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Bond King Gross Says Ditch the Dollar Before It’s Too Late

Contrarian Profits — Fri, 05 Jun 2009 17:30:52 +0000

We spent the morning musing on the Maginot Line. The French built this elaborate line of fortifications along its border with Germany in the 1930s to thwart an invasion by its Great War enemy. When Germany invaded France in May 1940, Adolf Hitler’s armies simply bypassed the line and invaded France through neighbouring Belgium. The Maginot Line proved to be an elaborate dud.

As Nassim Taleb points out in his book The Black Swan: The Impact of the Highly Improbable:

The story of the Maginot Line shows how we are conditioned to be specific. The French, after the Great War, build a wall along the previous German invasion route to prevent reinvasion – Hitler just (almost) effortlessly went around it. The French had been excellent students of history; they just learned with too much precision. They were too practical and exceedingly focused for their own safety.

What does this have to do with investing? It’s a fair question. To our humble minds, the story of the Maginot Line illustrates that we humans tend to base our vision of the future on past events and have trouble imagining a future radically different from what has happened before. We are, if you like, sitting ducks: we build our defensive walls and then guard them jealously only to be blindsided at the crucial moment.

One of our central aims in Notes is to imagine futures unpalatable to the mainstream – futures that often seem impossible because of their lack of precedent in the past. It’s niche work. Most people don’t have the time or the inclination to wonder about what will come next. But to be a successful investor, you must first peer into distance and imagine the world that’s coming.

Today, we offer up a vision of a diminished America – an America weakened by decades of living beyond its means and almost entirely reliant on its foreign creditors. Some might say this future has already arrived. But here at Notes, we believe the country has further to fall. We’re short, if you like, on US hegemony.

Bond king Bill Gross is also concerned. He calls this diminished America “the new normal.”

Gross is better qualified than most to prognosticate on America’s fate. He runs the world’s biggest bond fund. So it’s his job to know where the US economy is heading. He’s also an honorary underground investor: he puts his money where his mouth is and he doesn’t pander to mainstream opinion.

In his latest monthly missive, Gross argues that the tipping point for the end of US economic dominance is easy to spot and is a matter of simple mathematics.

Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the US that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those “sixteen tons” in Tennessee Ernie Ford’s famous song of a West Virginia coal miner. “You load sixteen tons and whattaya get? Another day older and deeper in debt.” Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations.

It’s a slow motion car crash, dear reader, and all we can do is sit and gawp. As Gross also points out, the US is already producing less wealth in proportion to the rest of the world. And less of its citizens are getting into the Forbes rich list as a result.

This does not come at a good time. America’s ability to borrow cheaply is dependent on its debt-to-GDP ratio, which at 13% is already at highs not seen since World War II. One way of improving this ratio is to grow GDP. But as Gross points out, this is becoming more and more difficult thanks to “private sector deleveraging, reregulation and reduced consumption.” And all of this does not begin to take into account what Gross describes as the “pig in the python” demographic squeeze on resources on the way.

Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

What Gross understands better than most is that we do not live in a world without consequences. This is the beauty of the bond markets: they provide (welcome) limits to the “something for nothing” culture that has gripped the US for far too long.

The big question, of course, and the one Team Obama would like to dodge for as long as humanly possible, is who is going to buy America’s tsunami of debt?

Broadly speaking, the problem is twofold. On the supply side, the US Treasury is set to issue roughly four times last year’s amount of bonds – an estimated gross issuance of $3 trillion. On the demand side, America can no longer rely on the current account/trade deficit to fund borrowings. As Gross points out, with this figure down to about $500 billion this year, China and other surplus nations simply won’t have the spare cash to fund Washington’s spending requirements.

There are only two possible outcomes to this supply-demand dislocation. The first is that the yield curve steepens. As we argued in yesterday’s Notes, there is enormous pressure right now on long-dated US Treasury yields. Yields are rising fast. And if this trend continues unabated, any “green shoots” will be choked off by the weeds of rising mortgage rates and corporate rates.

The second possible outcome is that the Fed steps into the breach and continues to buy back US Treasurys. This is horribly inflationary, as the money the Fed uses to pay for US debt is of the freshly printed variety. The Chinese are already getting nervous at the swelling of the Fed’s balance sheet. Should this trend continue private and sovereign holders of dollar-denominated debt will increasingly look to diversify out of their dollar assets, selling US Treasurys in the process.

The picture is a grim one. But the illusion of something for nothing is strong, and Team Obama shows no signs of quailing in front of this precipitous debt pile.

We read with horror in USA Today that one in six dollars of Americans’ income comes in the form of a federal or state check or voucher. This is the highest level of state-funded personal income since records began in 1929.

“In all,” reports the paper, “government spending on benefits will top $2 trillion in 2009 — an average of $17,000 provided to each US household, federal data show. Benefits rose at a 19% annual rate in the first quarter compared to the last three months of 2008.”

We don’t expect a return to balanced budgets anytime soon.

What other ways are there to hold on to your wealth in this “new normal”? It’s another fair question, and one that has been preoccupying us here at Notes for some time.

According to Gross, “staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets.” Here’s what he advises:

Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago.

Can We Take Yesterday’s GDP Figures at Face Value?

Contrarian Profits — Fri, 29 Aug 2008 11:38:10 +0000

“U.S. stocks strike solid gains on second-quarter GDP,” ran a gleeful headline yesterday on MarketWatch.

“Investors, showing no sign of concern about the outlook, took the GDP report at face value and pushed stocks up sharply on the news,” ran another breathless piece of editorial, following data that showed U.S. GDP up 3.3% in the second quarter.

But as Addison Wiggan and Ian Mathias pointed out yesterday in Agora Financial’s 5. Min Forecast, the government’s stimulus check program and a weaker dollar were partly responsible…

Government stimulus checks helped boost second-quarter GDP up 3.3%. That’s nearly double the Commerce Department’s initial projection. A weak dollar also helped U.S. exports rise. They’re up 13%… 4 points higher than the expected 9%.

And for every bit of good news, says the 5, there’s a litany of scary data close behind…

Bankruptcy filings, for example, were up 29% in June, year over year. Total filings for the 12-month period rang in just under 1 million.

And here’s a curious bit of data for both Buffett and Greenspan, champions of the “American productivity” school of euphorinomics: Between 2000-2007, U.S. worker productivity increased 18%, but salaries declined, on average, $2,000.

Despite producing an average of 2.5% more geegaws each year, the median inflation-adjusted family has fallen over the past seven years, from $58,000 to $56,000. “It’s a compelling example of a large disconnect,” says Jared Bernstein of the Economic Policy Institute. “Americans aren’t being rewarded for their productivity.”

And as Strategic Investment editor Dan Amoss said in an earlier post about bond king Bill Gross’s plea to Barack Obama to boost the budget deficit to $1 trillion, GDP figures are not necessarily a foolproof measure of the health of the economy…

I’ve always been skeptical of GDP as a measure of economic progress. It treats dollars spent and dollars invested equally (a dollar invested adds to capital formation, while a dollar spent subtracts from it). The GDP equation also treats government spending as a good thing. It is not. Aside from spending on the occasional “public good,” it just sucks capital out of the efficient, adaptive private sector and doles it out to politically powerful voting blocks.

For the sake of U.S. stocks, let’s just hope investors keep on taking those GDP figures at “face value.”

Bond King Bill Gross Wants Obama to Up the Deficit to $1 Trillion

Dan Amoss — Fri, 29 Aug 2008 10:44:26 +0000

The government’s bailouts of failed banks and its economic stimulus splurge widened the federal budget deficit to $102.8 billion in July.

Bond king Bill Gross would like to see the budget deficit reach $1 trillion.

Last month, he wrote an open letter to Barack Obama asking him, if he is elected, to save the US economy by upping federal spending by a further $500 billion.

According to Dan Amoss, Gross’s prescription for the economy would do more harm than good. For a start it would cause the price of oil imports to spike…

More from Dan…

In his July 2008 investment outlook, available on PIMCO’s Web site, Gross writes an open letter to Democratic presidential nominee Barack Obama. Presuming Obama will be the next president, Gross urges him to dramatically expand the federal budget deficit until it reaches a trillion dollars. I quote:

“While the Republicans will blame you for years and label you “Trillion-Dollar Obama” in future campaigns, there is, in fact, not much that you or any other president can do. You’ve inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender-of-last-resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years.”

The U.S. economy “will need an additional jolt of $500 billion or so of government spending real quick,” pleads Gross. His comically simple formula for GDP, this $500 billion “jolt” to the slowing real economy, is as follows:

“Some quick math for you, sir: Gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old C [consumption] + I [gross investment] + G [government spending] formula (scratch the trade deficit for now), when C + I is reduced by $500 billion, then G should increase by that amount in order to fill the gap. The G, sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well, there you have it: $500 billion + $500 billion = $1 trillion big ones, probably by sometime in 2011 or so.”

Only a Keynesian could argue that such an extraordinary waste of capital is a good thing. And only a Keynesian would believe that the simple GDP equation could summarize a vastly complex, adaptive economy.

I’ve always been skeptical of GDP as a measure of economic progress. It treats dollars spent and dollars invested equally (a dollar invested adds to capital formation, while a dollar spent subtracts from it). The GDP equation also treats government spending as a good thing. It is not. Aside from spending on the occasional “public good,” it just sucks capital out of the efficient, adaptive private sector and doles it out to politically powerful voting blocks.

Gross’ prescription to “save” the economy through wasteful spending would do much more harm than good. He aptly notes that the U.S. depends on foreigners to continually reinvest U.S. dollars back into the U.S economy and government.

As OPEC knows, many of the dollars recycled back into the U.S. were originally exchanged for oil imports. Gross acknowledges that the U.S. economy has an “energy cost” problem. But what does he think oil exporters’ reaction to an extra $500 billion spending “jolt” will be?

It won’t be pretty. Major oil exporters will demand higher oil prices and higher interest rates to offset what they know will be an ever-growing supply of U.S. dollar assets. Would you invest in an asset if you knew the future supply of that asset were guaranteed to increase at a rapid rate?

I have a more constructive suggestion for the next president:

DON’T dream up creative new ways to suck $500 billion in capital out of the private economy and redirect it into vote-buying programs. DO take a crash course on how the energy supply chain works, and invite Congress. Energy ignorance is the biggest immediate obstacle to the government being part of any sort of solution.

Inflation is here to stay, albeit with occasional “deflation” scares. Adjust your portfolio accordingly.

P.S. The above essay was pulled from the most recent issue of Strategic Investment. For more see here. Dan Amoss, CFA, runs Strategic Short Report and is a contributing editor for Strategic Investment. Dan joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years.

Source: Welcome to a Trillion-Dollar Deficit, Mr. President