Last week’s departure of Bill Gross from his role as Chief Investment Officer at PIMCO is likely to prove a turning point for interest rates in the West, and probably around the world.
Gross founded PIMCO (Pacific Investment Management Co) more than 40 years ago. During this time he built its assets under management to around $2tn. That is equal to annual GDP for Russia and Brazil, and more than India’s.
Clearly his nickname of the ‘Bond King’ was very well deserved.
He was a source of great wisdom for much of his time at PIMCO in his monthly newsletters. The blog first cited his thoughts back in July 2007, when he rightly argued that the US subprime problems would prove to be a far bigger issue than policymakers then imagined.
Gross’ concept of the New Normal was also, of course, a key influence on the blog when writing its highly successful eBook with John Richardson, and became part of its title, ‘Boom, Gloom and the New Normal’.
A key difference in approach, however, has been that the blog believes that demographics drives demand. Whereas Gross argues the conventional view that policymakers can create demand with the right blend of tax and stimulus:
- Thus the blog strongly disagreed with Gross when he argued UK bonds were sitting on “a bed of nitroglycerine“
- It argued instead that investors were seeking ‘return of capital’, and that bonds from the JUUGS (Japan, US, UK, Germany, Switzerland) would see extremely strong demand
- History shows that the blog was proved right in this debate
More recently, of course, a new debate has developed:
- Gross has argued that interest rates will settle at a new neutral rate of around 0% in real terms
- The blog certainly agrees with his analysis that Western growth rates will continue to disappoint
- But it worries that debt levels have now become unsustainable
Thus in an analysis published by Allianz Bank (PIMCO’s owners), “Ageing populations create repayment risk for government bonds” the blog argued that:
- Policy-makers continue to believe they can somehow kick-start growth by adding yet more debt
- Yet rising proportions of New Old inevitably create a deflationary rather than inflationary environment
- This combination, if policymakers don’t change course, will eventually mean the debt cannot be repaid
It is too early, of course, to know if the blog’s argument will prove correct. But Gross’ sudden departure certainly makes it more likely. Right or wrong, PIMCO has had $2tn of firepower to put behind its views. It has probably been the major source of support in recent years for government bond markets, as its investments have risen from $700bn in 2007, whilst those of other large bond-holders such as China and Japan have remained more stable.
Will this continue, now Gross is gone? Probably not. Few investors will lightly leave a manager who has a 40-year history of successful money-making. But now, they and their advisers may well decide that future returns at PIMCO are unlikely to be as good as in the past.
Time will tell. But it makes the blog feel more secure in its forecast last month that the Great Unwinding of policymaker stimulus creates interest rate risk.
And sadly, the blog would certainly no longer argue today that investing in the JUUGS would ensure ‘return of capital’. It fears the debt burden is now too great to ever be repaid, as central banks have created a debt-fuelled ‘ring of fire’.
The best view is always from the top of the mountain. At least that is how it feels today, with this month’s IeC Boom/Gloom Index (blue column) hitting a record high. Nor it is alone, as the S&P500 (red line), the world’s most important financial market index is also at record levels.
Central banks broke out the champagne some months ago, as they saw clear signs that their policy of boosting financial assets was taking prices to new highs. Since then, they have never stopped talking about the expected economic recovery that will now inevitably follow, and markets have followed by moving into melt-up mode:
- Their policy is based on a belief that lack of liquidity has caused today’s problems
- They argue that the 2008 Crisis broke some of the key plumbing in the financial system
- It needed a power-hose filled with $33tn of liquidity to flush through it, and unblock the problem areas
They may be right, of course. Investors certainly believe the story, whilst the IeC Index is higher today than before the 2008 crash – showing sentiment is overwhelmingly positive.
But what about in the real world? Is demand really about to improve?
PIMCO, the world’s largest bond fund with $2tn of investments see danger ahead. Their latest newsletter describes their view of the “perilous future potential of market movements” as they:
“Now focus on the possibility of a” T junction” investment future where markets approach a time-uncertain inflection point….Our actual scenario is likely to play out more gradually as private markets realize that the policy Kings/Queens have no clothes and as investors gradually vacate historical asset classes in recognition of insufficient returns relative to increasing risk.”
PIMCO, of course, were the original inventors of the New Normal concept, which the blog then adapted to describe our future world in which ageing populations dramatically change demand patterns. And the end-result of their new analysis comes to the same conclusion as the blog (their emphasis):
“If monetary and fiscal policies cannot produce the real growth that markets are priced for (and they have not), then investors at the margin – astute active investors like PIMCO, Bridgewater and GMO – will begin to prefer the comforts of a less risk-oriented migration”.
And their conclusion is simple to follow, namely “Global economies and their artificially priced markets are increasingly at risk, but the unwinding may occur gradually.”
The view from today’s mountain top may look fabulous. And as PIMCO point out, investors may decide to linger for a while, to enjoy it. But in the blog’s view, PIMCO’s view of the outlook is more likely to prove correct than that of the central banks.
Latest benchmark price movements since January 2013 are below with ICIS pricing comments:
PTA China, down 16%. “Stronger PTA futures on the Zhengzhou Commodity Exchange in China, on the back of financial institutions’ active buy-in activities, further bolstered PTA prices in the physical market.”
Benzene Europe, down 7%. ”Continued feedstock supply concerns amid European cracker restarts have boosted prompt pricing as well, and there are several aromatics units facing technical problems”
Brent crude oil, flat 0%
Naphtha Europe, up 3%. “Naphtha fundamentals have weakened slightly on lower domestic petrochemical demand and a slump in Asian exports,”
HDPE USA export, up 11%. “Global buyers uninterested in purchasing significant volumes”
US$: yen, up 17%
S&P 500 stock market index, up 23%
The head of Pimco, the world’s largest bond fund managers, provides influential support this month for the blog’s argument in ‘Boom, Gloom and the New Normal’ about the importance of today’s demographic changes. Bill Gross comments as follows in his new Investment Outlook:
“Demography is destiny, and like cancer, demographic population changes are becoming a silent growth killer. Numerous studies and common sense logic point to the inevitable conclusion that when an economic society exceeds a certain average “age” then demand slows. Typically the dynamic cohort of an economy is its 20 to 55-year-old age group. They are the ones who form households, have families and gain increasing experience and knowhow in their jobs. Now, however, almost all developed economies, including the U.S., are gradually aging and witnessing a larger and larger percentage of their adult population move past the critical 55-year-old mark.
“This means several things for economic growth:
• First of all from the supply side, it means productivity and employment growth rates will slow.
• From the demand side, it suggests a greater emphasis on savings and reduced consumption. Those approaching their seventh decade need fewer cars and new homes as shown in Chart 2 (above). Almost none of them have babies (thank goodness!).
• Such low birth rates and a significant reduction in demand have imperiled Japan for several lost decades now. A similar experience will likely turn many developed economy “boomers” into “busters” within the next several years.”
Hopefully Gross’ argument will help to highlight the paradigm shift that is underway.
77m Americans have already joined the New Old 55+ generation, and their numbers will rise 44% by 2030. Yet companies and policymakers are still focusing all their attention on younger age-groups, and ignoring the potential of the New Old. These are already 25% of the US population, and 29% of the Western population.
The blog’s series on the VUCA world today reaches C for Complexity.
Interest rates are key to company profitability. They determine rates of return for new investments, and their affordability. They also have a major influence on consumer spending patterns.
The debate over their future direction is just one example of current Complexity:
• Financial investors mostly argue that rates will go higher, perhaps much higher, in the major economies
• The world’s largest bond fund, PIMCO, even argued in January 2010 that UK bonds were sitting on a ‘bed of nitro-glycerine’
The blog has never agreed with this view.
It argues that the ageing Western population means investors now focus on return of capital. They also need to save more and spend less, as they are uncomfortably aware that their pensions are too small to fund their extra decade of life expectancy compared to previous generations.
It also coined the term JUUGS to describe the countries whose bonds would be perceived to provide the greatest safety – Japan, UK, USA, Germany and Switzerland. It has since followed their progress by comparison with the PIIGS (Portugal, Ireland, Italy, Greece, Spain).
The chart above shows 10-year interest rates today (blue column) in the PIIGS and JUUGS versus May 2010 (red):
• Average rates in the PIIGS were 5.8%, double the 2.7% in the JUUGS
• Today, they average 12% in the PIIGS, and just 1% in the JUUGS
• Rates have risen in all the PIIGS, whilst falling in all the JUUGS
The blog originally set out its argument in the Financial Times in September 2010. It was then developed further as chapter 2 of Boom, Gloom and the New Normal last June.
It argues that Japan is the role model for what is happening today. The JUUGS’ interest rates are only following the path taken there in recent decades. The reason for the correlation is that Japan’s own babyboomer generation are ~10 years older than in Western countries.
Of course, it could be that the blog has simply been lucky so far with the results of its argument. And it agrees rates could certainly jump if demand ever returned to Supercycle levels, as expected by the market consensus.
Thus the debate over interest rates highlights the Complexity of the financial world. Those whose judgement turns out to be wrong may well lose a large amount of money as a result.
Interest rates are key to the direction of the global economy.
But not in the way that was true during the 1982-2007 economic SuperCycle. Then, there was a global surplus of savings, due to the vast numbers of people in the Wealth Creating 25 – 54 age group.
So interest rates reduced dramatically in most countries, with the USA leading the way. Its 10 year government bond rates reduced from 15% in 1982 to just 5% by 2007.
Today’s market is increasingly dominated by the New Old generation of people aged 55+. As one would expect, older people are more concerned about security rather than growth. They value ‘return of capital’ more than ‘return on capital.
Thus a new UK investor survey reports that “protecting the value of existing assets” was the main priority. In turn, this means that investors are very nervous about markets where governments are borrowing too much, and have no plan to repay their debts.
This is why investors now prefer the JUUGS (Japan, USA, UK, Germany, Switzerland) to the PIIGS (Portugal, Ireland, Italy, Greece, Spain). The chart above updates the position since the blog first launched the concept (today’s interest rates = red line; August 2011 = blue column) :
• In August 2010, rates in the PIIGS averaged 5.9%: now they are 14.5%
• Rates in the JUUGS were 2.05%, now they are 1.5%
These demographically-driven changes have confused even the world’s largest bond investors, PIMCO, who suffered a rare year of major under-performance in 2011. They worried (rightly, of course) about the rising level of debt in some of the JUUGS – but failed for a while to realise this was not investors’ primary concern.
The key question at the start of 2012 is what happens next in the Eurozone. As the chart shows, Greece’s interest rate has gone ‘off the chart’ at 38%. And now, the real threat is contagion to Germany. As the Financial Times warns:
“If the euro stays together, it will only be because Germany pays, one way or another – hurting their bonds. If the euro breaks down…German finances would be trashed by the need to rescue its banks”.
Nobody knows how this very serious situation may play out.
We can all hope for good sense and wise policy to prevail. But hope is not a strategy, and can easily turn into wishful thinking. The blog will continue to keep a very close eye on developments.
All of us would love to be able to see into the future.
Chapter 4 of our new free eBook, ‘Boom, Gloom and the New Normal’, does just this.
It offers 10 predictions about how the world will look in 2021:
1. Young and old will be focused on ‘needs’ rather than ‘wants’.
2. A major shake-out will have occurred in Western consumer markets.
3. Housing will no longer be seen as an investment.
4. In emerging economies, companies will have recognised that the phrase ‘middle-class’ doesn’t define people with Western income levels.
5. Chemical markets will have become more regional.
6. Western countries will have increased the retirement age beyond 65 to reduce unsustainable pension liabilities.
7. Taxation will have been increased to tackle the public debt issue.
8. Social unrest will have become a more regular part of the landscape.
9. Consumers will look for value-for-money and sustainable solutions.
10. Investors will focus more on ‘return of capital’ than ‘return on capital’.
The New Normal offers the potential to restore a greater balance to society if companies refocus their creativity and resources on real needs.
There is also an urgent need for companies to focus on basic research to tackle these needs, rather than simply taking government grants to deploy old technologies.
The transition to the New Normal will be a difficult time. The world will be less comfortable and less assured for many millions of Westerners.
The wider population will find itself following the model of the ageing boomers, consuming less and saving more. Rather than expecting their assets to grow magically in value every year, they may find themselves struggling to pay-down debt left over from the credit binge.
More engineers and more scientists are going to be required to create the new products that will serve needs arising from the megatrends.
We will also need to find politicians with sufficient vision to sell the need for hardship and long-term struggle. This will be difficult, given that voters have become used to having all their wants met via quick ‘fixes’ of increased debt.
We could instead decide to ignore all of this potential unpleasantness.
But doing nothing is not a solution. It will mean we miss the opportunity to create a new wave of global growth from the megatrends. And we will instead end up with even more uncomfortable outcomes.
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