit rating are the primary consequences. 2. Norm Boone's Arguments for Rational Optimism Pres' fraternity brother, Norman Boone, recently wrote a thoughtful letter to improve the investment mood of his clients (he's a very bright guy with an MBA from the Stanford of the East and is in the same business as Caves & Associates). He first described today's pessimistic mood: Largely as a hangover from the near disaster we faced a couple of years ago, there still exists widespread fear and intense pessimism, as many investors feel overwhelmed by problems in the U.S., led by high unemployment, Government deficits, still falling housing prices and anger rather than solutions in Washington. Clearly there are substantial issues that have to be worked through. That said, a key concern is that the positive, optimistic, can-do mindset that has helped fuel so much of the growth and success of the U.S. is being mired down in pessimism. Norm then points out that "throughout history people have regularly overcome problems of similar and bigger magnitude." He draws from a book by Matt Ridley and a Wall Street Journal review of the book by (the) Bill Gates to identify "constant predictions of a bleak future throughout human history." Indeed, they were "real issues" but ones that "were blown out of proportion." According to Norm, there are "two reasons to be optimistic for the mid term: 1) the role of innovation and 2) some of the incredibly positive things that are happening in emerging economies in Asia, Latin American, Eastern Europe and even Africa." Norm quotes from Bill Gates' review of Ridley's book: "Pessimism is so often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new development and insights that might alter current trends." Norm completes this argument by noting record global spending on research and the very positive impact of the internet in rapidly disseminating information about new developments. Speaking about the stunning growth of emerging markets, Norm states: "You've got a new middle class that wants a better life and you've got a whole new generation of incredibly talented young people who are getting educated, applying a strong work ethic and beginning to make a huge impact as a result." He allows that emerging markets are facing large challenges of their own but sees no reason why they won't work through and overcome them. Norm finally turns to what this all means for the West, as follows: …pessimists read about China, India and other developing countries and conclude that they're going to achieve growth at the expense of Western countries, and all those super-bright, super-ambitious young kids are going to eat our lunch. And while this could in theory take place, an alternate scenario seems more likely to happen. Many western companies are well positioned to capitalize on the growing middle class in developing economies. A rising percentage of revenue and profits from top consumer goods firms like BMW, Procter and Gamble, Nike, Apple, Nestle and McDonalds are coming from these emerging countries. And the good news is that these multinational corporations not only have strong brands but also strong balance sheets. Western consumers and governments may be stretched financially but companies have record levels of cash and are in good shape financially. As for the argument that these emerging economies are going to win at our expense, this assumes that the size of the wealth pie we're dividing up is fixed. It's NOT – through trade and globalization, those emerging markets are going to dramatically increase the total amount of wealth in the world; as they grow, we will also benefit. [The argument] also assumes that western economies and companies won't adapt. According to Norm: The next step is for our belief in the future to return.

		Back to Market Reviews