On the wings of an eagle

I’ve always liked Jack Bogle, although I’ve never met him. He’s got heart, but as he’s probably joked a thousand times by now, it’s someone else’s — a 1996 transplant being the LOL explanation. He’s also got a lot of investment common sense, recognising decades ago that investment managers in composite couldn’t outperform the market; in fact, their alpha would be negative after fees and transaction costs were factored in. His early business model at Vanguard promoting index funds was a mystery to me for at least a few of my beginning years at Pimco. Why would most investors be content with just average performance, I wondered? The answer is certainly now obvious — an investor should want the highest performance for the least amount of risk and, for almost all measurable asset classes, index funds and many exchange traded funds (ETFs) have done a better job than almost all active managers primarily because of lower fees.

Buyer of last resort 

Through QE, the Fed continues tp buy bonds and support the banking system

The ‘almost all’ caveat is the reason I can write so freely and with such high praise for Vanguard. I am, after all, supposed to be promoting Pimco in these investment outlooks and Pimco is a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what he himself labeled in a recent Morningstar interview the ‘Pimco effect’. To paraphrase his interview, he spoke to index managers beating almost all active managers, but then “there was the Pimco effect”. We at Pimco thank him for that with a “Back atcha, Jack!” There’s actually a place for both of our firms and investment philosophies in this age of high finance. If Bogle’s concept of indexing was metaphorically similar to finding a cure for the cancerous devastation of high fees, then perhaps Pimco’s approach could be similar to mapping the investment genome and using it to produce consistently high alpha. There’s room for each of these investment laboratories. I will admit that there are other active management labs as well that are worthy of not only recognition but investor confidence and dollars. I have nothing but the highest of praise for Bridgewater’s Ray Dalio and GMO’s Jeremy Grantham and their staff. Their voluminous thoughts occupy a special corner of my desk library. Each has a distinctly different approach to active management — Dalio’s focusing on a levering/delevering template and Grantham’s on a historical reversion to the mean for most asset classes.

Neither Vanguard, Pimco, Bridgewater nor GMO, however, has discovered a cure for the common cold. Our performance periodically, and sometimes for frustrating long stretches, stuffs our noses or aches our heads, and makes us wonder why we hadn’t been more careful about washing our hands during flu season. Our firms make mistakes, even if, in Vanguard’s case, it’s the indexed mantra of being fully invested in an overvalued market.

Where might our future mistakes be hiding? What keeps us up at night? Well, I can’t speak for the others, having spoken too much already to please Pimco’s marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the ‘new normal’ characterisation of our post-Lehman global economy, now focuses on the possibility of a ‘T junction’ investment future, where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world. We are both in agreement on the perilous future potential of market movements. Mohamed’s T, I believe, was meant to be more descriptive than literal, and is a concept, like the new normal, that may gain acceptance over the next few months or years.

Banking on a neagtive rate 

To get growth going, the fed has sustained borrowing rates at zero

But aside from a financial nuclear bomb à la Lehman Brothers, our actual scenario is likely to play out more gradually, as private markets realise that the policy kings/queens have no clothes and as investors gradually vacate historical asset classes in recognition of insufficient returns relative to increasing risk. The actual T might in reality be shaped like a winged eagle, signifying something more gradually sloping left or right. This year’s April taper talk by the Federal Reserve is perhaps a good example of this forward path of asset returns. Admittedly, the reaction in the bond market was rather sudden and it precipitated not only the disillusioning of bond holders, but also an increase in redemptions in the retail mutual fund space. But the Fed recognised the negative aspects of financial conditions, postponed the taper and interest rates came back down. Sort of a reverse Sisyphus moment — two steps upward, one step back as it applies to yields and more like eagle wings than a T. Investors now wait nervously for news on the real economy as well as the medicine that Janat Yellen will apply to it.

That medicine, however, will most assuredly include negative real interest rates that at some point will give bond and stock investors pause as to the continued potency of historical total return policies generated primarily by capital gains. Bond investors found that out in May, June and July after 10-year Treasuries bottomed at 1.65%. Stock investors, however, were only mildly discouraged and continued their faith-based, capital gain dependent investments despite what should be the obvious conclusion: that quantitative easing and low interest rates were as critical to the market as they were to bonds. “What other choice do we have?” has become the mantra of stock investors globally, which speaks more to desperation than logical thinking.

Well, my point about the gradual as opposed to sudden disillusioning of investors worldwide is just that. The standard ‘three musketeers’ menu for retail investors has always been: investment grade, high-yield bonds as well as stocks. In recent years, institutional investors have gravitated to alternative assets, hedge funds and unconstrained space, so for them there appears to be an increasing array of higher return alternatives.

All of the above, however, contain artificially priced assets based on artificially low interest rates. Some are unlevered, like Treasury bonds, but nonetheless priced too high by the Fed in an effort to encourage migration to riskier bonds and/or asset classes. Others, such as many alternative assets, depend on the levering of portfolios themselves, borrowing at 10-50 basis points in overnight repo and investing at higher rates of return despite their artificiality.

But investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets, basically telling investors that they have no alternative than to invest in riskier assets or to lever high-quality assets. “You have no other choice,” their policies insinuate. “Get used to negative real interest rates, move out on the risk spectrum and in the process help heal the real economy,” they seem to command.

Holy grail

inflation returning to 2% is high on the Fed's wishlist

Yet, this near five-year migration across the global asset plains in search of taller grass and deeper water has had its limits, both in price and real growth space. If monetary and fiscal policies cannot produce the real growth that markets are priced for (and they have not), then investors at the margin — astute active investors like Pimco, Bridgewater and GMO — will begin to prefer the comforts of a less risk-oriented migration. If they cannot smell the distant water or sense a taller strand of Serengeti grass, astute investors might move away from traditional risk such as duration as opposed to towards it. Deep in the bowels of central banks, research staff must lay the unmodelable fear that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose momentum after the real economy fails to reach orbit, even with zero-bound yields and quantitative easing. 

In gradually moving away from traditional risk assets, I again refer to my August investment outlook, called ‘Bond Wars’. In it, I suggested that bonds and bond portfolios contain a number of inherent ‘carry’ risks and that duration or maturity was but one of them. I suggested that if the Federal and other central banks had artificially lowered yields and elevated bond prices, then a traditional bond fund should underweight duration and perhaps overweight other carry alternatives such as volatility, curve and credit. This we have done, and our relative performance reflects it. The ‘Pimco effect’, as Jack Bogle calls it, is alive and well in 2013. Our primary thrust has been to focus on what we are most (although not totally) confident about: that the Fed will hold policy rates stable until 2016 or beyond. While this and its conjoined policy of quantitative easing may have only redistributed wealth as opposed to creating it (picking savers’ pockets while recapitalising banks and the wealthiest 1% of our population), it is a policy that a Janet Yellen Fed seems determined to pursue. The taper will lead to the elimination of quantitative easing at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2% inflation, at a minimum, have been achieved. If so, front-end Treasury, corporate and mortgage positions should provide low but attractively defensive returns. We have positioned our Bond Wars portfolio — heavily front-end maturity loaded along with credit, volatility and curve steepening positions, with the aim of outperforming Vanguard as well as many other active managers.

There is no doubt, however, that this portfolio construct is dependent on the eagle’s wings as opposed to the junction of a T. Overlevered economies and their financial markets must at some point pay a price, experience a haircut and flush confident investors from the comfort of this Great Moderation part II. We at Pimco will prepare for that day while hopefully consistently beating Vanguard along the way.