Financial Advisor: The bond market has finally reasserted itself vis a vis the stock market this year. Did that surprise you?
Gross: I knew it had to come sometime. It's been several years in the making, according to my judgment, so that shows you how early or late I guess I can be. But whenever the Fed is on the move and the economy is perceived to be slowing down with a threat at some point to expected growth rates in terms of corporate profits, that's going to be the case. Now when the Fed is raising rates, that's not always the best environment for bonds either, but it's more destructive for stocks.
Fuss: It's actually sort of dull this year. What has not changed about the bond market is the low level of liquidity, particularly in the corporate market but in the bond market in general. There was less liquidity than there was two years ago. The liquidity started going out of the market about two years ago and then really left in August of '98 and has only come part way back in, so that's what was new about the market a couple years ago.
Now that in and of itself is not necessarily a bad thing. It's very bad for somebody that would want to sell a lot of bonds, obviously, because they're not going to find a welcoming bid. It's equally bad for somebody who needs to buy a lot of bonds because they don't find that much for sale. It also has led to, in my opinion at least, some value distortions.
Gross: The big surprise is the liquidity in the government sector. Obviously, the Treasury itself is having a big effect there in terms of buybacks. They're reducing the outstanding liquidity, and there's nothing to be done about that as long as we continue to run a surplus and the Treasury uses the surplus to buy debt and to issue less.
It's surprising for that reason, and it's also surprising in the corporate and emerging markets - there's only one real area with any liquidity left, in my opinion: That's the mortgage market. Although it's fair to say that the corporate calendar has been significant and if you measure the liquidity of a market by the ability of buyers to absorb new issues, then the liquidity is there. But there's certainly no liquidity on a secondary basis and no liquidity in the corporate market for lower quality bonds. For the most part, the liquidity of the bond market overall has been substantially reduced relative to where it was before Asia.
Financial Advisor: Many in the financial markets seem to be assuming that the Fed can engineer another soft landing a la '94-'95. Isn't that kind of a bold assumption?
Fuss: Wouldn't it be nice? It is bold. It might not be a bad assumption. At this point, I don't even want to make a bet either way on that. But it does look to me like for whatever reason - and I think cost of short-term money is part of it - that business is slowing a bit. It's showing up in consumer hard good sales, and soft good sales for that matter. It's still early on the retail sales numbers. There can be funny stuff in the numbers. The analysts that are working with the retailers, such as the department stores and the discounters, are definitely coming back saying this is not just one store or another. This is fairly widespread.
There has clearly been a slowdown, and it's been enough to start to back inventory up at the apparel manufacturers, and for that matter, the people who make washing machines, so there is a slowdown. Now the hard goods, the white goods, the washers, the refrigerators, that kind of stuff slows down as building starts and housing turnover slows.
Gross: We just had what we call a secular forum, which is a look at the next several years in terms of the global economy and the global financial markets, and we came forward with the suggestion that a significant slowdown, and/or a recession, which is in direct contrast to what you just described as a soft landing, has a higher probability than a soft landing and maybe even as high a probability as greater than 50%.
Fuss: My guess - and our economics department may laugh at me for this - is we're probably going to drop back to a rate of growth of somewhere around 1.5% or 2%. I always have a hard time trying to figure out what is my forecast and what is my hope. The healthiest thing all the way around would be not too much of a decline in the rate of growth because if our economy really does go down a lot, it may be uncomfortable for us, but God help anybody in Thailand. Because they are net exporters, and if a giant net importer like the United States slows down, they'll feel it in spades.
Gross: I think this hope and speculation on a soft landing is just that for several reasons. Greenspan has done an excellent job throughout his tenure, and there's faith in the almighty and in Greenspan himself that he'll be able to do it at least one more time.
But I think one of the problems is that even Greenspan is sailing in uncharted waters here based upon the wealth effect, based upon the question marks that all of us have in terms of productivity growth and the sustainability of productivity. And so even the infallible, I guess, is potentially fallible for several reasons.
We may be approaching a level in terms of short-term rates, where the Fed simply makes a mistake and overreaches their potential targets. At 6.5% or 7% or whatever their eventual resting point is, given the wealth effect and the productivity question, it's hard to know exactly what the right way is in this new age economy. The Fed could overdo it and produce a rather hard landing as opposed to a soft landing.
One of the problems Greenspan has with raising rates is that he can't really lower rates very quickly. That's flexibility that he's had in prior cycles. But this time around if he even hints at lowering interest rates, he starts the stock market on the upward climb all over again.
Financial Advisor: It goes into orbit.
Gross: Exactly, so while he can certainly lower rates in a significant downturn or cataclysmic plunge of the economy or the financial markets, he's going to be very reluctant to do so absent those extremes. So this question of central bank overreach and the inability to lower rates, perhaps over the next six, 12, 18 months, once we get to the sweet spot, wherever that is, is going to be one of the potential problems that weighs against this soft landing. In other words, you have to find the sweet spot almost on the money. You know, if Greenspan were shooting darts at a dartboard, that dart's got to hit dead center. It can't hit six or seven or eight points on the fringe.
Fuss: That used to happen a bit when the Fed really tightened. In old cycles when the Fed really leaned into the market, really took money out of the system, that would happen. The Fed certainly has been raising short-term interest rates, and to a degree, you can say that money is tighter now than it was. But this is not tight, tight, tight money.
Gross: There are other potential problems in the global economy that suggest that perhaps a soft landing may not be, like the question of Japan. They haven't really pulled themselves out of the sinkhole to any significant event and they're still 15% of world GDP. If they reverse course, then that could be a potential problem. There's the overwhelming problem that I've eluded to in terms of an equity bubble and the fact that we're 35% off the top in the Nasdaq and 5% to 10% down in terms of other averages and what that implies for consumer spending. We're in uncharted waters. Perhaps just as significant could be a reversal of the dollar. We haven't seen that yet. It's off about 5% or 6% from the top relative to the Euro.
Financial Advisor: If you would assign probabilities to these three different outcomes, a soft landing, a recession, or a continued rapid expansion, what would you give each?
Fuss: I would bet 60% on the soft landing. I would bet 25% on recession and 15% on rapid expansion. I think the most likely scenario is the soft landing, and the reason I feel that way is that as soon as it becomes apparent that the Fed will not tighten anymore, I expect some pickup in liquidity that's sort of derived from markets. I'd be quite surprised if we go into a real definable recession. But I'd be flabbergasted if the rate of growth picks up from here.
Gross: Well, the stronger bet I would say would be recession. Obviously, if you averaged it out, you'd say soft landing. But I would say 50% recession, 30% soft landing, 20% rapid expansion.
Financial Advisor: Not many people really see a recession out there.
Gross: We're talking about 18-24 months. Because if the Fed goes up another 50 or 100 basis points, we get into this problem of overreach and the inability to lower interest rates like I talked about on the other side, so my trend target would probably be 18 to 24 months, and it would be predicated, at least to some extent, on the Fed moving even higher from here.
Financial Advisor: There are a lot of anecdotal signs of a slowdown out there in the housing side. People in the construction business say their backlog isn't what it was. Do you think part of this is the first signs of the wealth effect?
Gross: That's the key. The Nasdaq is down 35% and that was from the peak. Some would argue it's above where we were 12 months ago. So you have all these different time frames and levels and it gets confusing. But the fact is that the psychological effect of coming off 35% from a peak can be very damaging at the margin to those who were spending the big money, and the big money was no doubt being put into second homes and third cars and the expensive goods and services that would logically fall from a wealth effect. I think that's what we're beginning to see now. We're not seeing the average American, who doesn't have much in the market, cut back substantially. But you're seeing the wealthy investors at the margin cut back. In addition to that I think you're also seeing the effects of higher oil prices.
Over the past six, seven, eight months, gasoline, has been moving steadily higher, and that's absorbed a nice piece of change from the average American, who doesn't even invest in stocks. That, in combination with the wealth effect plus higher interest rates [on mortgages and credit cards] is starting to absorb some purchasing power and spending power from the U.S. consumer.
Financial Advisor: So you basically put a 50% chance on recession within 24 months?
Gross: Well, put it in terms of the next three years. But I'd say some point in the next 12 to 24 months is our most dangerous period because of the potential for the Fed to overreach and the inability of the Fed to drop rates once they get to where they think they're going. That certainly takes more than six months from here.
The fact is there's so much excess in the U.S. economy and to some extent excess in the Japanese economy. Europe is sort of in the middle of the seesaw. But the United States has excess in terms of the trade deficit, has excess in terms of the savings rates of U.S. consumers; there are no savings. There are excesses in terms of the wealth effect and the bubble, excesses in terms of the dollar, and excesses in terms of corporate debt. So there is lots of excess, a lot of it having the same origins in terms of credit creation and an over exuberance of investment that may or may not be productive in future use.
Fuss: Remember, we're coming off very high numbers. But nevertheless, should we draw a trend line from that? I don't think so, because people are still working. They're getting paid good money. But at the increment, there are some signs and you can't dispute it. And when you flip through the commodity pages and look at industrial commodities, not oil and gas but everything else, you find a decline in the price of the underlying commodities. My first rule has always been if I want to gauge how things are going, I pick up the commodity page and see what's happening.
Right now even in linerboard and boxboard, the edge is off the rise in price and the incremental price is actually down a little bit. In a lot of these cases, people were double ordering. There was a lot of double ordering, particularly in some areas of paper. And I think there was quite a bit of double ordering in some areas of petrochemicals. There were some strange price actions for some of the petrochemical projects and some of the specialty chemicals that just didn't make sense, even allowing for fairly good demand. I think that was people trying to build inventory if they had price rises. Now all of a sudden that's stopping.
Financial Advisor: If we have a soft landing, we could go another couple of years before we are in a recession. This could turn out to be a 13-, 14-year expansion.
Fuss: It certainly is, in my mind, within the realm of possibility. The older part of me says, 'Now wait a minute.' I've been doing this for 42 years now. What changed in the early to mid-'80s was that the federal government stopped taking as large a share of our gross national output. Defense spending used to be 8% of GNP, something like that, in '83, '84, '85. Now it's a little less than 4%. That has freed up a lot of resources.
Financial Advisor: Why do you think the economy has expanded so dramatically so late in the business cycle?
Fuss: There are so many new varieties of activity, and the liquidity's been there. We've had enormous liquidity until recently. The stock market expansion itself created a lot of liquidity, but it's just been a vibrant, healthy thing, and people do produce more now than they used to. They are more productive. Even my barber cuts hair faster than he used to. But you know it just has been one of those magic times where it just continued to go on and the liquidity stayed a lot longer in this economic cycle than it ever had before. There was more liquidity for the economy than there ever has been before.
Also, the government is a smaller issuer of funds in the capital markets to the point where the federal government right now gives money back because they're paying down marketable debt. Federal debt IOU's in the future on Social Security are still building up. But as far as impact on the market, they are a supplier of money to the market.
Most states and most major counties and municipalities have gone cash-flow positive, so they're not net demanding money any more. They are providing funds to the market slightly, and so that leaves the federal agencies, which have been borrowing a lot of money, and that ties into the mortgage market and the corporate market and individuals, all of whom have been borrowing more money.
Now corporate borrowing has really tailed off lately, so on a net basis, both investment-grade and below investment-grade corporate borrowing has really dropped a lot. But there's been the liquidity out there. Money has been there if you needed it.
Gross: There are two other reasons. One of the reasons has to do with productivity and technological innovations, whether it's the Net or derivatives of the Net or simply technology being applied to the workforce in the form of computers. This does appear to be something real in terms of higher productivity levels, whether that's a half percent a year or one percent or whatever relative to historic levels it's hard to judge and Greenspan doesn't know either. The productivity miracle, if you want to call it that, is part of the explanation.
Another part though is simply that prior to the last six months, the U.S. central bank and Europe and, of course, Japan as well have been in a very liquefying mode.
After Asia and after Russia and after Long Term Capital Management collapsed the committee to save the world jumped in there. Rubin, Greenspan, and Summers. They put money into the global economy at a very rapid rate and we see that in money growth.
You see that in the stock market. We've had a very liquid economy, a very productive economy, and that combination in the seventh or eighth year of our economic recovery has sort of given us an additional push and it's allowed us to grow and to reduce unemployment levels down to 4% or less with very little inflationary pickup simply because of this productivity miracle.
From this point forward though, with our 4% unemployment, there's no one left to work. That's an exaggeration. But the reverse of liquefication, the tightening on the part of the Fed and the tightening on the part of the ECB and the popping so far of the Nasdaq bubble are going to have an effect, so all of those things are working now and in the other direction. The big question is whether we can move down to 2% or 3% growth, which was what your soft landings imply, or whether we'd go down to 0% or a little bit less. A lot depends on that wealth effect. A lot depends on central bank overreach.
Financial Advisor: Isn't it possible with a lot of these dot-coms starting to lay off people and construction and real estate starting to lay off people, that the sort of virtuous cycle we saw in the mid- to late '90s could resurface? Or do you think there's just not enough slack left in the system anymore?
Gross: I don't think there's much slack. I think the reversal of the dot-com phenomenon does more to produce a psychological vicious cycle as opposed to a virtuous circle, you know, the layoffs, the failures, the stocks plunging from $100 to $1 or $2 in terms of the stock market price. All those things send negative feedback signals to investors and consumers in the economy, so if anything it's moving now in the other direction.
Financial Advisor: Some people think it's healthy.
Gross: Well, you know, to the extent that capitalism involves creative destruction and we're seeing some destruction, sure. It's healthy over longer periods of time. But it's certainly not healthy in the next few quarters or the next several years because it involves layoffs.
Financial Advisor: What sectors of the bond market do you like? What are you avoiding? What do you think the next big surprises will be?
Gross: The key emphasis on the bond market should be quality as opposed to duration and maturity or any type of international fix. I think if the potential for recession is there, then a focus on high quality is, in my mind, Ginnie Mae mortgages as the primary focal point for any investment portfolio. We have about 50% of our portfolios in Ginnie Mae mortgages. But those are high-quality pieces of paper, and they carry with them some yield at the same time.
The problems I have with governments and with corporates is governments are high-quality investments and I accept that in an economic slowdown that they're obviously a safe haven. The deterioration that I see coming forward or going forward is in the corporate side.
It's amazing to me that defaults are where they are and downgrades are where they are with GDP increasing by 5% or 6% on an annual basis. You wonder what will happen even if annual growth rates are reduced in half to 2% or 3%.
Financial Advisor: Much less in recession?
Gross: Exactly. Most importantly though, this new age global economy, to the extent it incorporates technology and productivity increases and all the advances of the net and so on, is really not a positive for the corporate bond market. The reason is simply that if the new age economy reflects the same attitude that the stock market does, there'll be a few winners and lots of little losers. Amazon.com will survive but lots of little dot-coms will fail. That's fine for stockholders because they can have a diversified portfolio of stocks. Say half of them don't make it but the other half go up four or five times, then they're still far ahead.
On the corporate bond side, corporate bondholders, even with Ama-zon.com, only get 100-cents back on the dollar so they can't profit by the same philosophy as a diversified portfolio. I apply this same winner-take-all philosophy to corporate America, not just to the Internet stocks but to industrial America, in which GM and Ford and Chrysler cut their costs by 10% or 15% by using the net and therefore reduce the profit margins of their suppliers, etc., etc. The fact is that corporate bondholders do not thrive in a new age economy.
They get hurt significantly because the losers give you 20, 10, and zero cents on the dollar, and the winners only stay at 100.
Financial Advisor: Dan, what do you like?
Fuss: Right now I like everything other than Treasuries. I'm staying within the U.S. dollar block right now.
There's nothing wrong with Treasuries; it's just that everything else is cheaper so I like everything else. In particular, I like the agency market. I like the investment grade corporate market, but I'm using far more caution these days, not because of the cycle but because of a change.
Many companies are borrowing to buy in their stock, so I'm being very cautious with the single A and double A-rated type corporate names. I'm afraid what they're doing through financial policy will gradually bring their rating down to the BBB range.
Because of where we are in the cycle and because of this less liquidity situation, you have wider spreads on everything else relative to Treasuries, particularly corporates.
It's a really strange market. It used to be at this phase of the cycle, I'd much rather be buying the widget types who are your basic industrial suppliers and ignoring the commodities. This cycle, I'd much rather be buying the commodities and ignoring the industrial suppliers so you really have to sort of stand on your head when you do it.
Financial Advisor: Bill, you've been a lot more pessimistic about the economy in the last five years than the economy has actually been, but it really hasn't hurt your performance. Do you try to look for bets you can place that you'll win if you're right or wrong?
Gross: That's the secret to it. Bond people tend to be more negative than the stock people and maybe even more negative than your typical economist, so that shows through I think. But the performance, nonetheless, has done very well because we've found the areas that we prosper under both scenarios. That has meant buying emerging markets at the right time, not before the Asia crisis but after. Buying mortgages throughout most of the period of time, making the proper duration, maturity playing, all of that said.
I would agree with you that my skepticism of the U.S. economy has been overdone and that the economy has done much better than what I had thought and what I would have hoped and at any point over the last six, 12, 18, 24, 36 or 48 months.
Fuss: I'm being careful because it's sort of a matter of corporate financial policy that your optimum point is triple B or triple B+, whereas it used to be A+, so I'd rather wait until it's a triple B+ before I buy the bonds. This means our buying is focused in the triple B area where we see decent credits and don't see a difficult pricing environment.
You have areas where if you're a part supplier to anybody, take auto parts, probably one of the best examples, you have a highly fragmented business. There are a zillion different auto parts manufacturers but the auto industry has changed and you now have sort of tier one and tier two through 100. Tier one are the handful of suppliers who can design, manufacture, and deliver around the world.
Financial Advisor: What do you think the implications of your bond-market outlook are for stocks?
Gross: It's actually vice versa, the implication of the stock market on the bond market. Now at least temporarily, it's the reverse. Over a long term basis, you have to believe that if corporate bonds go the way that I think they're going to go that because corporate bonds are at least senior obligations to corporate stocks, that 9%, 10% or 11% yields on - high-yield or even BAA corporate bonds, have to be sending some type of message to some investors out there that stocks may not be able to match those returns. Whatever the discount rate is that's applied to corporate earnings, if I could be so irreligious in suggesting the thought, whatever the discount rate is, the fact is that if rates move up and earnings are discounted forward at a higher rate, they are worth less.
Financial Advisor: Bonds have outperformed stocks so far this year. You think that'll continue in the second half?
Fuss: Yes, you have to be careful what stock index you're using. I think bonds will outperform the S&P or the Wishire. In the longer term, a lot of what is happening in here is actually very, very good news for stocks and not half bad news for bonds, but you'll feel it much more in stocks. The problem with stocks is that they got too high. The market had all this liquidity and it got ahead of itself.
Financial Advisor: It got a life of its own.
Fuss: Right, so that part of it probably gets corrected here. In the longer term, the most important thing is whether or not we have peace in the world in the aggregate sense. When you have a time of peace, you have room for prosperity if you govern yourself properly. I think we're doing that right now. I think that's a fundamentally good thing for both stocks and bonds. Shorter term, stocks got rather silly on the price side.
Any normal valuation ratios would indicate that's the case and that seems to be primarily due to a lot of liquidity, plus people felt safer buying stocks. I think the economy will continue on, but it will probably correct stock valuations some more. I suspect bond valuations are past the bottom as far as price.
I think that part's done, but I don't think we're past the bottom in stocks as far as price. I think stocks will probably take a little more to come in line here but nothing scary. But then if there was something really scary, I guess the markets would correct.
It's been a rotational market. The Nasdaq did get silly, and it did come down. My instinct is that stocks overall are still a little high relative to bonds, and I think they'll correct, but not that dramatically.
Financial Advisor: Thanks to both of you.