Editor's Note: In late August, Paul McCulley, manager of the Pimco Short-Term Fund and chief Fed watcher at the big bond fund complex, discussed his contrarian economic outlook with Financial Advisor Editor-in-Chief Evan Simonoff. Simonoff: Paul, you apparently believe that we're likely to, in the next few years, experience a significant acceleration in the rate of inflation? McCulley: I think that where we are in inflation right now is not sustainable. Either we're going lower or we're going higher, that we're not going to stay right here. I don't think 1% inflation is aerodynamically sustainable in our economy. The risk to the economy is far more severe if we go down for inflation than if we go up for inflation because if we go down for inflation here, you move into the territory of deflation. Therefore, I think that deflationary risk will be met by a government response, which is super accommodating monetary policy, very Keynesian fiscal policy and pro-inflation regulatory policy. The forces of government will be applied to prevent us from going into the land of deflation, which is a matter of arithmetic in some respects. That would be a very positive scenario. As I put it in my writing, if we go down 200 basis points for inflation from here, no one knows how to fix that. However, if we went up 200 basis points, a sophomore macroeconomics student would know how to fix that. So I think that policy makers, quite appropriately led by the Fed, will consider not just the probability but the consequences of movements in inflation and underwrite a somewhat higher rate of inflation so as to truncate the deflationary risk. Simonoff: Everybody tells you that virtually no corporations right now have any pricing power whatsoever. McCulley: Which is a problem. Simonoff: Do you see this situation healing itself eventually, or do you see it really as being totally driven by the public sector? McCulley: I think that the Fed would like to see some degree of restoration of pricing power. In fact Greenspan said as much, in a very elliptical way, back in February when he said that it would be good to see corporations be able to take back some of the extreme price discounting of the recession as a means of restoring corporate profit margins. And he noted that arithmetically that would mean a somewhat higher rate of inflation, but would not consider that to be an inflationary problem. And I guess if we were to have a poster child for that phenomena, it would be Detroit. Detroit is selling pot loads of cars and losing money on every one. Granted that the 94% of Americans who have a job-and the unemployment rate is still low at 6%-the 94% that have a job are getting a sweetheart of a deal. But ultimately, we live in an integrated economy and the consumer is also a worker. And the companies that workers work for must ultimately make some money. So actually the consumer smiles as long as he's got a job during deflation. But ultimately, he stops smiling if he loses his job. I think pricing power restoration comes about through easy money, a lower dollar over time and probably some degree of re-regulation in various sectors, including the telecom sector, where effectively, you can get long distance phone calls for free. Ultimately, the provider of long distance phone calls does need to make a rate of return on capital. Simonoff: Aren't you probably likely to see more regulation in the airline industry? McCulley: What we have here is a number of industries in America that are quasi-natural oligopolies or monopolies. It's a dirty little secret that nobody wants to talk about, but it is a fact. When an industry has very high fixed costs and very low marginal costs, which describes the airline industry, and you deregulate it, then effectively you end up with cutthroat pricing that destroys the inherent profitability of the industry. And you get the same thing in utilities. You get the same thing in long distance telephone. And you arguably get the same thing in motor vehicles. A lot of industries that have high fixed costs but low marginal costs are natural monopolies and, therefore, need to have a referee, otherwise known as a regulator, to put some degree of order in the pricing. Where I think longer-term thinkers are putting their energy these days, is trying to figure out what the regulatory structure is going to look like three to five years down the road. We've got a mess on our hands in the airline sector, and the government is directly involved there because of the unfortunate tragedy of September 11 last year. Whether or not the government would have gotten involved in that industry without September 11 is a question we'll never know the answer to. A lot of the disinflation and deflationary pressures of the last decade or so have been one-off, i.e., you can't repeat them for the simple reason the act of doing them destroyed profitability and solvency in associated industries. Simonoff: Some people call what we're going through right now a process of creative destruction. McCulley: I use the phrase frequently. So does Bill Gross. It comes from Joseph Schumpeter and was his description of what entrepreneurial capitalism is about, which is that risk capital is constantly seeking the new innovative technology and method of production in order to make profits. But the fact that the profits and innovation means that you attract new interests and extraordinary profits are but fleeting as competition erodes extraordinary profits. So the economy is in a constant stage of creative destruction, which is a huge win for the consumer, obviously. It's not necessarily a huge win for the investor class. Just think in terms of your four-function calculator. Twenty-five years ago, you paid $100 for a four-function Texas Instruments calculator. And now, people give them away as party favors. So any profits that were there for the taking in making four-function calculators clearly were taken, and the process of creating the structure has a tendency to turn all manner of economic activity into commodities. So, everyone's trying to find the next new thing that's not a commodity, but then, once they find it, it attracts capital and it becomes a commodity. And it's the absolute beauty of capitalism. The problem is that capitalism also has boom-bust methodologies, which gives birth to the notion that you need to have a government sector that is anti-boom and also anti-bust, otherwise known as countercyclical. Call me a Keynesian because I obviously am one. Simonoff: Do you think we're out of the recession now, or not? McCulley: We're out of the recession. Recessions are about going down. And what was happening last year is two particular items and GDP were going down, not slowing down but literally going down. And that was business investment and inventories. And once you stop going down, then the recession is over. It doesn't mean that you have a vigorous recovery on the other side, but means that you don't have to go to hell twice for the same sin. And obviously, business investment was an intense sinner, as well as inventories. And they were obviously connected because of the lot of the business inventory-business investment was in the tech sector, which had heavy inventories, with Cisco being a poster child for that 12 to 18 months ago. So I think that the recession is over because we've stopped going down, and I think we will have and are having a recovery that is challenged by a couple of things. Number one is that the consumer sector never went down during the recession, as historically is frequently the case. You look at last year, as well as this year, and both housing and motor vehicles have been sturdy as all get out. So the fact that you never went down in housing and cars means that you can't bounce back. So I think that a bit of an arithmetic head wind to the recovery is that you didn't have a recession in those classic sectors. The flip side is that I think you will probably have a recovery, perhaps even one with a little bit of a V- shape in business investment and/or inventories, but that it will be restrained because corporate America has checked itself into the Betty Ford Center for balance sheet repair. Risk capital is more expensive and more difficult to get your fingers on. So I think we'll have a ho-hum recovery. The whole risk of double dip that everyone talks about is really about the risk that the consumer sector goes down. There's clearly room for consumers to go down, given the fact they didn't go down over the last 18 months. The question is, is there any reason for them to go down? Put differently, is there any reason for the home sector and the motor vehicle sector to fall out of bed? My answer is no, as long as you have the appropriate accommodative monetary and fiscal policy, and particularly with respect to the home sector have the conduit of Fannie and Freddie to pass along, as it were, the accommodative money and credit availability. So actually, I don't think the risk of a double dip is very high because it would require a colossal policy mistake either by the Fed or fiscal authorities in pulling back from their accommodative stance. Earlier this year, the Fed wanted to pull back from its accommodative stance. But clearly, the Fed has gotten religion, that being accommodative is not an emergency condition but a condition that needs to have a serious half-life on it as the economy heals itself from the heavy duty case of post-bubble disorder in the business sector. Simonoff: Is this recovery going to look a lot like the early '90s, that is, a statistical recovery but it won't feel like one? McCulley: It could be. But it will be different than the early '90s. The phrase that was used back then was jobless recovery. The unemployment rate held up, notwithstanding the fact that we were in statistical recovery. We could see a fair amount of similar characteristics in this one. Back then, the post-bubble disorder was in the property market, notably the commercial property market. You had a bubble there led by thrifts and banks and then you blew it up, and then you had the banking system check into the Betty Ford Center for balance sheet repair. The banking system is not in dire straits now at all. It's the corporate sector, notably the triple B sector, with particular areas under acute stress, whether it's energy or the telecom sector or the airline sector. Detroit's not under acute stress, but it's certainly not in a feel-good mode either. You will see corporate America working on de-levering, improving profit margins via cost cutting, and we will not see a return to robust job creation for a long period of time. Simonoff: What do you think are the implications for financial assets? Until three months ago, people thought stocks could be flatline for five years. It turned out what everybody was predicting seemed to get compressed into the three months. McCulley: I think that both stocks and bonds are going to be delivering on a secular basis, low to mid-single digits. I mean, double-digit returns on either asset class on a normalized basis is somebody smoking pot. It just ain't going to happen. On the bond side, it's arithmetically impossible, given the current level of yields. On the equity side, I would say that you have a similar arithmetic challenge otherwise known as valuation. We never got cheap in the stock market on valuation, call it P/Es, if you will, or dividend yields, notwithstanding the fact that we had a pretty nasty bear market the last two years. It just tells you that two years ago, we had a full-blown adult-size bubble. And blowing up the bubble still hasn't taken us to cheap. If you could get between 3% and 7%, I think you're supposed to be a happy camper. Within the bond complex itself, you probably would get your best returns on a normalized basis over the next five years from the corporate sector, because corporate spreads to Treasuries are exceedingly wide. Now, that doesn't come without risk, obviously, but we've already priced in a lot of risk in the corporate sector, which has had an absolutely nefarious run this year. If I look at bonds versus stocks, the intriguing one for me right now is corporate bonds versus corporate stocks. I look at corporate bond yields versus equity dividend yields. And I look at corporate CEOs trying to de-lever, and I think that unambiguously favors corporate bonds over corporate equities. Remember, when CEOs are going for growth, that's good for equity. When they're going for survival, that's good for debt. Simonoff: Are hard assets the place to be for the next decade? Some people are saying real estate's beginning to build a bubble of its own. Others look at the dynamics of growth of the third world and problems of the Middle East and like energy and other commodities, as well. McCulley: Yes. With respect to real estate first, which is really not traded on a global basis, I think we have an adolescent bubble in real estate nationwide here in America. And I stress the word "adolescent." It's not an adult-sized bubble. I think that we might get to an adult-sized bubble in the next three to five years. In fact, my valuation work indicates that the median-priced home in America could rise 30% over the next five years cumulatively and still not be more richly valued than it was in 1979. At the margin, American households will continue to put additional savings money into the property market in part because they've been severely beat about the head and shoulders in stocks. Property has never been more tax advantaged as it is now-that the first $500,000 of gains on property every two years is tax-free also helps. That was a change in the tax law three years ago. So I think property will continue to do well. I don't look at that so much as an investment per se, because it's a means of people covering their natural short of not having a roof over their head. From the standpoint of other, more "exotic" investment opportunities, I think the dollar is going down over the next three to five years, notably against Europe. So I think that the international class unhedged, particularly probably European equities, will be an interesting area. And unhedged, people conceptually could get to double-digit returns there because I think the dollar should come down quite meaningfully against the euro in the years ahead. With respect to commodities, it probably makes sense for people to have a slice there, as well. We've had 20 years of a secular bull market in the dollar. That's over, and I think a weaker dollar should put a floor underneath commodity prices. We've had massive disinvestment in commodities over the last 20 years. Which means that they're both oversold and under-owned, and probably under- produced-or the capacity produced there has withered away in many respects over the last 20 years. So there's a good contrarian play in commodities. Simonoff: Any particular commodities? McCulley: I'm not an expert in commodities. I would tend to want to think in terms of buying something that was indexed to a basket of them, and, in fact, there are several products in the marketplace that do that. My friend Jeremy Grantham is a huge fan, obviously, of timberland. I think that it's a good contrarian play, in part because I think the dollar is in secular decline. Simonoff: I can understand you saying the dollar is overvalued. But why would anybody want to hold euros when their economies have sputtered for decades? McCulley: Because they don't want to hold dollars. So that's a wise-ass response. You've got two things with respect to the dollar that can make it come down. One, you know, global investors become less enamored of it. I sometimes refer to the dollar as the cover charge into the party in celebration of capitalism in America, and that party is over. More importantly, in many respects, is that as a policy matter we would want to have a weaker dollar in the years ahead. Part of the process of restoring a degree of pricing power to corporate America-particularly corporate America exposed to global competition is a somewhat lower dollar. Simonoff: You say the capitalist party has run amok, and certainly, with all the accounting scandals, that would be hard to argue with. However, some of the underlying trends of the 1990s, particularly productivity, seem to indicate that there was something real to what we experienced. Even in this period of post-bubble disorder, productivity growth seems to be sustained. McCulley: There was something real to the new economy underneath all of the hype and bubble and infectious greed, to use Mr. Greenspan's new phrase. I don't think it was all a fraud and a mirage. There was something fundamentally real. The most important thing is that we have sufficient acceleration in our structural productivity that we now consider 4% unemployment to be the natural rate of unemployment, and we're sitting here at 6% unemployment. We all agree that it would be a wonderful thing for the unemployment rate to come down. Whereas you go back five to 10 years ago and the economic community and most importantly, the Fed, considered 6% to be as low as you could go on the unemployment rate. Simonoff: Your colleague, Bill Gross, has pointed out that the reason we got 17% a year for 17 years in stocks was that 20 years ago, you could get 14% in bonds. If there is to be another boom in financial assets, are we going to have to go through a period of high inflation? If you look at the era right after World War II, which set up the great bull market of the '50s, you had very high inflation in the late '40s. Is it possible to have another boom in financial assets without first having a period of severe underperformance? McCulley: Fascinating question, and the short answer is no. You can't have another boom in financial asset returns without having a period of hell first, which is a long, long period of the stock market doing nothing and becoming cheap. Put another way, a period of the P/E multiple coming down and down and down as earnings continue to move up, but stock prices don't. Over on the bond side, you'd need to have a period of upside for inflation, and therefore higher yields, before you could have a period of disinflation. So I think the answer to your question is that you can't really have another boom from here. But I think Bill was right in that you can only have a disinflationary boom in asset prices when you have room to disinflate, and there is no room to disinflate now. There's only room to deflate. And that's the last thing that we want to do because deflation is absolutely nefarious for corporate solvency, as well as corporate return on capital. We're in that situation that you can't get to a boom from here. You have to go somewhere else to start, and between here and somewhere else is a period of purgatory for financial asset returns, if not hell. It was a journey, not a destination, and I think that's usually important for investors to recognize, that disinflation is not a destination. Only during the journey do you make extraordinary returns on stocks and bonds. Once you get there, actually, there is nothing happy about price stability from the standpoint of returns on stocks and bonds. As a quick aside, when you go back to the period you're talking about in the '50s, you had a re-rating of stocks versus bonds that helped stocks do well versus bonds. Effectively, P/E multiples on stocks went up relative to what would be implied by bonds, or put differently, you had a secular fall of the required dividend yield. Simonoff: One last point. You seem to talk about deflation and feel that it's synonymous with a depression. During the last 30 years of the 19th Century, a period of phenomenal technological change, the U.S. economy experienced significant deflation, and I think the price levels fell something like 30% over 30 years. You had phenomenal growth. That was an extraordinary, exceptional time in economic history, with many booms and busts. But isn't it possible that deflation in a more mature economy like America today could be more manageable? McCulley: I think it's manageable in some sectors. Technology, obviously. It probably would be more manageable if you hadn't had the preceding bubble in debt. The thing that's really nefarious about deflation is that it increases debtors' real debt burdens . Japan has been managing in that environment, and they haven't had a depression on the order of the 1930s in Japan, but certainly, they've had a lost decade. So the deflation risk is not a canned green peas and small firearms scenario, but a lost decade scenario.