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War! What is it good for? Absolutely nothing! Say it again y’all War! “War” Edwin Starr Actually it probably is good for something – war, that is. A lot of mankind’s technological advances have been bred in the bowels of wartime – radar and nuclear energy to name a few from World War II. And let’s not forget The problem though, with this Gandhi/John Lennon “all you need is love” philosophy is that it denies the inherent genetic makeup of human nature. Survival of the fittest is inbred in our DNA and Pollyannas who suggest that human beings are pliable and malleable like a pacifist potter’s wet clay have just not joined Descartes and nearly 7 billion current participants in this 21st century Age of Reason. Still with Gandhi and Lennon in such esteemed company as Jesus and the Buddha who urged us to just give peace a chance, there must be something we can do that acknowledges our warlike genes while utilizing the rationality of progressive thinking. The solution, quite simply, is to elect less warlike leaders, which means those with DNA tilted to nurture, as opposed to nature, which means – yes, you male chauvinist piglets – more women and fewer male presidents. I mean other than commercially sponsored and male-motivated mud wrestling, how many women do you actually see fighting each other? Behind the lines and over the cell phone, yeah sure, the backbiting can be pretty awesome, but guns and knives? Even Farrah Fawcett on Charlie’s Angels just sort of pulled hair and scratched a lot of faces. Jesting aside, however, I’m dead serious and you should be too. If we were, dead serious, there would be a lot fewer bodies in the streets of What I’ve been saying over and over again on the investment side is that the Fed will cut rates later this year and that their two key criteria will be employment and asset prices. With construction laborers about to hit the unemployment lines and the U rate in jeopardy of rising more than the Fed feels comfortable with, an ease as soon as mid-year may be in the cards. I have a strong sense as well, that mortgage credit availability is in the midst of a cyclical squeeze due to subprime defaults and “better late than never” moral suasion/congressional supervision of mortgage bankers. This should not only continue to floor the housing sector but dampen consumption, as the combined effect of layoffs and Mortgage Equity Withdrawal, “withdrawal” produce a 2% or less real and a 4% or less nominal economy. Those numbers when extended for three or four quarters (which they now have been) are the stuff leading to output gaps, rising unemployment, declining inflation, and an easing in overnight Fed Funds rates. We live in an asset based economy, however, as I’ve pointed out frequently in recent years’ and months’ Outlooks, and it’s the increasing and in some cases bubblish trajectory of those prices that have supported the If that is the case, observing asset price swings will be instructive, yet still not necessarily productive in front running other bond managers to lock in currently “high” yields. All of us can observe asset price ticks of all sorts and the “efficiency” of such an approach may lead to nothing other than a momentum driven, “beta” rich but “alpha-less” quest. The secret to avoiding being a fish at the current poker table is to have a collective sense of what drives asset prices, which ones are affected first, and ultimately which ones are affected last – and to decide ahead of time whether heretofore bullish risk assets are going to correct or whether they will keep on keepin’ on. We at PIMCO, in our Forums and Investment Committee meetings, have a sense that in this U.S. and global cycle, perhaps more than any other previous one, it is the “carry” or perceived/expected “carry” of an asset over and above cash returns that is the driving force behind asset appreciation. Carry in this case refers to the return or yield relative to 5¼% in the
The first to be knocked off was of course the Yen as it sunk lower and lower under the burden of negative dollar carry – a 500 basis point gap as recently as three months ago, and now only slightly less. Bonds then began a mild bear market as the positive carry derived from historically low Fed Funds disappeared, resulting for the past three quarters in a negative yield curve – and negative carry. Should it have been any wonder that our third “little asset” (actually a pretty big Indian by Agatha Christie standards) was an asset supersensitive to financing costs and expectations for positive total returns? Home buyers and speculators have only recently realized that not only were they in a significant negative carry position relative to realized income (rents), but because houses have gone up so much in price that capital losses, not capital gains, might actually compound their negative carry. In the past few months, home prices have begun to sink YOY for the first time in decades. Commodities led by oil and copper were/are next, as futures prices in contango became negative carry relative to 5¼% cash. The High Yield asset-backed market appears to be “little asset number five” as delinquencies, defaults, and investors’ disenchantment wreak havoc with subprimes and ultimately other poorly underwritten mortgages. The Fed, while not smiling, is more than likely sitting back in a parental “I told you so” posture (actually Alan Greenspan did tell us so in a major speech concerning housing loans in late 2005). Contained “destruction” is what the Fed wants to see before short rates can be lowered. How does this movie play out? Some would say not until the Fed raises interest rates even more. That, however, is increasingly unlikely. What the last six months have shown us is that the U.S. economy and its asset markets are sensitive to 5¼% overnight rates and that asset prices are going down – first for those categories most sensitive to negative carry, and ultimately for those whose prices have been driven so high that 5¼% represents increasing competition: earnings yields on stocks at 5-6% for example or even those historical double-digit returns from the king of them all – private equity. What the housing top proved is that any asset can eventually become overpriced and fall of its own weight, carry or no carry. When the last of our ten little assets bites the dust is hard to know, and let me be fair – these are PIMCO’s “Ten Little Assets.” The Fed may have five, or four, and waiting for the bloom to come off the rose on the private equity bubble is probably not on Bernanke’s priority list for eventually cutting Fed Funds. But three things are, and each of them is being strangled by a currently restrictive 5¼% overnight rate: inflation, employment, and selected carry sensitive asset markets. We at PIMCO will be watching all three in an attempt to lock in yields that 12 months from now should be significantly lower, at least on the front end of the yield curve. If risk assets like stocks, emerging market and high yield bonds, as well as risk currencies such as the Brazilian Real, Mexican Peso, and William H. Gross Managing Director |
