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INFLATION: Coming to a theatre near you..... How do we combat the effects? Commodities and Equity in anything high quality (with pricing power) we can get our hands on...... Ask us for specifics. shawnm@pamria.com

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  1. 1. Investment Outlook April 2012 Bill GrossYour Global Investment Authority The Great Escape Delivering in a Delevering World About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages. The term delevering implies a period of prior leverage, and leverage there has been. Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally.
  2. 2. And almost always, the private sector was more than magically ascended. PE ratios rose, bond prices forwilling to play the game, inventing new forms of credit, 30-year Treasuries doubled, real estate thrived, andloosely known as derivatives, which avoided the anything that could be levered did well because theconcept of conservative reserve banking altogether. global economy and its financial markets were beingAlthough there were accidents along the way such as levered and levered consistently.the S&L crisis, Continental Bank, LTCM, Mexico, Asia in And then suddenly in 2008, it stopped and reversed.the late 1990s, the Dot-coms, and ultimately global Leverage appeared to reach its limits with subprimes,subprime ownership, financial institutions and market and then with banks and investment banks, and thenparticipants learned that policymakers would support with countries themselves. The game as we all havethe system, and most individual participants, by known it appears to be over, or at least substantiallyextending credit, lowering interest rates, expanding changed – moving for the moment from private todeficits, and deregulating in order to keep economies public balance sheets, but even there facing investorticking. Importantly, this combined fiscal and monetary and political limits. Actually global financial marketsleverage produced outsized returns that exceeded the are only selectively delevering. What deleveringability of real economies to create wealth. Stocks for the there is, is most visible with household balanceLong Run was the almost universally accepted mantra, sheets in the U.S. and Euroland peripheralbut it was really a period – for most of the last half sovereigns like Greece. The delevering is alsocentury – of “Financial Assets for the Long Run” – and relatively hidden in the recapitalization of banks andyour house was included by the way in that category of their lookalikes. Increasing capital, in addition tofinancial assets even though it was just a pile of sticks haircutting and defaults are a form of deleveraging thatand stones. If it always went up in price and you could is long term healthy, if short term growth restrictive. Onborrow against it, it was a financial asset. Securitization the whole, however, because of massive QEs and LTROSruled supreme, if not subprime. in the trillions of dollars, our credit based, leverageAs nominal and real interest rates came down, down, dependent financial system is actually leveragedown and credit spreads were compressed through expanding, although only mildly and systemically lesspolicy support and securitization, then asset prices threatening than before, at least from the standpoint of2 APRIL 2012 | INVESTMENT OUTLOOK
  3. 3. a growth rate. The total amount of debt however is and cap rates that could be compressed. Commoditiesdaunting and continued credit expansion will were on the relative losing end although inflation tookproduce accelerating global inflation and slower them up as well. That’s not to say that an oil companygrowth in PIMCO’s most likely outcome. with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from anHow do we deliver in this New Normal world that levers expansion of P/Es and a compression of risk spreads –much more slowly in total, and can delever sharply in well, not so well. And so commodities lagged financialselective sectors and countries? Look at it this way asset returns. Our numbers show 1, 5 and 20-yearrather simplistically. During the Great Leveraging of the histories of financial assets outperforming commoditiespast 30 years, it was financial assets with their expected by 15% for the most recent 12 months and 2%future cash flows that did the best. The longer the annually for the past 20 years.stream of future cash flows and the riskier/more leveredthose flows, then the better they did. That is because, This outperformance by financial as opposed to realas I’ve just historically outlined, future cash flows are assets is a result of the long journey and ultimatediscounted by an interest rate and a risk spread, and as destination of credit expansion that I’ve just outlined,yields came down and spreads compressed, the greater resulting in negative real interest rates and narrow creditreturn came from the longest and most levered assets. and equity risk premiums; a state of financial repressionThis was a world not of yield, but of total return, where as it has come to be known, that promises to be with usprice and yield formed the returns that exceeded the for years to come. It reminds me of an old movieability of global economies to consistently replicate staring Steve McQueen called The Great Escapethem. Financial assets relative to real assets where American prisoners of war were confinedoutperform in such a world as wealth is brought to a POW camp inside Germany in 1943. The livingforward and stolen from future years if real conditions were OK, much like today’s financial markets,growth cannot replicate historical total returns. but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty asTo put it even more simply, financial assets with long British and American officers to try to escape and getinterest rate and spread durations were winners: long back to the old normal. They ingeniously dug escapematurity bonds, stocks, real estate with rental streams INVESTMENT OUTLOOK | APRIL 2012 3
  4. 4. tunnels and eventually escaped. It was a real life story in relative terms, as we by necessity delever or leveraddition to its Hollywood flavor. Similarly though it is less. As well, financial assets cannot be elevated by zeroyour duty to try to escape today’s repression. Your based interest rate or other tried but now tired policyliving conditions are OK for now – the food and in this maneuvers that bring future wealth forward. Currentcase the returns are good – but they aren’t enough to prices in other words have squeezed all of the risk andget you what you need to cover liabilities. You need to interest rate premiums from future cash flows, and nowthink of an escape route that gets you back home yet financial markets are left with real growth, which itselfat the same time doesn’t get you killed in the process. experiences a slower new normal because of lessYou need a Great Escape to deliver in this financial financial leverage.repressive world. That is not to say that inflation cannot continue toWhat happens when we flip the scenario or perhaps elevate financial assets which can adjust to inflationreach the point at which interest rates cannot be over time – stocks being the prime example. They can,dramatically lowered further or risk spreads significantly and there will be relative winners in this context, butcompressed? The momentum we would suggest begins the ability of an investor to earn returns well in excessto shift: not necessarily suddenly or swiftly as fatter tail of inflation or well in excess of nominal GDP is limited.bimodal distributions might warn, but gradually – yields Total return as a supercharged bond strategy is fading.moving mildly higher, spreads stabilizing or moving Stocks with a 6.6% real Jeremy Siegel constant areslightly wider. In such a mildly reflating world where fading. Levered hedge strategies based on spread andinflation itself remains above 2% and in most cases yield compression are fading. As we delever, it will bemoves higher, delivering double-digit or even 7-8% hard to deliver what you have been used to.total returns from bonds, stocks and real estate Still there is a place for all standard asset classes evenbecomes problematic and certainly much more difficult. though betas will be lower. Should you desert bondsReal growth as opposed to financial wizardry becomes simply because they may return 4% as opposed topredominant, yet that growth is stressed by excessive 10%? I hope not. PIMCO’s potential alphafiscal deficits and high debt/GDP levels. Commodities generation and the stability of bonds remainand real assets become ascendant, certainly in critical components of an investment portfolio.4 APRIL 2012 | INVESTMENT OUTLOOK
  5. 5. In summary, what has the potential to deliver the most With regard to all of these broad asset categories, anreturn with the least amount of risk and highest investor in financial markets should not go too far on thisinformation ratios? Logically, (1) Real as opposed to defensive, as opposed to offensively oriented scenario.financial assets – commodities, land, buildings, Unless you want to earn an inflation adjusted return ofmachines, and knowledge inherent in an educated minus 2-3% as offered by Treasury bills, then you mustlabor force. (2) Financial assets with shorter spread and take risk in some form. You must try to maximize riskinterest rate durations because they are more adjusted carry – what we call “safe spread.”defensive. (3) Financial assets for entities with relatively “Safe carry” is an essential element of capitalismstrong balance sheets that are exposed to higher real – that is investors earning something more than agrowth, for which developing vs. developed nations Treasury bill. If and when we cannot, then the systemshould dominate. (4) Financial or real assets that implodes - especially one with excessive leverage. Paulbenefit from favorable policy thrusts from both Volcker successfully redirected the U.S. economy frommonetary and fiscal authorities. (5) Financial or real 1979-1981 during which investors earned less returnassets which are not burdened by excessive debt and than a Treasury bill, but that could only go on forsubject to future haircuts. several years and occurred in a much less leveredIn plain speak – financial system. Volcker had it easier than Bernanke/ King/Draghi have it today. Is a systemic implosion still For bond markets: favor higher quality, shorter possible in 2012 as opposed to 2008? It is, but we will duration and inflation protected assets. likely face much more monetary and credit inflation For stocks: favor developing vs. developed. Favor before the balloon pops. Until then, you should budget shorter durations here too, which means consistent for “safe carry” to help pay your bills. The bunker dividend paying as opposed to growth stocks. portfolio lies further ahead. For commodities: favor inflation sensitive, supply Two additional considerations. In a highly levered world, constrained products. gradual reversals are not necessarily the high probable And for all asset categories, be wary of levered outcome that a normal bell-shaped curve would hedge strategies that promise double-digit returns suggest. Policy mistakes – too much money creation, that are difficult in a delevering world. too much fiscal belt-tightening, geopolitical conflicts INVESTMENT OUTLOOK | APRIL 2012 5
  6. 6. and war, geopolitical disagreements and disintegrationof monetary and fiscal unions – all of these and morelead to potential bimodal distributions – fat left andright tail outcomes that can inflate or deflate assetmarkets and real economic growth. If you are a rationalinvestor you should consider hedging our mostprobable inflationary/low growth outcome – what wecall a “C-“ scenario – by buying hedges for fatter tailedpossibilities. It will cost you something – and hedging ina low return world is harder to buy than when thecotton is high and the living is easy. But you should do itin amounts that hedge against principal downsides andallow for principal upsides in bimodal outcomes, thelatter perhaps being epitomized by equity markets10-15% returns in the first 80 days of 2012.And secondly, be mindful of investment managementexpenses. Whoops, I’m not supposed to say that, but Iwill. Be sure you’re getting value for your expensedollars. We of course – perhaps like many other firmswould say, “We’re Number One.” Not always, not forme in the summer of 2011, but over the past 1, 5, 10,25 years? Yes, we are certainly a #1 seed – withaspirations as always to be your #1 Champion.William H. GrossManaging Director6 APRIL 2012 | INVESTMENT OUTLOOK
  7. 7. “Safe Spread” also known as “Safe Carry” is defined as sectors that we believe are most likely to withstand thevicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market issubject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in valuedue to both real and perceived general market, economic, and industry conditions. Commodities containheightened risk including market, political, regulatory, and natural conditions, and may not be suitable for allinvestors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due tocurrency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereignsecurities are generally backed by the issuing government, obligations of U.S. Government agencies and authoritiesare supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfoliosthat invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by agovernment are fixed-income securities whose principal value is periodically adjusted according to the rate ofinflation; ILBs decline in value when real interest rates rise. Tail risk hedging may involve entering into financialderivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail eventinstrument could lose all or a portion of its value even in a period of severe market stress. A tail event isunpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative.Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and therisk that a position could not be closed when most advantageous. Investing in derivatives could lose more than theamount invested. There is no guarantee that these investment strategies will work under all market conditions or aresuitable for all investors and each investor should evaluate their ability to invest long-term, especially during periodsof downturn in the market. An investor should consult their financial advisor prior to making an investment decision.This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions aresubject to change without notice. This material is distributed for informational purposes only. 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