Thursday, July 5th, 2012
Investment Outlook, July 2012
What’s In A Name?
by William H. Gross, PIMCO
- Not only banks and insurance companies but sovereign nations as well cannot all be counted on to guarantee a return of principal, let alone a return on investment.
- An authentic debt crisis – which the world is now experiencing – can only be ultimately cured in two ways: 1) default on it, or 2) print more money in order to inflate it away.
- There are very few clean dirty shirts in this world. Timing in investment markets is critical and at the moment the U.S. is considered to be the cleanest.
What’s in a name? I wish I’d asked my parents how they came up with mine, because I’ve never really been a good “Bill.” That is not to say that I’m uncomfortable in my own skin – I usually am – but I’ve never really been at ease with the name. Perhaps it’s genetic because the discomfort seems to run in the family. Who could blame my father I suppose for insisting on “Dutch” as opposed to Sewell Gross the IV! Imagine: a nameological tyranny of four successive Sewells! It ended with him, but then there was my brother Craig who insisted on Chip and my sister Lynn who in her fifties changed her name to Lyn. At least I didn’t have to worry about calling her by the wrong name, although I have boo-booed on birthday cards. In any case, we Grosses seem to dislike our names.
Having kids, however, allowed me to set the record straight or at least mutate those genes which kept rejecting given names that seemed appropriate to parents, but not to Gross progeny. My first attempt at cracking the code came with my first son, Jeff. I liked “Jeff.” It was short, masculine and was the first name of a Duke basketball star in the 1960s. I’d be a better Jeff than a Bill. Next up was Jennifer, whose name came from a Donovan number one hit song and then there was Nick. Nick was actually Sue’s favorite name, but I easily conceded. Who couldn’t like Nick? Saint Nick, just in the Nick of time, Nick, Nick, Nick. I would’ve been a good Nick.
Now at 68, however, I’ve run out of naming opportunities which has caused me to begin to nitpick my last name. I mean there are Smith(s) because their occupational heritage was presumably a craftsman, and Johnson(s) who were the sons of John, but Gross? What’s a Gross? A Gross, as it turns out, is twelve dozen or 144. Numerology is not my bag, but the frequency of this number’s occurrence is more than eerie. My first home was on 14401 La Mancha and my home for the last 25 years has been 144 Seabring Way. I was born in 1944, the 144 in this case being necessarily interrupted by a centurion digit. In addition, while my birthdate was 4/13 instead of 4/14, my mother always informed me as mothers do, that I was born at 9:36 p.m. which I only recently calculated to be 144 minutes short of the 4/14/44 date. Very strange.
Gross also means “big” in German and was adopted by the English with an E on the end as in Grosse Point, Michigan. Neither of those connections disturbs me, nor does the expression “how gross.” I always sort of shrugged and told myself to get over it. What bothers me most about it though is that I keep getting advertising pamphlets in the mail from Jewish mausoleums. Seems like half the Grosses in the world are Christian and half are Jewish. The Christians don’t seem to be concerned about my hereafter, but the followers of the Jewish faith do. For that I’m thankful, but I’d prefer not to be reminded of my impending doom, so at 68 I wish I wasn’t a Gross. Not a Bill, not a Gross – go figure. What’s in a name?
7% returns out of reach
Mayor Michael Bloomberg in a February trip to his state capital to discuss pension funding told a legislator that “if I can give you one piece of financial advice, it’s: If somebody offers you a guaranteed 7% on your money for the rest of your life, you take it and just make sure the guy’s name isn’t Madoff.” So names, it seems are important to others outside the Gross family and I probably should hold off changing the “Bill” and even the “Gross” if only because it’s not Madoff. That 7% return though – I’m not sure it’s possible in this era of the New Normal where negative real rates on Treasuries and its incumbent financial repression dominate bond and asset markets alike. Aside from the 7% return expectation however – which many pension funds and liability structures assume at a bare minimum – what struck me about the Mayor’s comment was the assumption that there were legitimate guarantors of investment returns throughout the world. Even assuming that Madoff and his Ponzi lookalikes are now under lock and key, recent events have shown that not only banks and insurance companies with their presumed “money good” guarantees, but sovereign nations as well cannot all be counted on to guarantee a return of principal, let alone a return on investment that comes anywhere close to matching 7% in nominal terms. What does Greece tell us if not that money, credit and financial investments dependent on ever expanding growth of credit are sometimes subject to buzz cut defaults with scalp level clippers, as opposed to a trimming of the bangs with haute couture scissors. 7%? Greek, Spanish and almost all non-Germanic Euroland bond investors would be happy for much less – they’d request a modern day Will Rogers haircut, which was defined in the 1930s when he said, “I’m more concerned about the return of my money than the return on my money.” Trillions of global investment dollars, Euros and Yen would settle for just that if they could only reclaim their prior investments at par, and then silently deposit them in a mattress for safekeeping.
Debt crisis can’t be cured with more debt
What global investors, fixated on historical cyclical trends as opposed to secular delevering dynamics fail to appreciate is that economies and their financial markets historically have taken several decades as opposed to several years to renormalize once the fatal grip of too much debt wreaks havoc on the assumed perpetuity of capitalism’s prosperity machine. Can a debt crisis be cured with more debt? Yes, if initial debt levels are reasonable and central banks are able to rejuvenate the delicate dance between debtor and creditor – each believing that they are getting a good deal in terms of risk, reward and the deployment of funds between now and some future maturity. But when debt as a percentage of GDP, or debt service as a percentage of household income, or the appropriateness of the term structure (short vs. long) on both borrower and lender balance sheets becomes imbalanced, then the well-oiled capitalistic engine may sputter and in some cases – as in Greece – freeze up. That’s when a debt crisis can’t be cured with more debt, be it in the form of QEs or LTROs, or implicit firewalls created or to be created by Eurobonds, ESMs, the IMF or any other agency that presumably is money good. The fact is that the current burden of global debt is only being lightly alleviated via zero-bound interest rates. None of it, other than Greek PSI or minor amounts of private U.S. mortgage debt has been extinguished over the post-Lehman era; it has only been transferred from one pocket to another. Banks, insurance companies and mutual funds have passed the peripheral Old Maid from their hands to that of the ECB, or to Spanish and Italian banks, and ultimately on to the German core. Does it matter that Greece decides to stay with the Euro or that the Southern peripherals move towards austerity, or that the U.S. in November decides to go Red or Blue? Not much. Solutions for real growth matter only at the margin. An authentic debt crisis – which the world is now experiencing – can only be ultimately cured in two ways: 1) default on it, or 2) print more money in order to inflate it away. Both 1 and 2 are poison for bond and stock holders, which is why 7% returns – guaranteed or not – are so comical.
In search of those mythical returns, investors have shifted both bond and equity funds into what we at PIMCO call the “cleanest dirty shirt” countries. Not content to wallow in the mud of the southern Euroland PIGS despite their (coincidentally) 7% yields, investors have preferred 0% 2-year German Schatz or almost as ridiculous 0% 30-year U.K. linkers under the assumption that their principal at least will be “guaranteed.” For 30 years though, U.K. investors will guarantee themselves a return at or below their future purchasing power. Mayor Bloomberg it seems has a Sophie’s Choice – 7% with debt–laden, mud-caked Spanish polo shirts or 0% with bleached but still stained knock-offs. His Honor – and all other investors – must decide if as Shakespeare posed “a rose is a rose by any other name.” Is a clean dirty shirt a dirty shirt by another name? And if not, in the midst of a global debt crisis can there actually be such a thing as a clean dirty shirt that justifies near 0% yields? The fit, it seems, may be a tad tight the closer bonds get to zero.
Is the U.S. shirt really clean?
This observer must obviously admit – as do rating services – that some countries are better than others. Those with initial debt conditions that don’t exceed historical norms, those that can print and issue debt in their own currencies, those that have reasonable trade balances, those that emphasize the sanctity of property rights, those that dominate the global military stage, those with innovation and education, those…. I could go on. Many of the above conditions point investors to the ultimate “safe haven,” the cleanest of the dirty shirts, the champion of champions, rose of all roses – the United States. I will not dispute it, market movements have confirmed it and my own experience in 2011 is a testament to it. Don’t underweight Uncle Sam in a debt crisis. Money seeking a safe haven will find it in America’s deep and liquid (almost Aaa rated) bond and equity markets.
Yet there may come a time when the king adorned in his clean dirty shirt may be redressed or perhaps undressed to reveal he has no clothes – just like Greece – just like many or most of the rest of them. The chart below shows America’s debt/GDP which at close to 100% is not near-term threatening, but if continued upward on trend could be absolutely debilitating. 7-8% annual deficits while alleviated and tempered by the financing of them with negative real interest rates, promise to raise that 100% number to 125% within five years if nothing is done. Yet as stunning and as Greek-like as that percentage is, it comes nowhere close to the actual liabilities of the U.S. government that represent promises nearly as sacrosanct as the interest and principal on a 30-year Treasury. Social Security, Medicare and Medicaid liabilities when measured on the same present value basis as our current $15 trillion of outstanding debt, total four times as much: $66 trillion according to unbiased, non-political, Office of Management and Budget (OMB) estimates of future liabilities. In addition, studies estimated the unfunded liabilities of state and local governments at an additional $38 trillion. All together they would accelerate the line in chart 1 to 800% of GDP. And we look down on the Greeks?
Mayor Bloomberg was on to something when he told Albany legislators to look for anyone or any firm with a name other than Madoff to seek out their vaunted 7%. What he didn’t say is that our U.S. President – past, present and future – heads a financing scheme that has similar characteristics. Think of the U.S. balance sheet with its $66 trillion dollars of liabilities as one giant PIK bond – Payment In Kind. The corporate bond market has PIKs although they tend to be junk market rated. Instead of paying actual current interest they promise to pay future bills with more and more bonds – payment in kind. That’s what Social Security ($8 trillion) is; that’s what Medicare is ($23 trillion); and that’s essentially what Medicaid is ($35 trillion) although the latter is appropriated annually and therefore disguised as an actual debt. U.S. Treasuries are one giant PIK bond that can only partially be paid off under assumptions of Old Normal 3% real growth rates, or check writing by the Federal Reserve that inflates away the debt and a bondholder’s real principal at the same time.
So Mr. Mayor, I would tell investors this: There are very few clean dirty shirts in this world. Timing in investment markets is critical and at the moment the U.S. is considered to be the cleanest. That’s why PIMCO owns them. But things change. A blossoming rose wilts over time. A good name can be slandered, a great opportunity to change fiscal direction squandered within a few short years. This debt crisis should be considered global as opposed to regional, and investors should recognize that clean dirty shirts are not forever thus. Over time, they may have to change their name, their rating, or at least their reputation as a clothes horse.
William H. Gross
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC.
Copyright © 2012, PIMCO
Tags: Basketball Star, Bill Gross, Birthday Cards, Brother Craig, Cracking The Code, Debt Crisis, Dirty Shirts, Duke Basketball, Gross Investment, Investment Markets, Investment Outlook, Nick Nick, Nick Of Time, Own Skin, Return On Investment, Saint Nick, Sewell, Sewells, Sister Lynn, Sovereign Nations, Time Nick, William H Gross
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Thursday, May 31st, 2012
Wall Street Food Chain
by William H. Gross, PIMCO
- Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors.
- Both the lower quality and lower yields of such previously sacrosanct debt represent a potential breaking point in our now 40-year-old global monetary system.
- Bond investors should favor quality and “clean dirty shirt” sovereigns (U.S., Mexico and Brazil), for example, as well as emphasize intermediate maturities that gradually shorten over the next few years. Equity investors should likewise favor stable cash flow global companies and ones exposed to high growth markets.
The whales of our current economic society swim mainly in financial market oceans. Innovators such as Jobs and Gates are as rare within the privileged 1% as giant squid are to sharks, because the 1% feed primarily off of money, not invention. They would have you believe that stocks, bonds and real estate move higher because of their wisdom, when in fact, prices float on an ocean of credit, a sea in which all fish and mammals are now increasingly at risk because of high debt and its delevering consequences. Still, as the system delevers, there are winners and losers, a Wall Street food chain in effect.
These economic and/or financial food chains depend on lots of little fishes in the sea for their longevity. Decades ago, one of my first Investment Outlooks introduced “The Plankton Theory” which hypothesized that the mighty whale depends on the lowly plankton for its survival. The same applies in my view to Wall, or even Main Street. When examining the well-known wealth distribution triangle of land/labor/capital, the Wall Street food chain segregates capital between the haves and have-nots: The Fed and its member banks are the metaphorical whales, the small investors earning .01% on their money market funds are the plankton. Yet similar comparisons can be drawn between capital and labor. We are at a point in time where profits and compensation of the fortunate 1% – both financial and non-financial – dominate wages of the 99% and the imbalances between the two are as distorted as those within the capital food chain itself. “Ninety-nine for the one” and “one for the ninety-nine” characterizes our global economy and its financial markets in 2012, with the obvious understanding that it is better to be a whale than a plankton. Not only do Wall Street and Newport Beach whales like myself have blowholes where they can express their omnipotence as they occasionally surface for public comment, but they don’t have to worry as yet about being someone else’s lunch.
Delevering Threatens Global Monetary System
Yet while the whales have no immediate worries about extinction, their environment is changing – and changing for the worse. The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes, which lie on a visible horizon, may not be so beneficial for our ocean’s oversized creatures.
The balance between financial whales and plankton – powerful creditors and much smaller debtors – is significantly dependent on the successful functioning of our global monetary system. What is a global monetary system? It is basically how the world conducts and pays for commerce. Historically, several different systems have been employed but basically they have either been commodity-based systems – gold and silver primarily – or a fiat system – paper money. After rejecting the gold standard at Bretton Woods in 1945, developed nations accepted a hybrid based on dollar convertibility and the fixing of the greenback at $35.00 per ounce. When that was overwhelmed by U.S. fiscal deficits and dollar printing in the late 1960s, President Nixon ushered in a new, rather loosely defined system that was still dollar dependent for trade and monetary transactions but relied on the consolidated “good behavior” of G-7 central banks to print money parsimoniously and to target inflation close to 2%. Heartened by Paul Volcker in 1979, markets and economies gradually accepted this implicit promise and global credit markets and their economies grew like baby whales, swallowing up tons of debt-related plankton as they matured. The global monetary system seemed to be working smoothly, and instead of Shamu, it was labeled the “great moderation.” The laws of natural selection and modern day finance seemed to be functioning as anticipated, and the whales were ascendant.
Too Much Risk, Too Little Return
Functioning yes, but perhaps not so moderately or smoothly – especially since 2008. Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core. Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors. QEs and LTROs totaling trillions have been publically spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea when compared to 2–3% inflation now commonplace in developed economies.
Both the lower quality and lower yields of previously sacrosanct debt therefore represent a potential breaking point in our now 40-year-old global monetary system. Neither condition was considered feasible as recently as five years ago. Now, however, with even the United States suffering a credit downgrade to AA+ and offering negative 200 basis point real policy rates for the privilege of investing in Treasury bills, the willingness of creditor whales – as opposed to debtors – to support the existing system may soon descend. Such a transition occurs because lenders either perceive too much risk or refuse to accept near zero-based returns on their investments. As they question the value of much of the $200 trillion which comprises our current system, they move marginally elsewhere – to real assets such as land, gold and tangible things, or to cash and a figurative mattress where at least their money is readily accessible. “There she blows,” screamed Captain Ahab and similarly intentioned debt holders may soon follow suit, presenting the possibility of a new global monetary system in future years, or if not, one which is stagnant, dysfunctional and ill-equipped to facilitate the process of productive investment.
Tags: Bill Gross, Bond Investors, Brazil, Central Banks, Equity Investors, Estate Move, Fishes In The Sea, Food Chains, Giant Squid, Global Monetary System, Gross Investment, Haves And Have Nots, Investment Outlook, Little Fishes, Market Investors, Member Banks, Money Market Funds, Stocks Bonds, Street Food, Wealth Distribution, William H Gross, Winners And Losers
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Wednesday, May 2nd, 2012
Tuesday Never Comes
by William H. Gross, Co-Chief, PIMCO
- The current acceleration of credit via central bank policies will likely produce a positive rate of real economic growth this year for most developed countries, but the structural distortions brought about by zero bound interest rates will limit that growth and induce serious risks in future years.
- Not suddenly, but over time, gradually higher rates of inflation should be the result of QE policies and zero bound yields that will likely continue for years to come.
- Focus on securities with shorter durations – bonds with maturities in the five-year range and stocks paying dividends that offer 3%–4% yields. In addition, real assets/commodities should occupy an increasing percentage of portfolios.
The global economy is floating on an ocean of credit, and a good thing too as our cartoon friend Wimpy reminds us. Without it, he would be a hungry puppy by next Tuesday and nearly seven billion world citizens would be worse off if barter, and not credit, was the oil that lubricated trade. Unlike Wimpy, early societies functioned without an exchange of (money) or the promise to pay it back in the future (credit). Growth was limited, however, because savings or investment could not be incented properly. Those that wanted to save for a rainy day had no means to express that caution; better to consume a banana or a hamburger today than to watch it rot and become worthless on Tuesday. But money changed all of that and the ability to borrow and exchange it for repayment at some future date was the economic elixir of the ages. Shakespeare, with his admonition to “neither a borrower nor a lender be,” might have won a 17th century Pulitzer, but definitely not a Nobel Prize for economics.
Still, the use of credit never really kicked into high gear until the discovery of fractional reserve banking and the ultimate formation of central banks to facilitate and protect its disbursement. Picture a Wild, Wild West Bank in Yuma, Arizona back in 1901. It had a big safe where miners left their gold nuggets for safe keeping, but in order to become more than a depository, the bank needed to issue notes and letters of credit in an amount greater than the gold in its vault. Theoretically there was some of the owner’s gold dust in there too, but who was counting as long as gold came in and gold went out and Yuma’s citizens thought that the bank’s notes were backed by tangible evidence of wealth. Fractional reserve banking was aborning in the 20th century, sharpshooters and all.
Problem was that many of those local banks with their individual currencies and drafts went out of business, leading to panics and mild depressions throughout the growing states, and so in 1913 the dollar became our single currency, and the Federal Reserve our official central bank. The Fed, with a certain amount of gold certificates, would then extend credit to its member banks, which would then extend credit to businesses, which would magically promote savings, investment and economic growth. No leftover hamburgers on Tuesday for Wimpy – his tummy was grumbling and by god, or by Fed, he was gonna get it NOW.
This process of credit and its creation powered global economies for the next century. It benefited not only consumers who wanted their burgers now, but lenders and investors who were willing to go hungry on Friday for the benefit of getting their money back with interest on Tuesday. Both sides experienced a win/win exchange as the real economy charged ahead, creating jobs, technological advances and the eradication of disease. What was not to like about credit? Nothing really, except much as the absence of it hindered ancient societies, the excess of it now hobbles modern economies. Credit is the foundation of the wealth creation process, but it can also be the cause of financial instability and potential wealth destruction. Like nuclear energy, “atomic” credit or debt must be controlled if it is to benefit, as opposed to destroy.
And so the job of modern-day central bankers – Bernanke, King, Draghi and their global counterparts – is to decide how to control a beneficial chain reaction without it getting out of hand. In many ways they are like their Wild, Wild West counterparts, trying to convince skeptical depositors that the gold will always be there. Yet, since 1971, when Nixon cratered Bretton Woods, there has been no explicit or even implicit gold backing. The U.S. and therefore the world’s finance-based economies have been backed by an increasing amount of IOUs, which are simply paper promises to create more paper when there is an old-fashioned 20th century run on the banks, or incredibly enough – even when there is not. Lacking a disciplined parental example, the banks, investment banks, money managers and hedge funds piled paper on top of paper as well, creating derivatives and seemingly endless chains of repos and rehypothecation of repos to amass a total amount of credit that literally cannot be counted. Estimates suggest global credit in the financial sector exceeds $200 trillion, with developed economies’ central banks holding only $15 trillion in reserves or figurative “gold dust.” If so, then the global banking system is levered at least thirteen times. These numbers don’t even count the amount of side bets or credit default swaps, which can’t be used as burger payments, but which total $700–$800 trillion alone. Wimpy has financed so many Whoppers that Tuesday can never come. Judgment day must always be around the corner or after the next weekend. Wimpy cannot pay the tab, except with more and more credit creation, as Euroland countries are discovering first hand.
Yet how much credit is too much credit and how is a dedicated central banker to know? Part of the problem is in clearly defining what does or doesn’t fit the definition. There are the families of M’s – M1, M2 and the disbanded M3 in the U.S. – the former two of which the Fed now loosely uses to monitor a growth rate so as not to bring credit creation to a boil. 21st century privateers, however, proved there can be no accurate gauge of credit growth as long as banks and the shadow banks can create their own money at will. CDOs, CLOs and securitized lending that managed to skirt regulatory standards for bank loans by applying 1%, 2% and 5% “haircuts” to securitized assets made a mockery of sound banking and ultimately created great risk for central bankers and their ability to temper the excess of credit creation. In 2008, central bankers never really knew how much debt was out there, and to be honest, they don’t know now.
Austrian school economists might say “no matter, forget the counting – all a central banker has to do is observe the interest rate, the price of credit, to know whether things have gotten out of hand.” And they may have had a point – even after 1971 and up to the mid-1990s, but then economies and the credit that was driving them morphed into a universe that the conservative Austrians would not have recognized. With the dotcoms, the subprimes and now the reflexive delevering of our financial system, it is practically impossible to know what interest rate is applicable. With the QEs and LTROs reducing real yields far below absolute zero, a central banker must wander aimlessly in policy space, wondering how much credit to create, how many Treasuries to buy, and how firm a twist to give the yield curve in order to allow Wimpy the chance for another burger and a side order of fries.
What they should know – and what the following chart, provided by the always observant Jim Bianco, shows – is that when QEI and QEII lapsed in recent years, stock prices declined by 10%–15% until magically they came back to live another day. The same stunting effect can be observed in the bond market when measured by real as opposed to nominal interest rates. They go down with QEs and up in their absence.
Admittedly, Chart 1 shows only two real data points, which are difficult for a Fed Chairman or his staff to rely on, but common sense underlies the historical observation as well. With the Fed buying nearly 70% of all five- to 30-year Treasuries during Operation Twist, and similarly large percentage amounts of Treasury and Agency mortgage-backed issuance since the beginning of QEI in December 2008, who will buy them now, if the Fed doesn’t?
The Fed appears to have a theory that is somewhat incomprehensible to me, stressing the “stock” of Treasuries as opposed to the “flow.” Future flows and annual supplies of $1 trillion and more, the theory argues, will be gobbled up by the market even without the Fed’s help, at current artificially suppressed yields because the private market’s “stock” of Treasuries has been depleted. Much like a wine cellar, I suppose, that is now nearly empty because policymakers have been drinking the rare vintages, wine lovers will now be forced to restock their cellars to get a historically comfortable inventory. Hmmm, being a beer drinker myself, I might otherwise assume that appetites might switch due to higher prices (and lower yields). And if wine or bonds were mandated to fill the cellar, then why not a foreign wine or a foreign bond? And too, I’m sure the Chinese in addition to PIMCO clients would be willing at the margin to change their preferences to real as opposed to financial assets. More conservative investors might migrate to cash as the preferred alternative, because the price of bonds or burgers was too high. Wimpy, in other words, might just go vegan if burgers aren’t cooked to taste.Because of QEs, the associated Twist, and similar check writing by the BOE, BOJ and ECB, several trillion dollars of what is academically referred to as “base money,” and what Main Street citizens would recognize as “gold dust,” has been added to global central bank vaults. Rather than dug out of the ground, this credit has been created at the stroke of a pen or a touch of the keyboard in today’s electronic monetary system. How that is done is a topic for another day, but since the early 1900s, and especially since 1971, it has been done so often that prices of goods and services are 400% of what they were when President Nixon decided to propel central banking to another orbit. “We are all Keynesians now,” he said back then, but he should have replaced Mr. Keynes with Mr. Burns, Miller, Volcker, Greenspan and Bernanke. We are all central bankers now, at least from the standpoint of endorsing stimulative policies that permit Wimpy and his seven billion counterparts to keep on eating burgers, and their lenders, by the way, to keep on coining profits.
Part productive, but increasingly destructive, the current acceleration of credit via central bank policies will likely produce a positive rate of real economic growth this year for most developed countries, but the structural distortions brought about by zero bound interest rates will limit that growth as argued in previous Outlooks, and induce serious risks in future years. In addition, inflation should creep higher. Do not be mellowed by the affirmation of a 2% target rate of inflation here in the U.S. or as targeted in six of the G-7 nations. Not suddenly, but over time, gradually higher rates of inflation should be the result of QE policies and zero bound yields that were initiated in late 2008 and which will likely continue for years to come. We are hooked on cheap credit just as Wimpy was hooked on Friday’s burgers. As I highlighted last month in “The Great Escape,” bond and equity investors should focus on securities with shorter durations – bonds with maturities in the five-year range and stocks paying dividends that offer 3%–4% yields. In addition, real assets/commodities should occupy an increasing percentage of portfolios. Wimpy would not be pleased by this change of diet nor by the cost and risk of burgers for delivery next Tuesday. But for him, and for central bankers, the hope is that Tuesday never comes.
William H. Gross
Tags: Admonition, Bank Policies, Bill Gross, Central Banks, Disbursement, Distortions, Fractional Reserve Banking, Future Years, Global Economy, Gross Co, Gross Investment, Hungry Puppy, Investment Outlook, Maturities, Nobel Prize For Economics, Qe, Real Assets, William H Gross, Wimpy, World Citizens
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Friday, April 6th, 2012
Here are this month’s Top 20 Stories according to you:
Tags: David Rosenberg, Doug Kass, Economic Indicator, Ecri, False Sense Of Security, Glitter, Gold, Gross Investment, Investment Outlook, Investment Performance, Jakobsen, John Hussman, Latent Risks, March 19, Ray Dalio, Recession, Record Quarter, Saut, Sense Of Security, Sprott, Twelve Steps, Warren Buffett
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Tuesday, March 27th, 2012
The Great Escape:
Delivering in a Delevering World
by William H. Gross, PIMCO
- When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
- In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
- We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
The term delevering implies a period of prior leverage, and leverage there has been. Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. Stocks for the Long Run was the almost universally accepted mantra, but it was really a period – for most of the last half century – of “Financial Assets for the Long Run” – and your house was included by the way in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.
As nominal and real interest rates came down, down, down and credit spreads were compressed through policy support and securitization, then asset prices magically ascended. PE ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.
And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.
How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.
To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.
This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie staring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.
What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks and real estate becomes problematic and certainly much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.
That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.
Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.
In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) Real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread and interest rate durations because they are more defensive. (3) Financial assets for entities with relatively strong balance sheets that are exposed to higher real growth, for which developing vs. developed nations should dominate. (4) Financial or real assets that benefit from favorable policy thrusts from both monetary and fiscal authorities. (5) Financial or real assets which are not burdened by excessive debt and subject to future haircuts.
In plain speak –
For bond markets: favor higher quality, shorter duration and inflation protected assets.
For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks.
For commodities: favor inflation sensitive, supply constrained products.
And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.
With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”
“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.
Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.
And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.
William H. Gross
“Safe Spread” also known as “Safe Carry” is defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. An investor should consult their financial advisor prior to making an investment decision.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.
Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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Saturday, March 17th, 2012
AdvisorAnalyst.com’s Top Fifteen Stories (February – March 2012) According to You
Tags: Big Time, Bill Gross, Citizenry, Complacency, David Rosenberg, Economic Indicator, Eric Sprott, Grandchildren, Gross Investment, Indentured Servitude, Investment Lessons, Investment Outlook, Jeremy Grantham, Jeremy Siegel, physical gold, Portfolios, Quarterly Letter, Saut, Thirteen Qualities, Twelve Steps, Warren Buffett
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Tuesday, February 28th, 2012
- Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth.
- Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills.
- The PIMCO defensive strategy playbook: Recognize zero bound limits and systemic debt risk in global financial markets. Accept financial repression but avoid its impact when and where possible. Emphasize income we believe to be relatively reliable/safe; seek consistent alpha.
They say defense wins Super Bowls, but the Mannings, Bradys and Montanas of gridiron history are testaments to the opposite. Putting points on the board, especially in the last two minutes, has won more games than goal line stands ever have, even if the scoring has been done by the field goal kickers, the names of whom have been confined to the dustbins of football history as opposed to the Hall of Fame in Canton, Ohio. Canton, however, has an approximately equal number of defensive in addition to offensively positioned inductees, so there must be a universally acknowledged role for both sides of the scrimmage line. What fan can forget Mean Joe Greene, Deion Sanders or Mike Ditka? The old, now politically incorrect showtune laments that “you gotta be a football hero, to fall in love with a beautiful girl,” but football and any of life’s heroes can play on either side of the line, it seems.
My point about pigskin offense and defense is the perfect metaphor for the world of investing as well. Offensively minded risk takers in the markets have historically been the ones who have dominated the headlines and won the hearts of that beautiful gal (or handsome guy). Aside from the rare examples of Steve Jobs and Bill Gates, however, the secret to getting rich since the early 1980s has been to borrow someone else’s money, throw some Hail Mary passes and spike the ball in the end zone as if you had some particular genius that deserved monetary rewards 210 times more than a Doctor, Lawyer or an Indian Chief. Nah, I take that back about the Indian Chief. The Chiefs, at least, have done pretty well with casinos these past few decades.
Still, the primary way to coin money over the past 30 years has been to use money to make money. Although the price of it started in 1981 at a rather exorbitantly high yield of 15% for long-term Treasuries, 20% for the prime, and real interest rates at an almost unbelievable 7-8%, the gradual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seemingly endless virtuous timeline. Books such as “Stocks for the Long Run” or articles such as “Dow 36,000” captured the public’s imagination much like a Montana to Jerry Rice pass that always seemed to clinch a 49ers victory. Yet an instant replay of these past few decades would have shown that accelerating asset prices weren’t due to any particular wisdom on the part of academia or the investment community but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the singular mantra of central bankers ever since the departure of Paul Volcker, but there was no sense that the shampoo bottle filled with money would ever run dry. Well, it has. Interest rates have a mathematical bottom and when they get there, the washing of the financial market’s hair produces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the financial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age.
This transition is not commonly observed, although it is relatively easy to prove statistically and even commonsensically. Take for instance the rather quizzical notion that lower yields must produce an equal number of winners and losers since there is a borrower for every lender and the net/net therefore should have no effect on the real economy or its financial markets. Chart 1 shows that since 1981, which marks the beginning of the secular decline of interest rates, personal interest income has rather gradually (and now somewhat suddenly) shrunk relative to household debt service payments.
It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benefit more from lower yields. As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced. Metaphorically, it’s akin to a 4th quarter two minute Super Bowl drill, but one where the receivers haven’t been properly hydrated. They’re a half step slow, their legs are cramping, and it shows. Lower interest rates are having a negative impact on households because their water bottles are filled with 50 basis point CDs instead of Gatorade.
While Wall Street and levered investors have fared better than their Main Street counterparts, it’s not as if they’re in “primetime Deion Sanders” shape either. Conceptualize the historical business model of any financially-oriented firm for the past 30 years and you will see what I mean. Insurance companies, for instance, whether they be life insurance with their long-term liabilities, or property/casualty insurance with more immediate potential payouts, have modeled their long-term profitability on the assumption of standard long-term real returns on investment. AFLAC, GEICO, Prudential or the Met – take your pick – have hired, staffed, advertised, priced and expensed based upon the assumption of using their cash flows to earn a positive real return on their investment. When those returns fall from 7% positive to an approximate 1% negative, then assumptions – and practical realities – begin to change. If these firms can’t cover inflation with historical real returns from their float, then they begin to downsize in order to stay profitable. The downsizing is just another way of describing a transition from offense to defense in a zero bound nominal interest rate world where almost any level of inflation produces negative real yields on investment.
Not only insurance companies but banks suffer from this inability to maintain margins at the zero bound. In the process, they close retail branches that once were assumed to be the golden key to successful banking. Defense! And here’s one of the more interesting anecdotal observations on our current zero-based environment, one to which my investment paragon – Warren Buffett – would probably immediately admit. His business model – and that of Berkshire Hathaway – has long benefitted from what he has described as “free float.” Those annual policy payments, whether for hurricane, life or automobile insurance, have long given him a competitive funding advantage over other business models that couldn’t borrow for “free.” Today, however, almost any large business or wealthy individual can borrow or lever up with minimal interest expense. Buffett’s “Omaha/West Coast” offense is being duplicated around the world thanks to central bank monetary policies, placing an increasing emphasis on stock and investment selection as opposed to business model liability funding. Buffett will succeed based upon his continued strong offensive play calling, but the rules of the game are changing.
The plight of Buffett of course is in some respects the plight of PIMCO or any investment/financially-oriented firm in this new age of the zero bound. And it seems to us at PIMCO that successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills. What does that mean? Well, let’s briefly describe PIMCO’s own historical investment offense for the past 30 years in order to provide a defensive contrast:
PIMCO Offensive Strategy 1981 – 2011
Ready, Set, Hut 1, Hut 2 –
- Recognize downward trend in interest rates and scale duration accordingly.
A. Emphasize income and capital gains. PIMCO Total Return Strategy.
B. Utilize prudent derivative structures that benefit from systemic leveraging – financial futures,
swaps (but no subprimes!)
C. Combine A and B along with careful bottom-up security selection to seek consistent alpha.
PIMCO Defensive Strategy 2012 – ?
Ready, Set, Hut, Hut, Hut –
- Recognize zero bound limits and systemic debt risk in global financial markets. Accept financial repression but avoid its impact when and where possible.
A. Emphasize income we believe to be relatively reliable/safe.
B. De-emphasize derivative structures that are fully valued and potentially volatile.
C. Combine A and B along with security selection to seek consistent alpha with admittedly lower nominal returns than historical industry examples.
So there you have it – the PIMCO playbook. I suppose if I had any common sense I would hold up that clipboard to the front of my mouth like sideline coaches do during big games. Don’t want to chance any of the competition reading our lips to get a heads up on PIMCO’s next offensive play call. But then that’s never been my or Mohamed’s style, given the importance of informing you, our clients, of what we are thinking when it comes to investing your hard-earned capital. Go ahead competitors and read our lips, we’ll just pound that pigskin down the field anyway. Besides, as I’ve pointed out, the emphasis these days should be on the defensive coach. Leveraging has turned into deleveraging. 15% yields have turned into 0% money. The Super Bowls of the future will have their Mannings and Bradys, but the defensive line may record more sacks and make more headlines than ever before.
William H. Gross
Tags: Bill Gross, Bradys, Debt Risk, Defensive Strategy, Deion Sanders, Derivative Structures, Downward Trend, Dustbins, Field Goal Kickers, Financial Repression, Football Hero, Global Financial Markets, Gross Investment, Hail Mary, Handsome Guy, Interest Rate Environment, Investment Outlook, Joe Greene, Lamentation, Mike Ditka, Monetary Wealth, Offensive Skills, Offensive Strategy, Pigskin, Printing Money, Rare Examples, Ready Set, Risk Takers, Ron Paul, Scrimmage Line, Superpac, Whimper, Zirp
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Wednesday, February 1st, 2012
Investment Outlook, February 2012
Life – and Death Proposition
by William H. Gross, PIMCO
- Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
- Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
- We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration.
Where do we go when we die?
We go back to where we came from
And where was that?
I don’t know, I can’t remember
Virginia Woolf, “The Hours”
I don’t remember much of this life, and like Virginia Woolf, nothing of the herebefore. How then, could I expect to know of the hereafter? I know at least that we all exist at and of the moment and that we make up those moments as we go along. I became a grandfather for the first time a few months ago and proud son Jeff asked for some fatherly advice as to how to go about raising his baby daughter Caroline. “We all do it in our own way, Jeff, you’ll make it up as you go along,” I said. Parenting, and life itself, is one giant experiment. From those first infant steps, to adolescent peer testing, flying from and departing the parental nest, gene replication and family building of our own, maturity and acquiescence, aging, decay and inevitable death – we experiment as best we can and make it up as we go along.
That death part though, oh where do we go after we have done all the making? There was another Jeff in our family, beloved brother-in-law Jeff Stubban who was as kind a man as there ever could be. Dying within three months of an initial diagnosis of pancreatic cancer, our family sobbed uncontrollably at his bedside as his breath, his spirit, his soul, departed almost on cue while a priest recited the rosary. Where had he gone, where is he now, what will become of him and all of us? Like many grieving families we look for signs of him and in turn for clues to our own destination. A lucky penny in the street, a random mention of his beloved New Orleans, an exterior resemblance of his shiny bald head in a mingling crowd. Where are you, Jeff? Tell us you are safe so that we might meet again.
Having now matured to trust reason more than faith I offer not so much a resolution, but an alternative to the unanswerable question of Virginia Woolf and the departed souls of Jeff Stubban and billions of others. If we don’t meet again – up there – then perhaps we’ll meet once more – down here. After all, the one thing I know for sure is that we got here once – and because we did, we could do it again. Rest easy, dear Jeff, and welcome to this world, dear Caroline. We’ll all just have to make it up as we go along.
The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter. A multitude of liability structures dependent on a certain level of nominal GDP growth require just that – nominal GDP growth with a little bit of inflation, a little bit of growth which in combination justify embedded costs of debt or liability structures that minimize the haircutting of or defaulting on prior debt commitments. Global central bank monetary policy – whether explicitly communicated or not – is now geared to keeping nominal GDP close to historical levels as is fiscal deficit spending that substitutes for a delevering private sector.
Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions. Most observers, however, would agree that monetary and fiscal excesses carry with them explicit costs. Letting your pet retriever roam the woods might do wonders for his “animal spirits,” for instance, but he could come back infested with fleas, ticks, leeches or worse. Fed Chairman Ben Bernanke, dog-lover or not, preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse. At his November 2011 post-FOMC news briefing, for instance, he noted that “we are quite aware that very low interest rates, particularly for a protracted period, do have costs for a lot of people” – savers, pension funds, insurance companies and finance-based institutions among them. He countered though that “there is a greater good here, which is the health and recovery of the U.S. economy, and for that purpose we’ve been keeping monetary policy conditions accommodative.”
My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began. My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. When interest rates approach the zero bound they may transition from historically stimulative to potentially destimulative/regressive influences. Much like the laws of physics change from the world of Newtonian large objects to the world of quantum Einsteinian dynamics, so too might low interest rates at the zero-bound reorient previously held models that justified the stimulative effects of lower and lower yields on asset prices and the real economy.
It is instructive to mention that this is not necessarily PIMCO’s view alone. Chairman Bernanke and Fed staff members have been sniffin’ this trail like the good hound dogs they are for some time now. In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same. At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis. First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.
What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. But modern capitalism is dependent as well on maturity extension in credit markets. No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.”
When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.”
Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount. Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.
Where else can one go, however? We can’t put $100 trillion of credit in a system-wide mattress, can we? Of course not, but we can move in that direction by delevering and refusing to extend maturities and duration. Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper.
Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.
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Friday, January 6th, 2012
Towards the Paranormal
by William H. Gross, PIMCO
- The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.
- A new duality – credit and zero-bound interest rate risk – characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.
- Until the outcome becomes clear, investors should consider ways to hedge their bets, including: maximizing durations, U.S. Treasury bonds that may potentially offer capital gains, long-term Treasury Inflation Protected Securities (TIPS), high quality corporates and senior bank debt, and select U.S. municipal bonds.
How many ways can you say “it’s different this time?” There’s “abnormal,” “subnormal,” “paranormal” and of course “new normal.” Mohamed El-Erian’s awakening phrase of several years past has virtually been adopted into the lexicon these days, but now it has an almost antiquated vapor to it that reflected calmer seas in 2011 as opposed to the possibility of a perfect storm in 2012. The New Normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly delevering. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012.
The Old/New Normal
But before ringing in the New Year with a rather grim foreboding, let me at least describe what financial markets came to know as the “old normal.” It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the U.S. and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise. All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity. Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labor force. They made paper, not things, so much of it it seems, that they debased it. Interest rates were lowered and assets securitized to the point where they could go no further and in the aftermath of Lehman 2008 markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust. Goodbye “Old Normal,” standby to redefine “New Normal,” and welcome to 2012’s “paranormal.”
This process of delevering has consistently been a part of PIMCO’s secular thesis but “implosion” and “bimodal fat tailed” outcomes are New Age and very “2012ish.” Perhaps the first observation to be made is that most developed economies have not, in fact, delevered since 2008. Certain portions of them – yes: U.S. and Euroland households; southern peripheral Euroland countries. But credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QEs) in the U.S., U.K., and Japan. Now it seems a gigantic tidal wave of QE is being generated in Euroland, thinly disguised as an LTRO (three-year long term refinancing operation) which in effect can and will be used by banks to support sovereign bond issuance. Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another.
So global economies and their credit markets instead of delevering and contracting, continue to mildly expand. Yet there is bimodal fat-tailed risk in early 2012 that was seemingly invisible in 2008. Granted, the fat right tail of economic expansion and potentially higher inflation has existed for the 3+ year duration. QEs and 500 billion euro LTROs can do that. At the other tail, however, is the potential for “implosion” and actual delevering. To the extent that most sovereign debt is now viewed as “credit” in addition to “interest rate” risk, then its integration into private markets cannot be assured. If only Italian banks buy Italian bonds, then Italian yields are artificially supported – even at 7%. If so, then private bond markets and non-peripheral banks in particular may refuse to play ball the way ball has been played since 1971– purchasing government debt, repoing the paper at their respective central banks and using the proceeds to aid and assist private economic expansion. Instead, fearing default from their sovereign holdings, any overnight or term financing begins to accumulate in the safe haven vaults of the ECB, Bank of England (BOE) and Federal Reserve. Sovereign credit risk reintroduces “liquidity trap” and “pushing on a string” fears that seemed to have been long buried and forgotten since the Great Depression in the 1930s.
But delevering now has a new spectre to deal with. Not just credit default but “zero-bound” interest rates may be eating away like invisible termites at our 40-year global credit expansion. Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the U.S., Europe and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.
Importantly, this is not another name for “pushing on a string” or a “liquidity trap.” Both of these concepts depend significantly on perception of increasing risk in credit markets which in turn reduces the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it. Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system-wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown. We all start to resemble Will Rogers.
A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system-wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper. Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk-free at a term premium spread – two/three/even five-year Treasuries being good examples. But when those front end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry-wide.
Tags: Bank Debt, Bill Gross, Bimodal, Cancerous Tumor, Different This Time, Fractional Reserve Banking, Gross Investment, Inflation Protected Securities, Inflationary Expansion, Interest Rate Risk, Investment Outlook, Market Outcomes, Mohamed El Erian, Municipal Bonds, New Duality, PIMCO, Ringing In The New Year, Treasury Inflation Protected Securities, Two Moons, U S Treasury, U S Treasury Bonds, William H Gross
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Tuesday, December 20th, 2011
by William H. Gross, co-Chief, PIMCO
- Investors should recognize that Euroland’s 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, such as Brazil and Asia, and bonds in the strongest developed economies, where the steep yield curve may offer opportunities for capital gains and potentially higher total returns.
A 12-year-old coffee mug has a permanent place on the right corner of my office desk. Given to me by an Allianz executive to commemorate PIMCO’s marriage in 1999, it reads: “You can always tell a German but you can’t tell him much.”
It was hilarious then, but less so today given the events of the past several months, which have exposed a rather dysfunctional Euroland family. Still, my mug might now legitimately be joined by others that jointly bear the burden of dysfunctionality.
“Beware of Greeks bearing gifts” could be one; “Luck of the Irish” another; and how about a giant Italian five-letter “Scusi” to sum up the current predicament?
The fact is that Euroland’s fingers are pointing in all directions, each member believing they have done more than their fair share to resolve a crisis that appears intractable and never-ending. The world is telling them to come together; they’re telling each other the same; but as of now, it appears that you can’t tell any of them very much.
The investment message to be taken from this policy foodfight is that sovereign credit is a legitimate risk spread from now until the “twelfth of never.”
Standard & Poor’s shocked the world in August with its downgrade of the U.S. – one of the world’s cleanest dirty shirts – to double A plus. But what was once an emerging market phenomenon has long since infected developed economies as post-Lehman deleveraging and disappointing growth exposed balance sheet excesses of prior decades.
Portugal, Ireland, Iceland and Greece hit the headlines first, but “new normal” growth that was structurally as opposed to cyclically dominated exposed gaping holes in previously sacrosanct sovereign credits.
What has become obvious in the last few years is that debt-driven growth is a flawed business model when financial markets and society no longer have an appetite for it. In addition to initial conditions of debt to gross domestic product and related metrics, the ability of a sovereign to snatch more than its fair share of growth from an anorexic global economy has become the defining condition of creditworthiness – and very few nations are equal to the challenge.
It was in this “growth snatching” that the dysfunctional Euroland family was especially vulnerable. Work ethic and hourly working weeks aside, the Euroland clan has long been confined to the same monetary house. One rate, one policy fits all, whereas serial debt offenders such as the U.S., U.K. and numerous G-20 others have had the ability to print and “grow” their way out of it.
Beggar thy neighbor if necessary was the weapon of choice in the Depression, and it has conveniently kept highly indebted non-Euroland sovereigns with independent central banks afloat during the past few years as well. Depressed growth with more inflation, perhaps, but better than the alternative straitjacket in Euroland. As currently structured, Euroland’s worst offenders now find themselves at the feet of a Germanic European Central Bank that cannot be told to go all-in and to print as much and as quickly as America and its lookalikes.
Proposals from the German/French axis in the last few days have heartened risk markets under the assumption that fiscal union anchored by a smaller number of less debt-laden core countries will finally allow the ECB to cap yields in Italy and Spain and encourage private investors to once again reengage Euroland bond markets. To do so, the ECB would have to affirm its intent via language or stepped up daily purchases of peripheral debt on the order of five billion Euros or more. The next few days or weeks will shed more light on the possibility, but bondholders have imposed a “no trust zone” on policymaker flyovers recently. Any plan that involves an “all-in” commitment from the ECB will require a strong hand indeed.
On the fiscal side the EU’s solution has been to “clean up your act,” throw out the scoundrels and scofflaws (eight governments have fallen) and balance your budgets. Such a process, however, almost necessarily involves several years of recessionary growth and deflationary wage pressures on labor markets in the offending countries. While the freshly proposed 20-30% insurance scheme of the European Financial Stability Facility (EFSF) offers hope for the refunding of maturing debt, it is the deflationary, growth-stifling, labor/wage destroying aspect of the EU’s original currency construction that threatens a positive outcome over the long term. Without an ability to devalue their currency vs. global competitors or even – “Gott im Himmel” – Germany itself, peripheral countries may have survival to look forward to, but little else. Perhaps the Italians and Spaniards will put up with it, but maybe they won’t. The ultimate vote of the working men and women in these countries will always hang over the markets like a Damocles sword or perhaps a French/German guillotine. If the axe falls, then bond defaults may follow no matter what current policies may promise in the short term.
Investors and investment markets will likely be supported or even heartened by recent days’ policy proposals. The problem of Euroland is twofold however. First of all, they will remain a dysfunctional family no matter what the outcome. You can’t tell a German much, and while they can issue what appear to be constructive orders and solutions to the southern peripherals, there is little doubt that none of them will “like it very much.” Slow/negative growth and historically wide bond yield spreads will therefore likely continue. Globalized markets themselves will remain relatively dysfunctional, pointing towards high cash balances in presumably safe haven countries such as the United Kingdom, Canada and the United States. The U.S. dollar should stay relatively strong, ultimately affecting its own anemic growth rate in a downward direction.
Secondly, and perhaps more importantly however, investors should recognize that Euroland’s problems are global and secular in nature, reflecting worldwide delevering and growth dynamics that began in 2008. It will be years before Euroland, the United States, Japan and developed nations in total can constructively escape from their straitjacket of high debt and low growth. If so, then global growth will remain stunted, interest rates artificially low and the investor class continually disenchanted with returns that fail to match expectations. If you can get long-term returns of 5% from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.
To approach those numbers, risk assets in developing as opposed to developed economies should be emphasized. Consider Brazil with its agricultural breadbasket and its oil. Consider Asia with its underdeveloped consumer sector but be mindful of credit bubbles. In bond market space, the favorite strategy will be to locate the cleanest dirty shirts – the United States, Canada, United Kingdom and Australia at the moment – and focus on a consistent, “extended period of time” policy rate that allows two- to ten-year maturities to roll down a near perpetually steep yield curve to produce capital gains and total returns which exceed stingy, financially repressive coupons. A 1% five-year Treasury yield, for instance, produces a 2% return when held for 12 months under such conditions. Bond investors should also consider high as opposed to lower quality corporates as economic growth slows in 2012.
Because of Euroland’s family feud, because of too much global debt, because of deflationary policy solutions that are in some cases too little, in some cases ill conceived, and in many cases too late, financial markets will remain low returning and frequently frightening for months/years to come. I can imagine the coffee mugs for 2020 now: “Gesundheit!” from the Germans, “C’est la vie,” from the French and “Stiff Upper Lip,” from the British. In the United States I suppose it’ll still say, “Let’s go shopping,” although our wallets will be skinnier. You can always tell an American, you know, but you can’t tell ‘em to stop shopping. Likewise, investors should always be able to tell a delevering, growth constrictive global economy – but perhaps not. Dysfunction is not exclusive to politicians. Families, it seems, feud everywhere.
Note: Initial paragraphs were originally published in Financial Times Markets Insight on November 15, 2011
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The views and strategies described herein may not be suitable for all investors. Investors should consult their financial advisor prior to making investment decisions.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Info
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