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Frank Talk From the Bond King

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With the exception of Federal Reserve Chairman Alan Greenspan and Treasury Secretary John Snow, no one swings a bigger club in the bond market than Bill Gross, managing director and chief pundit at Pacific Investment Management Company, or PIMCO. With good reason: Newport Beach, California-based PIMCO boasts $415 billion in assets, $77.4 billion of which resides in the various share classes of PIMCO Total Return, the largest bond fund in the U.S.

In a year marked by economic recovery, rising interest rates, war, and a heated presidential campaign, Gross has proved to be a skilled navigator: Total Return’s institutional shares logged a 4.76% total return through October, according to Standard & Poor’s, some 50 basis points better than the Lehman Brothers U.S. aggregate bond index. We profiled PIMCO and Gross in May (“The Bond King’s New World”). This month, we got Gross, who turned 60 on December 1, to sit still at his keyboard for a few minutes while we chatted with him via e-mail.

The presidential contest is over and we have a clear popular and electoral vote winner this time in George W. Bush. Can you give us your feeling for the big picture for the economy and markets now that the GOP has kept control of the White House and tightened its grip on both houses of Congress? What I said before the elections and what I continue to believe is that it didn’t really matter who won the White House because neither candidate has many options, especially when they’re staring at $400 billion-plus in budget deficits. What those deficits mean for bonds is that yields have to rise because the government cannot afford to pop the ballooning deficit because it is the necessary evil that is keeping the economy growing.

President Bush says his plans for Social Security include allowing some workers to invest part of their payroll taxes in private accounts. But the day is looming closer when what goes into the Social Security Trust Fund will fall short of what’s going out. As a bond market investor, are you concerned? Do you have a prescription or see a likely outcome? The prescription is not privatization–that will increase the underfunding by $1 trillion. Ultimately, Americans must work longer hours and retire later. That is the solution.

In 2003, you were highly critical of America’s entry into the war in Iraq. What is your current take? My position hasn’t changed much. Don’t forget I, too, fought in an unpopular war, Vietnam, so I continue to support our troops in Iraq. But I still question the mission.

Do you see any sign of foreign unease with American involvement in the war translating into a reluctance to hold U.S. dollar-denominated assets? There may be individuals who have decided to do this, but I have not seen any data that supports entire countries acting as such. However, what the war is doing is growing the U.S. deficits, and these deficits are being supported by the “kindness of strangers,” the Chinese, the Japanese, et cetera. As long as the strangers go along and are willing to finance the budget deficit at these low interest rates, we can look forward to a relatively placid period. But when–not “if,” but “when”–they decide to not go along with the program, that’s when the real danger exists for higher yields and substantially lower prices in Treasuries as they exit the barn for more profitable pastures.

You have argued strenuously that the way the government currently reports inflation is highly flawed and that the reported consumer price index is as much as 60 basis points less than what it would be if hedonic, or quality, adjustments were not factored in. This leads you to conclude that CPI adjustments for wages and social programs are being artificially held down, while real GDP is being artificially pushed up. Could you expand on that? My argument is that the government is using CPI as a quality indicator, as opposed to a cost-of-living indicator. Year after year, they inaccurately adjust the prices of computers, cars, and other durable goods downward to reflect the better quality of each of those products. I don’t argue the fact that cars and computers are getting better, but I do argue with the fact that individuals actually pay less for them in terms of the cost of living. Because of that, I believe CPI is really a percent higher than what the government says it is.

You brought a handwritten note called “The Things I’m Most Certain Of” to a recent PIMCO client meeting. Tell us about these points. “The Things I’m Most Certain Of” puts investing in an easy-to-understand context, meaning that’s what investing is all about: determining what you can be most confident of and then placing your bets in a measured proportion that reflects that confidence. To think that any idea has anything more than a two-to-one outcome given the near transparency of information and its immediate influence on prices would be somewhat delusional, I suspect, but there is always something that we are most certain of. The trick is to avoid slam-dunk exuberance, which could spell disaster for a portfolio. At the meeting, I said that PIMCO’s most certain idea is that real interest rates in the U.S. will have to be kept low. Too much debt in a finance-based economy precludes raising interest rates like we have in the past. While that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency over time.

You are not the only bond maven to conclude that no matter who won in November, some economic issues are so great as to transcend party politics. The current account deficit is over 5% of GDP, and we now have a mounting federal budget gap and a personal savings rate that has fallen to around 1%. But you have suggested that Fed Chairman Alan Greenspan has little choice but to keep real short-term interest rates very low for the near future. You see asset bubbles forming out of this mix. So what does this all mean for investors? If you believe as I do, you should buy the assets that are being bubbled: invest in bonds that are protected against inflation (TIPS and German bonds with less inflation risk) and short the dollar–all very carefully, by the way; one false move can ruin more than your day. The low rates I mentioned earlier speak to really low real short-term rates. If inflation continues upwards it would be logical for the Fed to raise nominal short rates just enough to contain prices, but not kill the economy. We have suggested one-half percent real as a future Fed target, but no one really knows. We will all just have to find out. With so much debt in our economy, a subjective analysis would caution against raising real rates too high. We believe that higher rates will be a long time coming.

How about commodities? What, if anything, does the recent rise in oil prices spell for the economy and bond market? Keep in mind that in the past month or so we have seen oil as high as $55 and recently dipping to around $40. Whenever oil prices rise, it takes money out of the pocketbooks of the consumers. To that extent, it’s disinflationary, unless the Fed decides to drop interest rates, to keep short-term interest rates below the inflationary mark, and therefore stimulate economic growth in reverse. Energy price shock is just flat-out negative because it both pushes up inflation and pushes down economic growth. Energy shock has a stagflation smell to it.

What about your personal portfolio, Bill? Where are you lightening up and where are you going in deeper? I’m a strong believer in eating my own cooking….so I have been investing in TIPS and various Euro bonds as well. Bon appetit.

Editorial Director William Glasgall can be reached by e-mail at [email protected].