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April 2010 Cyclical Tailwinds, Secular Headwinds and the Market of Bonds
Portions of the following article have previously appeared on CNBC.com and are reprinted with permission from CNBC. Date of original publication: April 7, 2010.

Tony Crescenzi
Senior Vice President, Portfolio Manager
Tony Crescenzi is a senior vice president, market strategist and portfolio manager in the Newport Beach office. Prior to joining PIMCO in 2009, he was chief bond market strategist at Miller Tabak, where he worked for 23 years. He helped create that firms asset management division and served as its chairman. Mr. Crescenzi has written three books, including his latest, Investing from the Top Down, which was published in 2008, and a 1,200-page revision to Marcia Stigums classic, The Money Market. He regularly appears on CNBC and Bloomberg television and in financial news media. Mr. Crescenzi taught in the executive MBA program at Baruch College from 1999 2009. He has 26 years of investment experience and holds an MBA from St. Johns University and an undergraduate degree from the City University of New York.

Torque: the measure of forces in a system that produce rotation In the U.S., there are a number of conditions in place that historically have correlated very strongly with job growth. The story is compelling, and evidence abounds indicating the U.S. economy is currently caught in a cyclical tailwind that will carry it and the financial markets for a while before secular headwinds become the more important influence. This means the yearlong rally in risk assets should continue, but it will be important to avoid excessive risk and to be on guard for price movement that becomes misaligned with the secular outlook. In other words, ride the cyclical tailwinds but heed the secular headwinds. While many jobs lost are likely to be recovered, many others are gone for good particularly in impaired industries which will likely keep pressure on the jobless rate and limit income growth and therefore corporate profits. Favor risk assets, but dont get too caught up in fascinations about lasting robust growth for the U.S. economy. Expect the Fed to eventually raise interest rates, but dont expect too much or for it to happen too soon. See the bond market increasingly as a market of bonds because todays cyclical forces will impact many segments of the bond market differently, in part because of the secular headwinds. Cyclical Tailwinds A plethora of indicators suggest job growth is around the bend: Productivity: Non-farm productivity over the past three quarters advanced at a 7.4% annual rate, the most for any three quarters since 1958. The increases occurred because companies raised output following a period of massive job cuts: Companies did more with less. There is only so much water that can be squeezed from a stone; there is only so much production that can be squeezed out of the existing work force. This is one of the factors applying torque to the system companies must eventually add workers (or worker hours) if they are to boost output enough to keep up with sales and avoid losing market share to their competitors. A counterview is that the increase in productivity is the start of a new trend: companies beginning to hasten plans to gain more efficiency.

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April 2010
3-Quarter Annualized Change in Non-Farm Productivity
10 8 6 4 2 0 -2 -4 Dec-56 Dec-59 Dec-62 Dec-65 Dec-68 Dec-71 Dec-74 Dec-77 Dec-80 Dec-83 Dec-86 Dec-89 Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07

Source: Bureau of Labor Statistics as of December 31, 2009

Chart 1 Inventories: After Lehman collapsed, demand for goods and services fell rapidly, leaving companies stuck with excess inventories. In response, businesses cut production to below the level of sales. The effort paid off, as inventories have since fallen. Today, the inventory-to-sales ratio is at a record low and falling, and the only way to stabilize it is to boost output at a monthly rate roughly double the long-term average of about 0.2% per month. This will require more workers. While lean inventories are desirable, companies wont let their inventories fall too much, lest they risk a loss of market share. As an important side note, as of March 31, 2010 the inventory index within the Institute for Supply Managements (ISM) monthly purchasing managers survey reached its highest level since July 1984.
Inventory-to-Sales Ratio, Wholesale Inventories

1.37 1.32 1.27 1.22 1.17 1.12 1.07 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10

Source: U.S. Census Bureau as of January 31, 2010

Chart 2
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April 2010 Delivery times: As an illustration, say that a pizza restaurant suddenly experiences a surge in orders for home deliveries. This restaurant has only one employee delivering pizzas, and this person is now struggling to keep up, meaning customers are now waiting 45 minutes instead of their usual 25 minutes. Some annoyed customers may decide to get their pizzas somewhere else. The restaurant must hire another delivery person or risk losing business. In essence, this is happening economy-wide. In February 2010 the supplier delivery component of the ISMs monthly purchasing managers survey reached its highest level since October 2005, a level indicating long lags in delivery that over the past 30 years is seen only in periods of strong job growth. Why? Because people want their pizza when they want it and will go wherever they need go to get it, and they will drop a supplier who is too slow.
ISM Supplier Delivery Index
70 65 60 55 50 45 40 35 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09

Source: Institute for Supply Management as of February 28, 2010

Chart 3

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April 2010 Order backlogs: This is a similar concept to delivery times. Overstretched companies need to take action hire more help to be able to fill their orders in a timely manner. The order backlog component of the ISM index is also in territory seen only when job growth is strong.
ISM Order Backlog Index
70 60 50 40 30 20 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

Source: Institute for Supply Management as of February 28, 2010

Chart 4 Final demand: There are many signs of a pickup in consumer spending in March and for the first quarter as a whole. For example, the International Council for Shopping Centers weekly index on chain store sales recently reported its greatest year-over-year increase since April 2007. In addition, car sales reached their strongest since September 2008, excluding the impact of the Cash for Clunkers program last fall. Increases in final demand create more torque by driving inventories lower, slowing delivery times and increasing order backlogs. Therefore, the acceleration in final demand is crucially important to the cyclical outlook it virtually assures there will be further increases in output that require either more astounding productivity increases or an increase in worker hours. Corporate profits: Corporate profits increased 30% to $1.467 trillion over the four quarters ended December 2009 (source: U.S. Commerce Department), and many forecasters are expecting continued large increases in the year ahead. John Maynard Keynes, the famous British economist, once said that the engine which drives enterprise is not thrift, but profit. Increases in corporate profits correlate strongly with job growth. Companies have the wallet, now they only need the will. Steady improvement in the economy is likely to provide it.

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April 2010

Corporate Profits
(in billions of dollars)

1650 1450 1250 1050 850 650 450 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08

Source: U.S. Commerce Department as of December 31, 2009

Chart 5 Housing completions: The number of housing completions over the past 2 years ran well above the number of housing starts, and as of February 28, 2010 roughly 2.2 million constructions jobs have been lost since levels peaked at 7.725 million in August 2006 (source: Bureau of Labor Statistics). These big losses are likely to ease because as home projects end, construction workers can more quickly move on to new projects because the number of projects ending no longer substantially exceeds the number of projects beginning. Put another way, the number of construction workers currently employed is now roughly aligned with the number of housing starts.

Housing Completions minus Housing Starts

600 500 400 300 200 100 0 -100 -200 -300 -400 -500 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09

Source: U.S. Census Bureau as of February 28, 2010

Chart 6
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April 2010 These cyclical tailwinds combine into what seems to be a gale force, and at the moment they are the dominant market influences and are already priced in. However, the extent to which they are realized and entrenched will have further repercussions. Secular Headwinds The secular headwinds buffeting economic growth are also powerful and will affect markets for quite some time. These headwinds will serve mostly as a guide for the limitations of the cyclical bounce on the value of financial assets. For example, while stock prices might rally on expectations for increases in corporate profits, secular influences may limit profit growth, which in turn will likely constrain stock prices. There are several secular influences: 1) 2) 3) 4) 5) Income growth Wealth destruction Credit availability Deleveraging Increased taxation and regulation

Income growth: While the torque in the system will likely lead to job growth and potentially strong growth, because companies cut jobs too drastically relative to lost sales the secular headwinds are likely to put limits on that growth. Though many jobs lost over the past several years will be recovered, many others are gone for good, particularly in structurally impaired sectors such as the automobile, housing, commercial real estate, retail and finance industries. In the automobile industry, for example, sales ran for years at an annual rate of around 16.5 million. Recently theyve run at a pace of around 10 million. Some industry observers think sales could rebound in a good month to an annualized rate of perhaps 12 million or 13 million. While that represents a strong rebound in percentage terms, the level is still below the old normal. In other words, the automobile industry is one that is structurally geared for a much higher level of activity than it is likely to experience for quite some time. This means that while some jobs lost in the sector might be recouped during the cyclical rebound, many will be lost for good.

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April 2010

Housing: There is a similar story here even a doubling of housing starts would still leave starts at a level that is half of its 2005 peak. The housing industry therefore is also structurally challenged and must shrink. This industry also demonstrates why it is important to think in terms of the levels of activity, not just in terms of growth rates.

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April 2010 In the absence of new industries, the lack of a full recoupment in jobs lost in impaired industries will limit the forthcoming decline in the jobless rate. This will in turn put limits on income growth and hence corporate profits, limiting the scope for gains in risk assets. They are likely to gain, but at a slower pace than the historical average. Investors should be leery when expectations for corporate profits move above the historical average and when big dividend increases are forecast. Surveys and forward-looking price-to-earnings ratios can gauge these expectations. Credit availability: The bursting of the credit bubble has taught both bankers and regulators valuable lessons that will not likely be forgotten for a generation, at least. Regulators are expected to continue to tighten their grip and require banks to put aside more money against their deposits, as well as introduce new leverage and liquidity ratios that constrain the growth of credit relative to past years. This would be part of a global schematic, with countries agreeing through the Bank for International Settlements to abide by more stringent capital requirements. Banks themselves will likely endeavor to maintain a stronger capital cushion against losses and will likely sustain the tighter credit standards they recently implemented.

Wealth destruction: Household net worth has fallen by more than $10 trillion since it peaked at $66 trillion in June 2007. Those losses, on top of the absence of the increases in household wealth that drove consumption for years, will likely restrain consumer spending, particularly because the nation is demographically older. Personal spending as a percentage of the U.S. economy is sure to decline from its current rate of 70%. Having experienced two financial shocks in a decade, households will be more protective of their wealth, particularly as throngs of people move toward retirement. Risk mitigation and frugality are likely to resonate more than the urge to consume and take risk, so the savings rate will likely be elevated compared with the recent past.

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April 2010

Increased taxes and regulation: Government balance sheets stretched at every level augur increased burdens on taxpayers. Tax rates are headed higher, as are fees and other sources of government-sourced revenue. While debatable, the new health care law looks likely to increase the size of government, which will require more money to pay for it. While some regulations put in place will prove beneficial for the soundness of the U.S. financial system, they will likely come with costs: chiefly, reduced economic activity. Also, the beneficial effects of last years $787 billion economic stimulus program are about to fade, at least in terms of their impact on GDP data. As an illustration, if $10 of government stimulus is added to $100 of GDP in the first year of the stimulus program, it will result in $110 of GDP. If in the second year the stimulus is just $8 it will result in $108 of GDP, and therefore will be a negative contributor to GDP, even though there is additional spending of $8. This is what is likely to happen by 2011. Stimulus dollars will continue to flow through but by lesser amounts than in 2009 and 2010. The Market of Bonds These two powerful winds leave bond investors not knowing which way to lean. Should they ride the cyclical tailwinds or heed the secular headwinds? The answer is they should do both. More than ever, the bond market has become a diverse market of bonds with diverse outlooks. This is in sharp contrast to early 2009, when investors could load up on anything with a yield spread to Treasuries and bet on fairly uniform movement in the direction of yields, the shape of the yield curve, market volatility and global policy rates. Todays investment landscape is much different, requiring investors to formulate strategies that more carefully consider the very different attributes of the bonds they are buying.
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April 2010 Corporate bonds: The corporate bond market consists of bonds with very disparate attributes. It is a market of bonds most of the time, especially now that corporate bond yields have moved sharply lower relative to U.S. Treasuries. In other words, investors arent being rewarded as much for the risks they take now than they were a year ago, when investors moved out the risk spectrum following actions taken by the Federal Reserve to underpin the value of financial assets. With risk premiums having fallen compared to a year ago, investors therefore must more carefully consider the risk attributes of the corporate bonds they buy. This is a big task, because no two corporate bonds are alike; some can be redeemed early, some are a hybrid of equities and bonds, and they can emanate from many different sectors of the economy, making it important to differentiate between industries that will benefit from the cyclical advance and those at risk from secular influences. Secular risks to the U.S. economy make it important to choose high-quality bonds as well as those that tend to have high recovery rates and dependable revenue streams. PIMCO Managing Director Mark Kiesel has written and spoken at length about the risks facing the corporate bond market; for example, he says investors need to be wary of the pendulum swinging from bondholders toward equity holders if companies direct cash toward equity investors through dividends and or share buybacks. These and other influences make it critical for those corporate bond investors who are riding the cyclical tailwinds to heed the secular headwinds. Municipal bonds: The municipal bond market is also a market of bonds. Secular headwinds make it more important to lean toward bonds with more dependable income streams. Revenue bonds, for example, have historically been influenced more by cyclical influences than have general obligation (GO) bonds, because revenues fluctuate. GO bonds, on the other hand, rely upon the general taxing power of the municipality. This taxing power is not in question, but investors must question whether municipalities will have enough money left over to get repaid. In other words, simply because a municipality raises taxes doesnt mean it will have sufficient money to pay its bondholders. Investors could instead choose revenue bonds with reliable and dedicated income streams. These include essential-purpose bonds with revenues tied to water, sewer, and energy use, and airports. Yield curve: Whereas in 2009 betting on a steep yield curve was one of the best wagers, the competing cyclical and secular influences make todays scenario bifurcated. For example, if torque does in fact lead to job growth, the coupon curve (two years maturity and beyond) will likely flatten it typically peaks with the peak in the unemployment rate. On the other hand, the money market will be slower to react and is not likely to move substantially until the eve of Fed rate hikes. Global bonds: The market of bonds broadens when the global bond market is included. Investors riding the cyclical tailwinds need to stay mindful of the secular headwinds that will influence not only the countries they select, but the selections they make within these countries, similar to what they must do in the U.S. The top secular influence here is the risk factor du jour: sovereign (government credit) risk. Investors who have been tailoring their bond portfolios to match major bond indexes may increasingly look away from their benchmarks, favoring countries with better debt dynamics and prospects for economic growth.
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April 2010 There are many other segments of the bond market that will surely see themselves transformed into markets of bonds. For example, the mortgage-backed securities (MBS) market will react to not only the many cyclical influences now in play, but the secular ones, such as the growing influence of the Fed as it changes from a market referee to both referee and player, having purchased $1.25 trillion of MBS over the past year and a half. An investor cant know with precision how the purchases and eventual sales will affect either the MBS market overall or the individual coupon stacks within the market. Similarly, investors need to constantly assess the Feds influence on the markets in swaps, derivatives, and Treasuries. In the time ahead, cyclical tailwinds and secular headwinds are sure to reinforce the market of bonds idea. Investors cognizant of these competing influences can ready themselves to take advantage of the opportunities that will arise, while also managing the risks.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. 2010, PIMCO.

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