Two Different Views, Both Ugly

[La_Serpiente]

Mods: There is no online link for this, so I typed out the entire thing.

Taken From Smart Money Magazine, a publication of the WSJ

Two Different Outlooks, Both Ugly

Bill Gross and Bob Rodriguez, two of the best bond managers in the business, have made successful careers out of accurately predicting economic trends. So what do their crystal balls tell them now?

Gross thinks the economy will stumble. Rodriguez disagrees. He thinks it's going to fall of the cliff.

Gross, who manages $350 billion in bonds assets for Pimco Funds in Newport Beach, Calif., is the world's biggest bond manager. he believes deficit spending and a declining dollar will slow economic growth. Investors will demand higher rates before lending money to cover the growing costs of the military and health care. "The Salad Days for bonds are over," he predicts.

To position his flagship portfolio, the $74 million Pimco Total Return fund for a downturn, Gross has reduced the duration -- a measure of risk that factors in average bond maturity, amount other things -- of his holdings. Expecting rates to rise, Gross has lowered his duration to 4.3 years, from 5.3 last spring, when rates were falling. If he's right, his portfolio should shield investors from the worst of the battering.

"My biggest fear this year has been no necessarily a recession or a weak economy, but a dollar rout, leading to a sale of U.S. Treasurys on the part of central banks or foreign institutions," Gross says. "that hasn't happened yet, but it's on the front burner for me." His portfolio consists largely of corporate issues and Treasury inflation-protected securities, or TIPS. he's taken profits on some of his junk bonds, which have rallied over the past 12 months.

Rodriguez, who's been bearish on bonds for the better part of two years, thinks Gross underestimates the threat of rising rates. In his fund, the $1.1 billion FPA New Income, duration is a minuscule 1.4 years. He says bonds are vastly overpriced, and sees an economic crisis right around the corner, as the government spends more and takes in less revenue. When that happens, bonds with long maturities will suffer most and issues that mature in a shorter time will hold their value better. The result is a portfolio that's lean on government bonds and heavy on cash.

"Interest rates in the 4 to 5 percent range aren't providing enough safety to compensate us for the risks we see in the system," he says. Rodriguez's short duration means that interest rates on the 10-year note would have to increase to 5 percent from the 4.23 in mid-November, for such a portfolio even to keep pace with the benchmark. "A substantial reduction in duration comes at a cost," says Gross, who doesn't expect such a big move. Rodriguez responds: "We'd rather give up opportunity returns , as opposed to real capital losses" if rates rise.

Of course, this is also a good approach if the economy improves, because in that case interest rates are also likely to rise, and the managers' defensive positions will serve them well. If that happens, Rodriguez is likely to do better than Gross, simply because his duration is shorter.

Through early November both managers were beating their peers. When bonds rallied early this past summer, the Gross portfolio got a pop. Then a sharp bond selloff hammered many government bond funds, but Rodriguez's fund gained 2.5 percentage points, and Gross's mildly defensive posture protected him somewhat. By early November, Gross's fund was up 3.9 percent for the year, compared with 3.4 percent for the typical intermediate-term bond fund. Rodriguez's was up 7 percent, beating nine out of 10 competitors.

So what should investors do? One options is to invest according to your outlook: Gross tends to beat competitors during bond rallies, and Rodriguez often trounces them in bear markets.

[sendero]

1. Interesting...

.... thanks for posting.

[rasputin1952]

I have felt this "economic recovery" is just a bubble...

As I am not an economist, I can't give an analysis that will hold water; but my gut says we're in for some seriously bad times ahead.

My step-dad once told me that every generation has a war, and every generation needs a recession/depression to show them how much value a human really has.

O8)

[ProfessorGAC]

3. Mixed Bag

I've had 7 econ papers published, so i know from whence i speak. I don't think we're headed for a big crash or anything, but the "growth" being trumpeted is being sustained almost solely by borrowed gov't cash. I've done the analysis, and combined with my econometric models in the past, i think the economy will decline to a slow crawl, with real growth rates around 0.6 - 0.8%. This isn't depression stuff, but it's pretty poor.

My models have shown, in the past, that deficits are a drag on economic growth and price stability. If the entire "growth" phenomenon we've seen in the past 5 months is funded by deficit spending, there is no reason to believe it's sustainable, nor is there a reason to suspect it won't drag things back down.

Cutting taxes and increasing spending is a fool's game. Figures this buffoon would be the one in charge while this country is playing a multi-trillion dollar fool's game.
The Professor

[IrateCitizen]

4. Couple of questions, Professor...

1) How do you view the continual decline of the dollar as affecting the US economy? One view might be that it would be good for restarting our manufacturing capacity, which you have previously noted is currently operating at only 70% capacity (I'd still like some evidence for that, just to know where you got it from), because it would make our exports cheaper. Of course, this could be countered by China's continuation of keeping the yuan at an artificially low level. Another view is that it could result in a shedding of treasury investments by foreign investors as they decreased in value, putting a great strain on the already sputtering federal treasury. I read yesterday where European markets are saying that the dollar could fall as far as $1.35 per Euro, a level thought irrational just a few months ago. If this happens, isn't there a risk of an increasing shift toward the Euro as international currency on the part of big investors?

2) What about the huge trade deficit? You stated previously that the US economy still produces more than anywhere else in the world, yet we have an ever-expanding trade deficit. How do you see this affecting economic growth in the near and far term?

Any answers you could give would be much appreciated. I've become fascinated with the field of economics over the past several years, and appreciate hearing POV's from those who have been practicing it. But at the same time, I remember the old saying about asking ten economists in a room to give their opinion and getting fifteen different opinions.... :D

[ProfessorGAC]

6. My Views

The value of a currency is tautalogical. As the value falls, the value of the goods produced in that country rises. (Same goods, same quality, for less money, right?) So, a float in the value of the dollar isn't inherently good or bad, it just is!

Obviously, that is within some limited allowable range. But, as long as we don't crank up the printing presses, the value of the dollar would stay intrinsically stable, (within that "natural" range). Think the yen in the 80's or the pound in the 60's. The yen fell precipitously in the late 80's/early 90's, but Japan didn't experience collapse or depression. Just an extended recession, while their goods flowed into the U.S. That stemmed the tide of the economy pressure of reduced currency value. Once again, currency value down, value of goods up!

As to your question re: the international currency number. Didn't we go through this already in the 80's over the yen? The yen was REALLY attractive for about 15 minutes. What really matters is the sustainable strength of the macroeconomy. The EU still produces less goods per dollar. Remember that while the overall EU GDP is larger than the U.S., it's not larger on a per capita basis. And, since their "p" is higher than that here, the GDP is held up by price, not by productivity. (Their Q is good, but not as good as here.)

Now, i've seen lots of faux analysis about the impact of the favored currency. But, i can find NOTHING in the data to suggest that macroeconomies follow the currency. The currency follows the center of economic gravity. There is nothing on the horizon, even The Idiot Prince's deficits, that would pull the center of gravity from the United States. The economy, while in the doldrums, is still as healthy as almost all others. Remember, there is a direct causative link between world economic health and that of the U.S. It's been that way for >50 years.

One last note on this currency thing: Keep in mind that the impact of the favored currency is a staple of neoconservative economics. If you're throwing in with their thought processes, best of luck to you. They've been wrong about everything else, i see no reason to believe they're right about this. (It's been suggested that the whole control of oil is rooted in a desire to assure that the petro currency stays dollars. I say it doesn't matter, and i've been correct way more often than those charlatans.)

As to the trade deficit, i see the problem in a different way. Actually, as long as the vast bulk of foreign trade is in the form of direct consumables, it keeps prices low and maintains some vibrancy of the middle class and encourages short term consumption. However, if it grows too large, and the reason is because our goods are not selling (as opposed to us just importing more and more), then the middle class income potential shrinks. With fewer dollars chasing the same goods, and the value of the currency declining, it makes the incoming goods equal in dollar volume, but lesser in absolute terms. So, the imports number stays high, but the fewer workers producing exportables forces that number lower, which increases the trade deficit.

That's a serious concern. Shrinking the size of, and buying power of, the middle class means the all aspects of GDP fall a bit (particularly C and NE). This lowers profitability and increases unemployment. The trade deficit becomes self-sustaining and rather than being a drag on GDP, actually becomes an active variable in reducing it.

It appears that the NE is a sigmoidal function, and i don't think we're that close to the inflection point. But, once there, i'd suggest we'd hit a cliff and it would get pretty dreadful, all at once.

As to your 10 economists, 15 opinions comment: If you listen to the 3 from the school that states what the data says is more important than what theories have been examined, you're more likely to get a meaningful and provable economic hypothesis. Then you could ignore the 12 two-dimensional hypotheses completely.
The Professor

[IrateCitizen]

7. Prof, thanks for the response

With regards to currency matters, I do realize that obsession with maintaining currency is a hallmark of classic neoliberal economics, most aptly demonstrated in its insanity by the International Monetary Fund. If anything, it seems to be a measure taken to benefit the finance industry first and foremost. But at the same time, I would have to say that the change over the last 18 months or so between the dollar and Euro has been somewhat disconcerting. I could be overreacting, but I also think it might play in a bit with the more highly regulated (and hence more stable) European markets and the Wild West that has been ushered in under Bush the Lesser.

With regards to trade deficits, I think that your analysis while sound from a strictly economic point of view fails to take into account some externalities that can have a big impact. Especially with regards to this statement: Actually, as long as the vast bulk of foreign trade is in the form of direct consumables, it keeps prices low and maintains some vibrancy of the middle class and encourages short term consumption. My concern with this approach is twofold. First, it seems that much of the present consumption is fueled by consumer debt -- or at least the absence of any real savings by most consumers. Our personal savings rate is almost non-existent when compared with our counterparts in the rest of the industrialized world -- especially Japan. It seems to be a short-term hedging of our future. My second concern is environmental -- the planet simply cannot sustain this pattern of indulgent short-term consumption. We're literally destroying the very ecosystems upon which we depend, both directly and indirectly, for our survival. At present, we are consuming 33% more resources than the earth is able to replenish. Most notable among these resources is potable water and arable soil. This doesn't even account for the damage that is being done to forests as they are cleared for short-term farmland.

I have found it quite perplexing that the words "economy" and "ecology" both have the same root word, "eco", taken from the Greek oikos which literally means "the environment in which we live" -- but so often the environment is not adequately considered when discussing the economy. This isn't at all a knock, but I also find it completely lacking in your descriptions. Do you have any thoughts on this?

[rasputin1952]

2. deleted dupe

n/t

[ElsewheresDaughter]

5. i concur....we are in for some really ugly times ahead