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On the Wings of an Eagle
Global economies and their artificially priced markets are increasingly
at risk, but the unwinding may occur gradually, says PIMCOs Bill
Gross.
By Bill Gross | Posted: 12-03-13 | 08:48 AM | Email Article
Ive always liked Jack Bogle, although Ive never met him. Hes got heart, but as hes
probably joked a thousand times by now, its someone elses; a 1996 transplant being the
LOL explanation. Hes also got a lot of investment common sense, recognizing decades ago
that investment managers in composite couldnt outperform the market; in fact, their alpha
would be negative after fees and transaction costs were factored in. His early business model
at Vanguard promoting index funds was a mystery to me for at least a few of my beginning
years at PIMCO. Why would most investors be content with just average performance, I
wondered? The answer is certainly now obvious; an investor should want the highest
performance for the least amount of risk, and for almost all measurable asset classes, index
funds and many ETFs have done a better job than almost all active managers primarily
because of lower fees.
The almost all caveat is the
reason I can write so freely and
with such high praise for Vanguard.
I am, after all, supposed to be promoting PIMCO in these Investment Outlooks, and PIMCO is
a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what
he himself labeled in a recent Morningstar interview the PIMCO effect. To paraphrase his
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About the Author
Bill Gross is the managing director of
PIMCO, a leading global investment
management firm. PIMCO was founded
in 1971 and currently manages more
than $1,000 billion in assets.
interview, he spoke to index
managers beating almost all active
managers, but then there was the
PIMCO effect. We at PIMCO thank
him for that with a back atcha,
Jack! Theres actually a place for both of our firms and investment philosophies in this age of
high finance. If Bogles concept of indexing was metaphorically similar to finding a cure for
the cancerous devastation of high fees, then perhaps PIMCOs approach could be similar to
mapping the investment genome and using it to produce consistently high alpha. Theres
room for each of these investment laboratories. I will admit that there are other active
management labs as well that are worthy of not only recognition, but investor confidence and
dollars. I have nothing but the highest of praise for Bridgewaters Ray Dalio and GMOs
Jeremy Grantham and their staffs. Their voluminous thoughts occupy a special corner of my
desk library. Each has a distinctly different approach to active management Dalios focusing
on a levering/delevering template and Granthams on a historical reversion to the mean for
most asset classes.
Neither Vanguard, PIMCO, Bridgewater nor GMO, however, has discovered a cure for the
common cold. Our performance periodically, and sometimes for frustrating long stretches,
stuffs our noses or aches our heads, and makes us wonder why we hadnt been more careful
about washing our hands during flu season. Our firms make mistakes, even if, in Vanguards
case, its the indexed mantra of being fully invested in an overvalued market.
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Where might our future mistakes be hiding? What keeps us up at night? Well I cant speak for
the others, having spoken too much already to please PIMCOs marketing specialists, but I
will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the
creator of the New Normal characterization of our post-Lehman global economy, now
focuses on the possibility of a T junction investment future where markets approach a
time-uncertain inflection point, and then head either bubbly right or bubble-popping left due
to the negative aspects of fiscal and monetary policies in a highly levered world. We are both
in agreement on the perilous future potential of market movements. Mohameds T, I believe,
was meant to be more descriptive than literal, and is a concept, like the New Normal, that
may gain acceptance over the next few months or years. But aside from a financial nuclear
bomb la Lehman Brothers, 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. The actual T might in reality be shaped something like this:
, perhaps a winged eagle signifying something more gradually sloping left or right. This
years April taper talk by the Federal Reserve is perhaps a good example of this forward path
of asset returns. Admittedly the reaction in the bond market was rather sudden and it
precipitated not only the disillusioning of bond holders, but also an increase in redemptions in
retail mutual fund space. But then the Fed recognized the negative aspects of financial
conditions, postponed the taper, and interest rates came back down. Sort of a reverse
Sisyphus moment two steps upward, one step back as it applies to yields and more of a
, than a T. Investors now await nervously for news on the real economy as
well as the medicine that Janet Yellen will apply to it.
That medicine, however, will most assuredly include negative real interest rates that at some
point will give bond and stock investors pause as to the continued potency of historical total
return policies generated primarily by capital gains. Bond investors found that out in May,
June and July after 10-year Treasuries had bottomed at 1.65%. Stock investors, however,
were only mildly discouraged and continued their faith-based, capital gain dependent
investments despite what should be the obvious conclusion that QE and low interest rates
were as critical to their market as they were to bonds. What other choice do we have? has
become the mantra of stock investors globally, which speaks more to desperation than
logical thinking.
Well, my point about the gradual as opposed to sudden disillusioning of investors worldwide
is just that. The standard three musketeers menu for retail investors has always been 1)
investment grade and 2) high yield bonds as well as 3) stocks. In recent years, institutional
investors have gravitated into 4) alternative assets, 5) hedge funds and 6) unconstrained
space, and so for them there appears to be an increasing array of higher return alternatives.
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All of the above 1-6, however, contain artificially priced assets based on artificially
low interest rates. Some are unlevered, like Treasury bonds, but nonetheless priced too
high by the Fed in an effort to encourage migration to riskier bonds and/or asset classes.
Others, such as many alternative assets, depend on the levering of portfolios themselves,
borrowing at 10-50 basis points in overnight repo and investing at higher rates of return
despite their artificiality. But investors are all playing the same dangerous game that
depends on a near perpetual policy of cheap financing and artificially low interest
rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB
and the BOE are setting the example for global markets, basically telling investors that they
have no alternative than to invest in riskier assets or to lever high quality assets. You have
no other choice, their policies insinuate. Get used to negative real interest rates, move out
on the risk spectrum and in the process help heal the real economy, they seem to
command.
Yet this now near 5-year migration across the global asset plains in search of taller grass and
deeper water has had limits, both in price and real growth space. 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. If they cannot smell the distant water or sense a taller strand of Serengeti grass,
astute investors might move away from traditional risk such as duration as opposed to
towards it. Deep in the bowels of central banks research staffs must lay the unmodelable fear
that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose
momentum after the real economy fails to reach orbit, even with zero-bound yields and QE.
In gradually moving away from traditional risk assets, I again refer to my August Investment
Outlook called Bond Wars. In it, I suggested that bonds and bond portfolios contain a
number of inherent carry risks and that duration/maturity was but one of them. I
suggested that if the Fed and other central banks had artificially lowered yields and elevated
bond prices, then a traditional bond fund should underweight duration and perhaps
overweight other carry alternatives such as volatility, curve and credit. This we have done,
and our relative performance reflects it. The PIMCO effect, as Jack Bogle calls it, is alive
and well in 2013. Our primary thrust has been to focus on what we are most (although not
totally) confident about, that the Fed will hold policy rates stable until 2016 or beyond. While
this and its conjoined policy of QE may have only redistributed wealth as opposed to creating
it (picking savers pockets while recapitalizing banks and the wealthiest 1% of our
population), it is a policy that a Janet Yellen Fed seems determined to pursue. The taper will
lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will
continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved. If
so, front-end Treasury, corporate and mortgage positions should provide low but attractively
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defensive returns. We have positioned our bond wars portfolio heavily front-end maturity
loaded along with credit, volatility and curve steepening positions, with the aim of
outperforming Vanguard as well as many other active managers.
There is no doubt, however, that this portfolio construct is dependent on the eagles wings
as opposed to the junction of a T. Overlevered economies and their financial
markets must at some point pay a price, experience a haircut, and flush confident investors
from the comfort of this Great Moderation Part II. We at PIMCO will prepare for that day
while hopefully consistently beating Vanguard along the way.
Eagles Speed Read
1) Be confident in the PIMCO effect, as Jack Bogle calls it.
2) Look for constant policy rates until at least 2016. Front-end load portfolios. Dont fight
central banks, but be afraid.
3) Global economies and their artificially priced markets are increasingly at risk, but the
unwinding may occur gradually. Think !
William H. Gross
Managing Director
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market
is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be
worth more or less than the original cost when redeemed. 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. Mortgage- and asset-backed securities may be sensitive to changes
in interest rates, subject to early repayment risk, and their value may fluctuate in response to the markets
perception of issuer creditworthiness; while generally supported by some form of government or private
guarantee, there is no assurance that private guarantors will meet their obligations.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all
investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn
in the market. Investors should consult their investment professional prior to making an investment decision.
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. Forecasts,
estimates, and certain information contained herein are based upon proprietary research and should not be
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considered as investment advice or a recommendation of any particular security, strategy or investment product.
Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part
of this article may be reproduced in any form, or referred to in any other publication, without express written
permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of
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United States and throughout the world. 2013, PIMCO.

On the Wings of an Eagle http://news.morningstar.com/articlenet/SubmissionsArticle.aspx?submissionid=182160.xml
6 of 8 1/11/2014 11:09 AM
vandy73
Dec 4 2013, 8:22 AM
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This piece is too technical and arcane to be relevant to Morningstar
readers.More like free association,imho.
timbo11
Dec 3 2013, 10:28 PM
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Bill, best of your articles that I have read. Aside from the folksy but
expected marketing pitch, you paint enough detail to identify a
conundrum: policy makers are not going to leave things alone.
Mohamed calls it a T in the market trajectory forced by government
policies. Whether for good or ill is to be determined. I call it
micromanaging the economy. If that is what Mohamed and you
mean, then I agree that is the biggest threat. I also look for signs of
a whip saw up and then down like 2005-2008.
Also, too big to fail bankers are busy investing the Fed assets in
their coffers in ways that cut out retail and institutional investors.
High speed trading infrastructure, distressed residences for cash,
dark investment pools, moving markets to reap gains. Mortgages
and loans do not excite bankers right now (too much risk, too little
profit).
jmasdenver
Dec 3 2013, 5:50 PM
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A load of baloney! Gross is just trying to prevent more billions of
dollars from flowing out of PIMCO funds and saying to the suckers
that remain, "just wait, I'll be right eventually". Yeah right, maybe
in 2016!
Matthew9
Dec 3 2013, 5:44 PM
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bee we haven't had even a 10% correction in ages, so 15% is
certainly not hard to envision. I'm not sure EM in general would fall
anymore than domestic markets but China falling more certainly
wouldn't come as a surprise.
beecnul8r
Dec 3 2013, 3:05 PM
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Well, overall sounds like the Fed especially and other central banks
are going to cause some severe reactions the moment they
stop/slow the $85 billion a month boost. If businesses can't justify
expansion with these extremely low borrowing rates how can
On the Wings of an Eagle http://news.morningstar.com/articlenet/SubmissionsArticle.aspx?submissionid=182160.xml
7 of 8 1/11/2014 11:09 AM
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anyone expect support for an already oversold Market? Makes me
think we are already well into a bubble that will burst with a 15%
decline in the S&P and perhaps more for emerging markets and
China.
DBSMichigan
Dec 3 2013, 2:52 PM
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Least verbose piece I've seen from Bill Gross in a while.
Hilo99
Dec 3 2013, 2:31 PM
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"Front end maturity" meaning- ? Short duration bonds?


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