‘We ate all the nuts’
Liam Kennedy interviewed PIMCO’s Bill Gross and Mohamed El-Erian at their offices in Newport Beach, California
Bill Gross and Mohamed El-Erian have been preaching what you might term a gloomy doctrine for a couple of years now. Even if Newport Beach, California, isn’t such a bad place - you can see the Pacific surf from their offices - their investment world view seems most of all to be informed by the gathering, and lingering, clouds of financial turmoil. While others, politicians included, have experienced sudden mass sightings of green shoots, they don’t share all the optimism.
Their current view, well publicised in numerous notes and articles, is that we are living in an environment of a “new normal” and that this will involve de-leveraging, de-globalisation and re-regulation. Back in the days when Alan Greenspan was still preaching the gospel that was termed the ‘great moderation’ - a ‘goldilocks’ economy that was neither too hot nor too cold - PIMCO had a different opinion, referring to a stable disequilibrium. As early as March 2007, Paul McCulley, a PIMCO managing director, was writing about Hiram Minsky’s theories of stabilising and de-stabilising debt structures in the context of the then rapidly contracting US housing market. As Gross summarises, Minsky has it that stability is inherently unstable.
“Much of the great moderation in our view at least, now and in retrospect, was due to financial leverage, that is what central banks employed to keep it moderate so to speak, coming out of the dot com bubble and of course producing the housing and other bubbles,” recalls Gross.
Of course, as Gross also admits, being right can sometimes be easier than being right at exactly the right time. So PIMCO was a few months early in predicting the de-leveraging of the economy that was precipitated by the steady crash in the US housing market. But it stuck to its guns.
In fact, PIMCO started being right some time ago. McCulley started distributing Minsky’s texts around six or seven years ago, Gross recalls, to inform both investment committee meetings and the firm’s regular secular forums. The most recent of these forums took place in May, and was attended by Willem Buiter, former member of the monetary policy committee of the Bank of England, and Peter Costello, former Australian finance minister. Previous participants have included the likes of Larry Summers, president of Obama’s National Economic Council and former Treasury secretary, and Ben Bernanke, now chairman of the Federal Reserve.
Located in Orange County, Califiornia, PIMCO was arguably well placed to detect the bursting of the housing bubble as the air started to come out of the sub-prime mortgage market. PIMCO also sent its analysts out to the field a couple of years ago to test just how frothy the housing market was getting. “We had lots of people who were being sold products that they either didn’t understand or simply assumed that housing prices would continue to go up,” recalls El-Erian. “So the micro confirmed the macro and that is what ultimately led to the conclusion.”
What of the current situation? PIMCO is unsure, preferring to defer judgement on exactly what effect the current stimuli plans will have. Gross notes that the amount of credit available in the economy is critical for economic growth. But calculating either in US or global terms the amount of credit that has been destroyed - and which hence needs to be replaced - is a less easy proposition. Recreating that credit, through the various programmes of recapitalisation or asset buying, is also difficult for policymakers and the public, not least because of the public’s rational fear of the huge numbers involved, and the consequences for the public as taxpayer.
“In total the numbers are staggering and larger than anyone, including central bank chairmen, are used to or willing to imagine,” says Gross. “It doesn’t mean that we have to write globally a $10-20trn [€7-14bn] cheque, yet obviously there are limits to all of this. But the credit destruction has taken place just as we have delivered, in combination with the destruction of credit, the destruction of animal spirits, which is the heart and the essence of capitalism - the willingness to take a chance, to take a risk. You can’t measure that.”
El-Erian also says it’s not clear to which airport the policy-making pilots are taking us, the passengers. But as for what the new normal means in practical terms for us all as investors and members of the global taxpaying public, Gross and El-Erian are certain that the new normal may not mean that technology and higher productivity norms are, with certainty, going to translate into ever higher stockmarket peaks and the increase and spread of wealth that this has entailed for many in the US and beyond. Says El-Erian: “We are adults now and chastened adults, and ones who have to recognise that the excesses of the past do not automatically lead to reversion to the higher levels, and that applies not just to the stockmarket but also to low levels of unemployment and new peaks in industrial production on a global basis.”
It gets gloomier and, according to Gross, we were heading for some pretty staggering problems anyway: “In addition to all this, and it’s not a pure economic concept, the major G7 countries are flying straight into a demographic headwind, which, had we not even had a crisis, would have taken large budget deficits and a multitude of higher savings in order to address.” Or as he summarises: “If we were squirrels, we ate all the nuts and now its winter and we don’t have anything. It will be a long hard winter.”
Major demographic trends also inform pension funds’ world view. So what does all this pessimism mean in terms of investor behaviour? For El-Erian, pension funds should put their objectives at the centre of the equation. Not a new notion, but one he says is often overlooked. “In a dislocated world there are a number of things one can do during the journey,” says El-Erian. “The important thing is to recognise that you have legacy issues that you have to deal with. They can relate to certain investments or to certain managers.” The other aspect, he continues, is to allocate to sectors that have the support of the government. A third is to try to determine what indices make sense in this new world. “At the end of the day we need to talk about the three things your readers need to get right: their asset allocation, the vehicles they need to express that asset allocation and the risk management. But we get there by looking at both the journey and the destination.”
The latest US government support programme for financial institutions is the public-private investment partnership (PPIP). Many economists and investment managers have criticised the main precept of this programme - asking why banks would want to sell assets at fewer cents on the dollar than they are worth. Gross, however, thinks the PPIP could be a fantastic opportunity, should it be made to work. “It’s basically starting your own bank, starting it fresh with prices that are potentially attractive but not risk-free. So we look at it as an investment opportunity for clients, potentially.” And if it does provide price transparency, he concludes, that would be another welcome element. A few words of optimism in a PIMCO gloomy world.