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Your Global Investment Authority

Investment Outlook
February 2014
Bill Gross
Most Medieval
In days of old
when knights were bold
and ladies most beholden
straw seemed like silk
and water, milk
and silver almost golden
Not so sure about that
limerick it was probably a cruel world those days of old.
Yet much of it was fascinating and in some cases surreal.
Te relationship of man and God, for instance. Or better
yet man, animals and God. Unlike today, when most
believe that animals were put on this Earth for humanitys
pleasure or utility, most people in the Middle Ages believed
that God granted free will to Adam, Eve and all of His
creatures. Animals were responsible in some strange
way for their own actions and therefore should be held
accountable for them.
Accountable? Well yes, animals were actually put on trial for their
misdeeds. They might actually be considered evil. Beetles that munched
on church pews, pigs that dined off of late evening drunkards, locusts
that ravaged harvest wheat all were viewed in a similar fashion much
like their human counterparts thieves, adulterers and murderers alike.
Sometimes the animal would be brought before an actual court,
sometimes (as with insects) tried in absentia. In the case of ravaging
pigs, for instance, there might be a full judicial hearing with a prosecutor,
defense and a robed judge who could order a range of punishments,
including probation or even excommunication. No bad little piggies
went to heaven, it seems. Often, there would be an actual execution with
a hog being hanged by the neck until it was dead. The pork chops
followed shortly thereafter, I assume. There was no Humane Society in
1500. Somehow I thought those medieval times needed a more
reality-based ditty than the one cited above, so heres a modern-day
Chaucers attempt:
In days of old when pigs were bold
and people very prayerful
a locust might be canonized
and drunkards had to be careful.
Now on to the world of investing, me Lords and Ladies,
which by the way is full of little piggies feeding at the
trough, scaredy cats afraid of their own shadow, and
ostriches sticking their heads in the sand. And too, history
will record that capitalism and its markets are a dog-eat-
dog world. If so, weve currently got a menagerie to rival
anything in those days of old. But lets stick with the
piggies for the following Investment Outlook. Hopefully
the prose will be better than the previous poetry.
I nd it fascinating the number of ways that investors
approach the value of securities and other investments
such as commercial real estate or homes. Many of them are
legitimate and form a solid foundation in academic
research or even common sense. Natural interest rates,
P/E ratios, cap rates, risk and liquidity premiums, and even
real estates location, location, location are ways to
fundamentally price an asset. Add to that the emotional
inuence of human nature and you have a pretty good idea
as to why prices go up and down; not necessarily a pretty
good idea as to when they will go up and down, but at
least the why part is partially visible.
But lost in this rather complex maze of why is the function
of credit and credit expansion in a modern, nancial-based
economy that it dominates. Asset prices are dependent
on credit expansion or in some cases credit
contraction, and as credit goes, so go the markets,
one might legitimately say, and I do most
emphatically say that! What exactly do I mean by
credit? Well, money in all its multiple forms. Cash is a
form of credit in my denition because you can use it to
buy things. Bonds are credit. Stocks are credit. Houses and
real estate can be considered credit when they are
securitized and sold to investors in mortgage pools. In our
modern nancial economy, credit is anything that can be
transferred on a wire or a computer from one account to
another and ultimately be used as the basis for spending
money on things such as groceries or airplane tickets.
And so when an investor tries to think about prices for
these various forms of credit, it is necessary to get behind
the winds of credit itself, to see what causes credit to
behave like a mild South Seas breeze or a destructive
typhoon in the China Sea. Credit creation or credit
destruction is really the fundamental force that changes
P/Es, risk premiums, natural interest rates, etc. For most
investors that may be hard to understand, but that is
where the little piggies come in.
Imagine you are on that South Sea island with only two
people. Each of you owns half of the island, grows your
own food and has four little piggies for bacon and chops
and all of the good stuff that people like to eat. Things are
copasetic; the local economy is doing ne, but one day
your other buddy gures out a way to make a new crop
that you dont have. Shes the islands entrepreneur, so to
speak. Well, being jealous and perhaps a tad greedy, your
previous buddy refuses to share the secret. But she will
offer you a future share of her harvest for one of your little
pigs there being no money, credit or anything of the sort
on the island. You love that bacon, but the lady is living
higher on the hog, so to speak, with that new crop, so
you agree on a deal one pig for one years harvest of her
future crop. Despite the lack of a stock market,
crops are now trading at a P/E of 1 X pigs. One pig
equals one future years worth of your ex-buddys
bountiful harvest. Well the months roll by and one thing
leads to another, and for some reason you want some
more of your neighbors crop. Maybe its marijuana and
the island has just legalized it for medicinal purposes. Lets
just say. And lets say youre willing to part with another
pig for another share of medicinal weed. Neighbor,
sensing enthusiasm, says, No, itll cost you three pigs,
which is all you have, but youre feeling high and certainly
very hungry so you say OK. This funny smelling grass
now sells at 3 X pigs, or a pigs-to-grass P/E ratio of 3/1
and everybodys happy. Until well to get back to the
real world, those piggies have really been credit or cash
substitutes all along, and now in order to keep this system
going you need more pigs or more credit in order to
continue. But youre out of pigs. A funny thing now
happens in this capitalistic South Sea island and mainly to
the price of marijuana. It traded last year at 3 pigs to 1,
but since youre out of pigs and credit, the price collapses.
Grass goes to zero because there is no more credit; you
have no more pigs to pay for it.
So for those of you who dont live in Washington State or
Colorado or others who are a little miffed at this example,
lets just put it this way. P/Es of 3 or P/Es of 15 or
P/Es of 0 are intimately connected to the amount of
available credit. So are interest rates. If there was
only one dollar to lend and someone was desperate
to have it, the interest rate would be usurious. If
there was one trillion dollars of credit and no one
was eager to borrow for some reason or another,
then the rate would be .01% like it is today and for
the past ve years in my personal money market
account. The amount of credit and its growth rate are
critical to asset prices, and of course asset prices in our
modern economy are critical to growth and job creation
and future prospects for investment. We have a at/credit/
debt-based economy that depends on the continuous
creation of more and more credit in order to thrive and
some would say even survive. We need those pigs and
more of them. And they need to circulate and be traded
what some would call velocity in order to keep the
economy growing. Our South Sea island economy never
did change until the new crop was discovered, but
concurrently, not until the pigs started to be traded for it.
And so? Well, to use the U.S. as an example, we ofcially
have 57 trillion dollars worth of credit (stocks not being
part of the Feds ofcial denition) and probably 20
trillion more in what has come to be known as the
shadow system. But call it 57 trillion because the
Fed and Chart 1 do.
Source: Federal Reserve Board/Haver Analytics
U.S. Credit
45 50 55 60 65 70 75 80 85 90 95 00 05 10
Chart 1


It used to grow pre-Lehman at 810% a year, but now it
only grows at 34%. Part of that growth is due to the
government itself with recent decit spending. A decit of
one trillion dollars in 20092010 equaled a 2% growth
rate of credit by itself. But despite that, other borrowers
such as households/businesses/local and foreign
governments/nancial institutions have been less than
eager to pick up the slack. With the decit now down
to $600 billion or so, the Treasury is fading as a
source of credit growth. Many consider that as a good
thing but short term, the ability of the economy to expand
and P/Es to grow is actually negatively impacted, unless
the private sector steps up to the plate to borrow/invest/
buy new houses, etc. Credit over the past 12 months has
grown at a snails 3.5% pace, barely enough to sustain
nominal GDP growth of the same amount.
Is there a one-for-one relationship between credit growth
and GDP? Certainly not. That is where velocity complicates
the picture and velocity is inuenced by interest rates and
the price of credit. But with QE beginning its taper, and
interest/mortgage rates 150 basis points higher than they
were in July of 2012, velocity may now negatively impact
the equation. MV=PT or money X velocity = GDP is how
economists explain it in old model textbooks. Actually the
new model should read CV=PT or credit X velocity = GDP
but most economists are classically trained to the Friedman
model, which viewed money in a much narrower sense.
So our PIMCO word of the month is to be careful.
Bull markets are either caused by or accompanied by
credit expansion. With credit growth slowing due in
part to lower government decits, and QE now
tapering which will slow velocity, the U.S. and other
similarly credit-based economies may nd that future
growth is not as robust as the IMF and other model-
driven forecasters might assume. Perhaps the
whisper word of deation at Davos these past few
weeks was a reection of that. If so, high quality
bonds will continue to be well bid and risk assets
may lose some luster. In any case, dont be a pig in
todays or any days future asset markets. The days of
getting rich quickly are over, and the days of getting rich
slowly may be as well. Most medieval, perhaps.
And too, stick with PIMCO. Believe me when I say,
we are a better team at this moment than we were
before. I/we take the future challenge faced by all asset
managers with close to a sacred trust. Not the one that
the ancients granted to animals, but a more modern one
embraced by the relationship of client/duciary and the
need to be held accountable, sort of like the pigs and
locusts in days of old when knights were bold.
Most Medieval Speed Read
1) Asset prices depend on credit creation and expansion.
2) The U.S. and other countries create less credit from
the public standpoint as their decits decline.
3) 34% credit expansion in the U.S. may not be enough
to maintain 3% growth, especially if asset prices go
down and velocity is affected.
4) Dont be a pig in a highly levered global marketplace.
There is risk out there.
William H. Gross
Managing Director
Newport Beach
840 Newport Center Drive
Newport Beach, CA 92660
+1 949.720.6000
Hong Kong
New York
Rio de Janeiro
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