Can you get out of a debt crisis by piling on another layer of debt?
That’s the question on everyone’s mind and the one Bill Gross of Pimco attempts to answer in this month’s Investment Outlook. He starts out defining the problem as a lack of aggregate demand – the Keynesian understanding of depression.
To begin with, let’s get reacquainted with the fundamental economic problem of our age – lack of global aggregate demand – and how we got to where we are today: (1) Twenty years of accelerated globalization incrementally undermined the real incomes of most developed countries’ workers/citizens, forcing governments to promote leverage and asset price appreciation in order to fill in what is known as an “aggregate demand” gap – making sure that consumers keep buying things. When the private sector assumed too much debt and asset prices bubbled (think subprimes and houses, or dotcoms/NASDAQ 5000), American-style capitalism with its leverage, deregulation, and religious belief in lower and lower taxes reached a dead end. There was a willingness to keep on consuming, there just wasn’t the wallet. Vigilantes – bond market or otherwise – took away the credit card like parents do with a mall-crazed teenager. (2) The cancellation of credit cards led to the Great Recession and private sector deleveraging, the beginning of government policy reregulation, and gradual deglobalization – a reversal of over 20 years of trade policies and free market orthodoxy. In order to get us out of the sinkhole and avoid another Great Depression, the visible fist of government stepped in to replace the invisible hand of Adam Smith. Short-term interest rates headed to 0% and monetary policies of central banks incorporated new measures labeled “quantitative easing,” which essentially involved the writing of trillions of dollars of checks to replace the trillions of dollars of credit that disappeared after Lehman Brothers. In addition, government fiscal policies, in combination with declining revenues, led to double-digit deficits as a percentage of GDP in many countries, a condition unheard of since the Great Depression. (3) For awhile it seemed that all was well, that the government’s checkbook could replace the private market’s wallet and credit cards. Risk markets returned to normal P/Es as did interest rate spreads, and GDP growth resumed; it was only a matter of time before job growth would assure the world that we could believe in the tooth fairy again. Capitalism based on asset price appreciation was back. It would only be a matter of time before home prices followed stock prices higher and those refis and second mortgages would stuff our wallets once again. (4) Ah, but Dubai, Iceland, Ireland and recently Greece pointed to a potential flaw in the model. Shaking hands with the government was a brilliant strategy in 2009 when it was assumed that governments had an infinite capacity to leverage themselves.
I agree with this brief history. As I have mentioned before, real wages in the U.S. peaked in 1973 in part due to globalization. In order to keep the gravy train going, debt and leverage has been the order of the day ever since. But this all went horribly wrong in the credit crisis and we have been living in quite a different world since. So what’s next? Bill Gross thinks it’s a socialization of private sector debts via increasing government debt loads, which Gross says is bad for the relative performance of government debt as compared to corporate debt. He even bolds this section.
Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee. The Kings, in other words, in the process of increasingly shedding their clothes, begin to look more and more like their subjects. Kings and serfs begin to share the same castle.
All of which gets us back to the original question of whether more debt is what the doctor ordered. Gross punts here. Instead he makes a relative value call that is effectively long high quality corporate debt (think Berkshire Hathaway (BRK.B) or Microsoft (MSFT)) and short government debt as spreads narrow. This is what you see in emerging market debt crises when the sovereign is debt-laden. Often, a high quality corporate can have a better credit rating than the sovereign, particularly if it is a multi-national who’s income stream is earned abroad, making it immune to the domestic economy and the sovereign’s taxation policy. To the degree you have exposure to sovereign debt, Gross suggests being overweight those sovereigns that have lower credit and inflation risk (think Germany, Canada or Norway). This is a repeat of the views he expressed a month ago.
The careful discrimination between sovereign credits is becoming more than casual cocktail conversation. A deficiency of global aggregate demand and the potential impotency of policymakers to close the gap are evolving into a life or death outcome for the weakest sovereigns, with consequences for credit and asset markets worldwide.
I suspect Gross is not long Greek sovereign bonds. As to the original question, it is more philosophical than real from an investor’s standpoint. During times of economic volatility, an investor in bonds wants to ensure the return of capital a lot more than the return on capital. And that means shunning risk. Determining relative credit and inflation risk is a lot more important than figuring out exactly how you get out of a debt crisis.
Don’t Care – Bill Gross, March 2010 Investment Outlook, Pimco
Update: Below is a video of Gross on Bloomberg giving greater insight into his commentary. Gross talks a lot about Fed official Jeffrey Lacker’s opinion that the Fed needs to start selling MBS paper and that the Fed will at a minimum definitely stop buying MBS paper this month. Enjoy.