Excerpts from Bill Gross

There have been times in the past where I’ve disagreed with Bill Gross, especially when he talks his own book.   However, his latest is not merely an honest assessment of our situation but he’s essentially suggesting to avoid many of the mutual funds he manages, forthright indeed.

Aside from the unthinkable outright default, there are numerous ways that a government – especially a AAA rated one – can employ to reduce its future liabilities. Highlighted below are the prominent tools that can significantly affect investor pocketbooks:

1. Balance the budget and/or grow out of it
2. Unexpected inflation
3. Currency depreciation
4. Financial repression via low/negative real interest rates

Let me address each of them in brief:

1. Balance the budget/growth – The current Congressional compromise is but one small step for fiscal solvency. There is no giant leap for mankind anywhere on the horizon. Trillions of further spending cuts, and yes trillions of tax hikes, are necessary to stabilize our “official” debt/GDP ratio of 90% or so. One important detail to keep in mind: projected deficits in 2012 and 2013 of 7-8% of GDP rely on OMB growth estimates of 3%+ in the next few years. Recent trends give pause to these estimates as does PIMCO’s New Normal, which believes 2% not 3% is closer to reality. If so, deficits move right back up to near-double-digit percentages of GDP. Likewise, should interest rates ever rise from current 2% average levels, a 100 basis point increase raises the deficit by 1% and erases any hoped for gains. Sisyphus would be familiar with this seemingly unsolvable dilemma.
2. Unexpected inflation – While markets are global these days, figures sometimes lie and policymakers often figure. Focusing investors’ attention on statistics emphasizing “core” or “chain-linked” methodologies can entice investors to stay home, or in the case of foreign nations, to “invest American.” Central bankers, not just in the U.S., but the U.K., have long been arguing for a reversion of headline 3% CPI numbers to the 2% or lower “core” standard expectation. “Patience,” they argue, but “prudence” might be the better watchword. If so, then the expected “unexpected” inflation would mimic the old Roman custom of coin shaving or its substitution with base metals instead of silver or gold. Inflation is the result no matter how you coin it, which puts more money in government coffers to pay their bills and less money in your pocket to pay yours.
3. Currency depreciation – High deficits, both fiscal and trade, combined with low interest rates for extended periods of time produce declining currency valuations against more prosperous, and more policy conservative competitor nations. Few Americans are aware that the dollar’s recent 12-month depreciation of over 15% is an explicit tax on their standard of living. Uncle Sam, the government overseer, benefits enormously: one rather clever way for the U.S. to pay its bills to foreign creditors is to pay them in depreciated dollars. The Chinese and other offshore holders wind up getting not only .05% interest on their Treasury Bills, but 12 months later – voila! – their Bills are worth only 85 cents on the dollar in global purchasing power. The Chinese should be reading Shakespeare, not Confucius – especially the second half of “neither a borrower nor a lender be,” when it comes to U.S. dollars.
4. Financial Repression via low/negative real interest rates – I have commented on this Carmen Reinhart, commonsensical technique in prior Outlooks. If the Treasury is borrowing money from you or PIMCO at .05% for the next six months and CPI inflation is averaging 3%, then lenders/savers are being shortchanged beyond even rather egregious historical examples. The burden of “sixteen tons” of debt á la Tennessee Ernie Ford is considerably reduced at 5 basis points of annual interest. “Loading” coal or debt in this case at near 0% yields doesn’t make the borrower another day older, nor deeper in debt. Actually it’s a shot of Botox for the borrower, but a shot of lead for the lender. Duck!

Going For The Gold

One of the most frequently asked questions posed is “What’s keeping you up at night?” It doesn’t take much when you’re the father of teenagers.   At the moment the world is filled with enough real life dramas that should be the topic of conversation and concern.  On the investment side of the worry list, we’ve already been through a lot this year from the tremendous earthquake and tsunami in Japan to the budget / default issues plaguing the U.S., Greece and much of Europe.   The disaster in Japan alone could have cost as much as one percentage point to our second quarter GDP.   Much of this was related to auto manufacturing and most of it was very quietly handled as no one wanted to admit to gaps in the supply chain.   One the bright side, the Japanese caused slowdown is in the past and a resurgence of Japanese activity is at hand.

The second quarter of 2011 was a fairly rough quarter and our portfolios gave back much of the gains from the January to mid-February.  My view has been that the market weakness which began in the latter half of February is likely to have been an ordinary garden variety market correction which is a necessary evil and not the start of a severe bear market in stocks.   The primary warning signs associated with severe bear markets are not currently present: inverted yield curves, sharp increase in junk bond yields vs. Treasuries or significant earnings estimate declines.  With growth slowing in the US and worldwide in May, it’s easy to be thinking with a negative bias, but we’re not going into recession….yet , and a second half resurgence  is still on the table while virtually all consumer and investment sentiment indicators show that our current risks are well known at this point.

The most recent market pullback and investment fears are reminiscent of last summer’s economic soft patch with threats of deflation but with two differences.   One:  the Japanese disaster which interrupted the flow of manufacturing especially of autos.   Two: recognition by investors of the inept and partisan politics of our political leadership. The consensus opinion is that our economy will stage a modest rebound in the second half, primarily due to Japan coming back online.   The fear of a budget shutdown by August 2 is still being trumped by corporate earnings growth at present, the long term macro fear of total US debt to GDP is still a year or two away.

While the primary second quarter trend was down for the markets, it appears the selloff has been contained.    The correction was enough to eliminate the excessive bullishness that had built up from the previous rally, in the short term market direction is anyone’s guess but I envision a trading range for the next quarter.   In January I mentioned the prediction from Ned Davis Research for a major market top in August.  In the past few years the cycle predictions by Davis have been fairly good but much of 2011 has been out of sync with the predictions and as of yet there is no fundamental justification based on S&P 500 estimated earnings for a Bear market.

Despite the soft patch of economic weakness the guiding indicator to our investment exposure remains positive and a recession is unlikely at present.    While forward earnings for the S&P 500 index peaked at approximately $98.75 in June, the ensuing slowdown has been very shallow and not enough to endanger the present bull market.  At present earnings are at $97 (hardly indicative of a Recession) and it would take a further drop in the range of $94 a share in earnings to go into bear/hedge mode.  In addition, just as bad as the month of May was, June is shaping up to have been quite a positive month so time will tell.

“The Great Reset”: Gold, Silver and Currencies

I fear that there is no politician in the US today who has the will to do the right thing for their country, and tell the truth about our debt realities, other than perhaps Ron Paul.    At some point we’ll have to raise our debt levels but it won’t end there.  I fear that our country will be printing money and increasing debt for some time to come.   To be frank, there has never been a case where a developed economy was able to pare down debt while maintaining the economy or employment.   As a countries debt level increases the corresponding economic rebounds become shallower and shallower resulting is frequent recessions in which the response is…..issue more debt!  All similar situations resulted in the printing of more money and increased debt leading to a significant devaluation of the currency and Treasury markets.

One of the biggest changes we made to portfolios in the second quarter was the sizeable addition of Gold, Silver and the Swiss Franc.   These are three safe haven assets where capital will likely continue to flow to with the continued erosion of the dollar and Euro.    Gold is the big winner and primary beneficiary of devaluation of currencies and the debt crisis.

For 16 years the primary investment instrument that I’ve used for client’s has been stocks, however with the realization that “this time is really different” I am prepared to continue to cut back on equity holdings should our economy show further weakness and debt levels increase.   I’ve already liquidated all debt holdings, including Treasuries, Corporate bonds and Municipals.  I would not be surprised to see that metals and currencies replace U.S. equities in accounts should the dominoes fall the way I anticipate.   I’d love to be wrong but there are many precedents for what may occur in our country in the next 2-5 years, most recently in Latin America in the 1980’s.

For our client portfolios, most of the proceeds that went to Gold came from our sale of the TLH (10-20 year Treasury) and a portion of our holding in High Yield Securities.   Purchase of the Swiss Franc came largely as a replacement to our long term holding in high yield bond ETF JNK.  With this latest bout of economic weakness I don’t believe there is meaningful upside to owning Treasuries or high yield, but with the debt crisis in Greece, Italy, Portugal and Ireland not to mention the US there is I believe, a valid case for owning gold shares (GLD) and the Swiss Franc as a hedge against calamity.

In addition, I believe it’s a matter of time before US Treasuries are downgraded by the agencies.   If this were to occur there could be several dramatic results, one of which being a huge crush of money market funds being forced to sell Treasuries.   Most money markets are required to own solely AAA rated securities and it’s likely that many money markets could see the value of their shares fall below $1 per unit.

Furthermore, increased debt issuance with downgrades in quality likely mean that interest rates will eventually move higher as investors will demand higher yields in return for lower quality.

What is especially intriguing about Gold at the moment is the current significant negative sentiment towards the metal.   Typically, I’d expect that sentiment to be quite positive since it’s trading so close to its annual high, but sentiment is actually quite negative.   Sentiment is a reverse indicator, the worse the sentiment the better the prospects.

Sad to say our politicians appear to be more concerned with entrenched policies and kicking the can down the road than dealing with the issues head on.   It appears incredibly frustrating to solve our economic issues when one party benefits from failure and fear.  Austerity measures such as budget cuts and higher taxes add a further burden to the economy.   When you hear a politician especially a Republican state that we need to “cut the debt and increase employment” they are talking a fantasy.   Eric Cantor’s “Cut Cap and Balance” bill, a “common sense” bit of legislation is fiction as well.   For 40 cents of every dollar the US spends comes from debt, it’s inconceivable to eliminate 40% of spending and assume the economy will be stable, let alone increase employment.  The quick result would likely be a Depression unless the phase in took a decade or more to implement.

It will take several years for the debt burdens to be processed and I do envision a severe bear market within a year or two, especially when the US must face reducing the deficit without the benefits of Treasury support such as what we experienced in the last year with Quantitative Easing.

In the meantime, earnings growth in the US is slowing but it’s not at levels to be excessively concerned about.   I would expect the markets to show even a modest upward bias to the end of the year.   While this letter has been primarily focused on the large macro issues of debt the micro view of corporate earnings growth is still pretty good.   It’s not a matter of “if” we’ll eventually have to address the sum of our nation’s debts, but a matter of when.  Timing is everything, and for the time being the world is not ready to crumble.

All the best,

Brad Pappas

Long all securities mentioned