Investment Outlook

Investment Outlook
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By Bill Gross, Managing Director, Pimco | August 2009 | 10 August 2009

Investment Potions

A country's GDP or Gross Domestic Product is really just an annual total of the goods and services that have been produced by its existing stock of investment (capital in the form of plant, equipment, software and certain intangibles), and labor (people working). Over the last 15 years or so in the U.S. that annual production (GDP) has increased in nominal (real growth and inflation) terms of 5-7%. Not every year, certainly not in boom or recessionary years, but pretty steadily over longer timeframes, and consistently enough to signal to the 'capitalists' that 5% was the number they could count on to justify employment hiring, investment spending plans, and which would serve as well as a close proxy for the return on capital that they should expect.

Nominal GDP is in fact a decent proxy for a national economy's return on capital. If each and every year we grew by 5%, then that would be sort of like a stock whose earnings grew by the same amount. Companies and investors then would be able to estimate the present value of those cash flows, and price investment and related assets accordingly— a capital asset pricing model or CAPM based on nominal GDP expectations.

While objectively hard to prove, logic dictates that that is exactly what has happened over the past several decades. Businesses expanded with a developing certainty that demand, expenses, and return on the economy's capital would mimic this 5% consistency [[and with reasonably low inflation: normxxx]]. Debt was issued with yields that reflected the ability to service those payments through 5% growth in both real and inflationary terms, and stocks were issued and priced as well with the same foundation. Pension obligations and similar liabilities were legitimized on comparable logic, as were government spending programs forecasting tax revenues and benefits.

Both real economy and financial markets then, were geared to and, in fact, mesmerized by this 5%, GDP/CAPM, "model." Now, however, things have changed, and it is apparent that there is massive overcapacity in the U.S. and indeed in the global economy. As reflexive delevering has unveiled the ugly stepsister of the "great 5% moderation," nominal GDP has not only sunk below 5%, but turned at least temporarily negative.

If allowed to continue— and this is my critical point— a portion of the U.S. production capacity and labor market will have to be permanently laid off. Nominal GDP has to grow close to 5% in order for the economy's long-term balance to be maintained. Otherwise, employment levels become unsustainable, retail shopping centers unserviceable, automobile production facilities unprofitable, and the economy itself heads towards a new normal where unemployment averages 8% instead of 5%, housing starts total 1.5 instead of 2 million, and domestic auto sales 12, instead of 16 million annual units.

Critically in the readjustment process, debts are 'haircutted' via corporate [and household defaults] and home foreclosures, and equity P/Es are cut based upon increased risk and substantially lower growth expectations. A virtuous circle of expansion turns into a vicious cycle of recession or low-growth stagnation. Label it what you will, but a modern capitalistic economy based on levered financing and asset appreciation cannot thrive if its "return on capital" or nominal GDP suffers such a significant shock.

Policymakers/government to the rescue— we hope. 0% interest rates, quantitative easing, $1.5 trillion deficits, trillions more in FDIC or explicit government guarantees, a trillion plus in MBS and Treasury bond purchases, TALF, TARP— I could, but I need not go on. Can they do it? In other words, can they successfully reflate to 5% nominal GDP and recreate an "old" normal economy?

Not likely. The substitution of government-backed vs. private-leverage is one strong argument against the possibility. Despite the attractive financing rates incorporated with the TALF, TLGP and other government-subsidized financing programs, they come with quality constraints (larger collateral haircuts and mortgage down payments, to name a few) that inhibit the "new normal" lenders from approaching the standards of the 5% nominal-based 'shadow' banking system.

Just last week, President Obama proposed new "transaction fees" for "far out transactions" undertaken by financial companies. "If you guys want to do them," he said, "put something into the kitty". In turn, there are internal Washington Beltway/external Main Street USA, politically imposed limits which will thwart policy expansion beyond the current stasis. Most of the politicos and even ordinary citizens are [already] screaming for limits on monetary/fiscal expansion: "No TARP II! 1.5 trillion dollar deficits are enough! The Fed must have an exit plan!" etc.

If there are such future political constraints or caps (both domestically and from abroad), then one should recognize that most of the ammunition has been spent [on just] stabilizing the financial system, and very little directed towards the real economy in terms of job loss prevention. Where is the political will or wallet now to grant corporate tax breaks for private sector job creation or even to hire new government workers, aside from a minor positive push with military enlistment? In brief, the "new normal" nominal GDP, the future return on our stock of labor and capital investment, will likely be centered closer to 3%, for at least a few years once a recovery is in place beginning in this year's second half. Diminished capitalistic risk taking and constrained policymaker releveraging will lead to that likely conclusion.

Investment conclusions? A 3% nominal GDP "new normal" means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope.

An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end. There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields, as well as selectively chosen emerging market commitments where nominal GDP growth prospects are tilted upward as opposed to gravitating to new lower norms. Madame Rue has met her match.