Bill Gross, founder and co-chief investment officer at bond-investing giant Pacific Investment Management LLC and one of the most influential voices on financial markets in the world, gave The Globe and Mail an exclusive interview in the wake of the U.S. Federal Reserve Board's Aug. 10 monetary policy statement - a key decision at a time when many market leaders, including Mr. Gross, have become deeply concerned with the growing threat of deflation in the U.S. economy. The following is a transcription of his conversation with David Parkinson, investment reporter and columnist.
A lot of people are talking about deflation - that was the big context of what people were looking for from the Fed this week. How worried should we be about deflation, or disinflation?
Well, we should certainly worry about disinflation, and that's what prompted the addition [Fed]policy. Deflation is that critical negative from which serious repercussions emanate - real interest rates start to increase, companies start to suffer, and the potential for consumer demand to simply wait it out accelerates. We're not at deflation yet - although to be fair, the two-year U.S. CPI number is about right on the zero line, so that might be mincing words. But we're certainly at risk of enduring a zero-to-1-per-cent number for the next 12 months at least. The Fed's not comfortable with that; they would prefer 2 per cent. It promotes a positive reflationary momentum as opposed to deflation.
Should we be worried about it? Yes. I think markets are worried about it, and I think the Fed's worried about it, and that's what we saw [with the Fed decision]
And it's not just in the U.S. Canada's in better shape, but other countries, while they're experiencing relatively higher inflation, those rates are coming down. Even in cases like Brazil and China and developing markets, there's the beginning of a trend toward lower inflation. The entire world is probably more susceptible to disinflation than reflation at the moment.
What are the implications - what does this mean for both bond and stock markets?
For high-quality bond markets, where it's assumed that the principal can be rolled over and paid - as in U.S. Treasuries - the implications are obviously positive. A high-quality bond investor wants low inflation, and ultimately they're comfortable with deflation, as long as the country doesn't devalue their currency substantially. So, high-quality markets like Treasuries, over the past few months when deflation has crept into the deadlines, they do well.
But risk markets - we're talking about stocks and high-yield bonds - they begin to suffer under the possibility that profits and sales will deflate as opposed to inflate. That's the problem with stocks, for instance, they depend on an increasing top line or higher revenues in order to justify their leverage and their infrastructure. The moment the top line, sales, of the company begin to deflate, that points to negative consequences for the bottom-line profits. So the risk assets don't do well in a deflationary environment. We've seen a lot of that in the past six-to-12-to-18 months - the global economy is delevering, which is a corollary to deflation. As a matter of fact, some would argue that that's what causes deflation, the delevering of balance sheets of sovereigns and households.
That's why the Fed is so desperately trying to turn this ship around - because the basis of the economy is predicated not on Treasury bonds, but on the selling and rolling of risk assets, that being equity and corporate bonds. There's a risk here to financial markets.
The Fed did step in and make some tentative moves to try to address the issue, with the decision to re-invest principal payments on agency debt and mortgage-basked securities. How is that going to be felt by the bond market?
If they mean what they say, it's a $200-billion [U.S.]to $250-billion annual reinvestment. At the same time, it basically keeps the Fed's balance sheet at the same number - it basically keeps it from going down, from disinflating. It certainly doesn't add anything from this point forward, but it did prevent subtraction. That's good, I guess.
What it basically does is it prolongs the period at which investors feel comfortable that the Fed will stay at 25 basis points [in the benchmark Federal funds rate] I mean, if they were going to raise the Fed funds rate, they would stop this quantitative easing before they did that. So this effort basically says, 'Hey, we may be here for longer than you think' - which, to PIMCO's mind, means two or three years at least. Does that flatten the curve? Well, yeah. It basically means two-year Treasuries and three-year Treasuries aren't going anywhere, and that 50 basis points [the current yield on the two-year bond]is better than 25 overnight, which is what the Fed funds rate is. So people buy twos and threes and fours, and that ultimately impacts fives and 10s as well.
The market recognizes that what's really important is how long the Fed stays at 25 basis points. This was sort of a term extender. And again, in my way of thinking, they're there for two or three years. And things can change - the economy could improve and that's what they hope for, and etcetera, etcetera. But it's not looking like that at the moment.
Do you think the Fed needs to do more? What do you think it will do from here? What do you think it should do?
I think they should do this - I think they are doing and will do this. But at the same time, they've sort of reached a dead end in terms of what monetary policy can accomplish.
At this point, it's a weak form of stimulus. What we saw 12-18 months ago was a strong form, in terms of dropping Fed funds to from 525 to 25 basis points, quantitative easing of $1.5-trillion and all the programs associated with it. We're now in a weak-form type of world where they've reached the end their line in terms of what they legitimately and logically can accomplish, absent some type of maverick behaviour on the part of the Fed - which isn't going to happen. The Fed has been saddled over the past 12 months in terms of their independence, and so they're not as frisky as they might be otherwise.
So, this is what they should do, that's what they're going to continue to do. But at the same time, the important thing from PIMCO's standpoint is that [Fed Chairman Ben]Bernanke has done all he can. Now it's up to [Treasury Secretary Tim]Geithner and to the Congressional leaders to do something right for a change. In our opinion, they haven't done things right. The stimulus that they've provided has been consumption-oriented - it's not directed at investment, industrial policy. It's up to the Congress and the White House to do something different, because what they've done up to this point has been ineffectual and obviously unsuccessful in terms of appropriately stimulating the economy to do what needs to be done: Produce jobs. We can talk about a 2-3 per cent real GDP rate and whether that's the definition of success or not, but it's unquestionable that the 16-per-cent unemployment rate of people who are jobless and have dropped out of the market and would work if there was any chance of finding a job, that's halfway to the Depression in terms of people who are on the street or are moribund in their homes, sitting on the couch.
I take it you feel that if the Fed was going to inject liquidity and expand their balance sheet in another round of quantitative easing, that that wouldn't do the trick - that there needs to be some government-policy backdrop so that money would be directed in a way that would actually make a difference?
We do. You know, we debate it daily, and we don't have all the answers. But solving a debt crisis with more debt certainly raises large question marks - it would be like a drunk trying to get sober by having another drink. Ultimately, another type of behaviour is called for. Our consumption-oriented economy, which has been dependent on wealth production through higher and higher asset prices, that game's basically over. The United States has to learn to produce something and become a legitimate player in the global economy, as opposed to a consumer. Making that transition by purchasing more and more debt the Treasury issues with a greater and greater frequency, is logically questionable. Ultimately, it doesn't lead you to a desirable destination. So, other policy has to be injected into the structural problem. Up until this point, the administration and the Congress seem to think they can just keep on keepin' on, but that only works for so long.
We're much more in awe of countries such as Canada, with a decently balanced budget, and with low debt-to-GDP, and with financial institutions that have been solvent and sound and conservative in their lending, and that have something to export - as opposed to what we've experienced here in the United States. So, north of the border has become, while not our favourite destination, certainly a preferable destination to what we see in the United States. And developing countries that have much lower debt, and a much smaller percentage of consumption, in combination with an export orientation - like Brazil, and Indonesia - countries that have learned the lessons of what too much debt can produce - that's where we look.
Yeah, we own some Treasuries, and yeah, we've benefited from it. But there are higher-yielding and better alternatives in this global marketplace than a U.S. two-year Treasury at 50 basis points.
So, then, what are you doing, and what are you advising investors to do, in terms of where they should be directing their money in this environment?
Investors, whether it's equity or bonds, should be oriented toward growth and stability, and, yes, a political foundation that promotes both. Growth is important even for bond investors, because growth allows for high real interest rates, which ultimately come down to the bottom line for a bond investor. And, obviously, growth is positive for stock investors.
So, investors should be looking around the world for the most stable growth that they can find, in the context of a political environment that itself is stable. I've mentioned Brazil, and, yes, Canada's a good place. Even Mexico has better initial conditions in terms of low debt than the United, States, but admittedly the stability issues and politics are a question. But in general, the developing world is in much better position than the developed world, so that's where dollars should go - both in terms of investment and in terms of their currency orientation. Because ultimately, countries like the United States and the "developed offenders", so to speak, Euroland and the U.K., their currencies depreciate against the stronger countries. The loonie has done pretty well against the [U.S.]dollar for the past five-plus years, and one of the reasons is they're sober and we're not.
So, investors should look for those three things - and diversify outside of their comfort zone.
OK, it's honesty and introspection time. When you're in these kinds of uncertain markets with so-called pivot points arising every few months, when you're immersed in it and you have a lot of people wanting your opinion on it - is this fun for you, or do these times make you wish you'd chosen a different profession?
As my wife would say, her expression when we're really having a good time is, "too much fun."
It certainly helps to have a good day, and a good year - and when it goes against you, it's not "too much fun." But the events of the past 18 to 24 months, as chaotic as they've been, have really been too much fun, because they've presented a challenge and allow you to match wits with not just other investors but with policy makers - and, in the process, to hopefully construct a better economy going forward.
It is fun to at least be listened to - not that I would or any of us here would pretend that we "make a difference" quote-unquote - but there's an attempt at least to point to a way that provides a solution. And so, gosh, what more could somebody want than a soapbox from which you're listened to, and are well-paid to stand on? For me, I couldn't imagine anything more fun. It's too much fun.