Investment Outlook

March 2012
Bill Gross Your Global Investment Authority

They say defense wins Super Bowls, but the Mannings, Bradys and Montanas of gridiron history are testaments to the opposite. Putting points on the board, especially in the last two minutes, has won more games than goal line stands ever have, even if the scoring has been done by the eld goal kickers, the names of whom have been conned to the dustbins of football history as opposed to the Hall of Fame in Canton, Ohio. Canton, however, has an approximately equal number of defensive in addition to offensively positioned inductees, so there must be a universally acknowledged role for both sides of the scrimmage line. What fan can forget Mean Joe Greene, Deion Sanders or Dick Butkus? The old, now politically incorrect showtune laments that you gotta be a football hero, to fall in love with a beautiful girl, but football and any of lifes heroes can play on either side of the line, it seems.
My point about pigskin offense and defense is the perfect metaphor for the world of investing as well. Offensively minded risk takers in the markets have historically been the ones who have dominated the headlines and won the hearts of that beautiful gal (or handsome guy). Aside from the rare examples of Steve Jobs and Bill Gates, however, the secret to getting rich since the early 1980s has been to borrow someone elses money, throw some Hail Mary passes and spike the ball in the end zone as if you had some particular genius that deserved monetary rewards 210 times more than a Doctor, Lawyer or an Indian Chief. Nah, I take that back about the Indian Chief. The Chiefs, at least, have done pretty well with casinos these past few decades. Still, the primary way to coin money over the past 30 years has been to use money to make money. Although the price of it started in 1981 at a rather exorbitantly high yield of 15% for long-term Treasuries, 20% for the prime, and real interest rates at an almost unbelievable 7-8%, the gradual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seemingly endless virtuous timeline. Books such as Stocks for the Long Run or articles such as Dow 36,000 captured

the publics imagination much like a Montana to Jerry Rice pass that always seemed to clinch a 49ers victory. Yet an instant replay of these past few decades would have shown that accelerating asset prices werent due to any particular wisdom on the part of academia or the investment community but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion. Rinse, lather, repeat Rinse, lather, repeat was in effect the singular mantra of central bankers ever since the departure of Paul Volcker, but there was no sense that the shampoo bottle lled with money would ever run dry. Well, it has. Interest rates have a mathematical bottom and when they get there, the washing of the nancial markets hair produces a lot less lather when its wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the nancial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate prot margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age. This transition is not commonly observed, although it is relatively easy to prove statistically and even commonsensically. Take for instance the rather quizzical notion that lower yields must produce an equal number of winners and losers since there is a borrower for every lender and the net/net therefore should have no effect on the real economy or its nancial markets. Chart 1 shows that since 1981, which marks the beginning of the secular decline of interest rates, personal interest income has rather gradually (and now somewhat suddenly) shrunk relative to household debt service payments.

Chart 1 1600 1400 1200 1000 $ bn 800 600 400 200 0

Losing End

Personal Interest Income Personal Debt Service Payments

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Source: Bureau of Economic Analysis, Federal Reserve, Credit Suisse

It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benet more from lower yields. As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced. Metaphorically, its akin to a 4th quarter two minute Super Bowl drill, but one where the receivers havent been properly hydrated. Theyre a half step slow, their legs are cramping, and it shows. Lower interest rates are having a negative impact on households because their water bottles are lled with 50 basis point CDs instead of Gatorade. While Wall Street and levered investors have fared better than their Main Street counterparts, its not as if theyre in primetime Deion Sanders shape either. Conceptualize the historical business model of any nancially-oriented rm for the past 30 years and you will see what I mean. Insurance companies, for instance, whether they be life insurance with their long-term liabilities, or property/casualty insurance with more immediate potential payouts, have modeled their long-term protability on the assumption of standard long-term real returns on investment. AFLAC, GEICO, Prudential or the Met take your pick have hired, staffed, advertised, priced and

INVESTMENT OUTLOOK | MARCH 2012

expensed based upon the assumption of using their cash ows to earn a positive real return on their investment. When those returns fall from 7% positive to an approximate 1% negative, then assumptions and practical realities begin to change. If these rms cant cover ination with historical real returns from their oat, then they begin to downsize in order to stay protable. The downsizing is just another way of describing a transition from offense to defense in a zero bound nominal interest rate world where any almost level of ination produces negative real yields on investment. Not only insurance companies but banks suffer from this inability to maintain margins at the zero bound. In the process, they close retail branches that once were assumed to be the golden key to successful banking. Defense! And heres one of the more interesting anecdotal observations on our current zero-based environment, one to which my investment paragon Warren Buffett would probably immediately admit. His business model and that of Berkshire Hathaway has long benetted from what he has described as free oat. Those annual policy payments, whether for hurricane, life or automobile insurance, have long given him a competitive funding advantage over other business models that couldnt borrow for free. Today, however, almost any large business or wealthy individual can borrow or lever up with minimal interest expense. Buffetts Omaha/West Coast offense is being duplicated around the world thanks to central bank monetary policies, placing an increasing emphasis on stock and investment selection as opposed to business model liability funding. Buffett will succeed based upon his continued strong offensive play calling, but the rules of the game are changing. The plight of Buffett of course is in some respects the plight of PIMCO or any investment/nancially-oriented rm in this new age of the zero bound. And it seems to us at PIMCO that successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills. What does that mean? Well, lets briey describe

PIMCOs own historical investment offense for the past 30 years in order to provide a defensive contrast: PIMCO Offensive Strategy 1981 2011 Ready, Set, Hut 1, Hut 2 1. Recognize downward trend in interest rates and scale duration accordingly. A. Emphasize income and capital gains. PIMCO Total Return Strategy. B. Utilize prudent derivative structures that benet from systemic leveraging nancial futures, swaps (but no subprimes!) C. Combine A and B along with careful bottom-up security selection to seek consistent alpha. PIMCO Defensive Strategy 2012 ? Ready, Set, Hut, Hut, Hut 1. Recognize zero bound limits and systemic debt risk in global nancial markets. Accept nancial repression but avoid its impact when and where possible. A. Emphasize income we believe to be relatively reliable/safe. B. De-emphasize derivative structures that are fully valued and potentially volatile. C. Combine A and B along with security selection to seek consistent alpha with admittedly lower nominal returns than historical industry examples. So there you have it the PIMCO playbook. I suppose if I had any common sense I would hold up that clipboard to the front of my mouth like sideline coaches do during big games. Dont want to chance any of the competition reading our lips to get a heads up on PIMCOs next offensive play call. But then thats

MARCH 2012 | INVESTMENT OUTLOOK

never been my or Mohameds style, given the importance of informing you, our clients, of what we are thinking when it comes to investing your hardearned capital. Go ahead competitors and read our lips, well just pound that pigskin down the eld anyway. Besides, as Ive pointed out, the emphasis these days should be on the defensive coach. Leveraging has turned into deleveraging. 15% yields have turned into 0% money. The Super Bowls of the future will have their Mannings and Bradys, but the defensive line may record more sacks and make more headlines than ever before.

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William H. Gross Managing Director

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 ination risk. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; while some swaps trade through a clearinghouse there is generally no central exchange or market for swap transactions and therefore they tend to be less liquid than exchange-traded instruments. 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 is distributed for informational purposes only. 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