The Last Vigilante

You don’t hear much about the bond market vigilantes anymore. They sort of rode off into the sunset a few years back, either having forgotten their role or perhaps having grown accustomed to their impotence in an era where deflation instead of inflation was public enemy number one. Their glory days were probably a little overrated anyway. Vigilantes are essentially lenders and decades ago when they first gained their reputation there were no inflation protected TIPS or real return commodity funds for a bond investor to send a message with. It was either bonds or cash, and the price of cash was set by the Lone Ranger at the Fed who was heading up the posse. All the rest of us sort of rode along, whoopin’ and a hollerin’, shootin’ our guns in the air like we were gonna lasso and hogtie those inflationary varmints. But we were kind of acting. Paul Volcker was the man, the Vigilante, and later I suppose it was Alan Greenspan, although to me he now seems more like Barney Fife than the Lone Ranger. I write this in half jest if only to introduce the notion that Volcker’s Wild West was a lot different than that of Greenspan’s today. While both marshals were entrusted with the dual responsibility of controlling inflation and maintaining a sound economy, Greenspan’s economy is a completely different one than the one Volcker rode his white horse into in 1979 and out of in 1987. Greenspan’s economy is a globalized economy, filled with negative vibrations revolving around substitution of cheap Asian and Latin American labor for workers here at home. It is an economy full of technological wonders such as the Net, cell phones, high-speed data transmission, and the like. We may not be able to go to the moon anymore, but things down here on mother Earth are certainly movin’ and shakin’. These changes have completely altered the perspective of our High Sheriff and Chief Vigilante. Now there are legitimate questions as to the natural rate of domestic unemployment in a globalized world, the sustainable level of productivity in a technology tinted economy and the resultant effects they have on inflation and economic growth – the Fed’s two primary responsibilities. It is not an easy assignment, this job of Chief Vigilante in the year of 2004.

And it’s not one, as I have pointed out in Outlooks past, where you can afford to risk bludgeoning the economy with sharply higher interest rates as Volcker did in the early ‘80s. It may appear more prosperous than that of the “rust belt” ‘80s but its foundation is much weaker because of high levels of debt throughout the private and now the public sector. The Lone Ranger has been replaced with Barney Fife for good reason. We need someone afraid of his own shadow these days because there are shadows aplenty to contend with. Because beyond the risks of globalization and the blitz of technological change, I would argue the most critical reformation in the past twenty years since Volcker’s prime has been the transition of the U.S. from a manufacturing/to a service/to a finance-based economy within the span of two decades. Purists will perhaps rightly quarrel with the chronology or maybe even the logic, but it seems to me in any case that the critical difference between then and now is that profits and employment – 2/3 of the critical constituents that a Fed Vigilante must protect (inflation being the third) – are now primarily a function of the amount of debt/leverage and its cost. Because this is so, we currently reside in a finance-based economy. This is no longer Dodge City of 1984 or even 1994 when we made things and sold‘em because we could do it better than global competitors. Now we make less of them, and those that we do produce we sell because financing rates are 0%. The suburbs of Dodge have changed their character as well. Instead of buying a home with a 30-year fixed mortgage and watching one’s equity grow via monthly amortization of principal, we refi twice annually, do it with variable or even interest only loans and then spend any equity we have accumulated via “take-outs.” You’d think we were headed to a casual Friday night evening at KFC or Burger King. And if my old friend General Electric is synonymous with the U.S. corporate sector, bite on this appetizer as indicative of the transformation of the U.S. economy. In 1980, 92% of its reported profits came from its manufacturing subsidiaries. In 2003, nearly 50% of earnings were supplied by financing subsidiaries highly dependent on leverage, the cost of that leverage, and its ability to maneuver through the swaps market by turning long-term rates into cheap 1% + short term financing.

My intent here is not to create another set of media sound bites by unearthing “GE” or jesting with a Barney Fife/Alan Greenspan comparison. Greenspan is a good man and a well-intentioned public servant. He believes he is a modern-day vigilante – fighting deflation instead of inflation and he had a point for a while back in 2002. GE is a great company with a near century of “progress.” But they, as well as yours truly and PIMCO have sort of skipped down this yellow brick road of capitalism, paved not with gold, but with thick coats of debt/leverage that require constant maintenance in the form of lower and lower interest rates. I’m arguing the case that Volcker in effect was perhaps the first and last Vigilante. Greenspan, GE, Gross? Vigilantes? We’re sort of all in this finance-based economy together, are we not? While Greenspan has blessed it and GE has taken advantage of it, PIMCO has facilitated it. Who makes it possible to refi all those mortgages by holding $100 billion of them in PIMCO portfolios? 0% car loans? Who makes it possible by snapping up asset-backed securities at LIBOR plus yields? GE’s swaps?   PIMCO’s got the same side of the trade.

But folks, all blame aside, I must tell you in advance that this story or movie does not have a happy ending. In terms of timing it may not be high noon, but High Noon it will be in terms of an ultimate outcome. Because in a finance-based economy that depends on more and more low cost money in order to thrive, the game ends when either the “more and more” or the “low cost” modifiers are replaced with “less” or “higher cost.” Let me explain with the two following charts.

Chart I

  Chart II

Visible proof of a finance-based economy is offered in Charts I and II which point out the growth in U.S. finance over the past several decades. As shown in Chart II, debt as a percentage of GDP has skyrocketed over the past 20 years and is now at historically high levels approached only briefly during the depression of the 1930s. The ratio then was a function of the heady roaring ‘20s to be sure, but also to its aftermath in which GDP fell nearly 26% during the payback of years that followed. Now, our debt and its distribution are much more sophisticated. Government, business, and consumers can borrow freely, and their individual debts are aggregated and then split into strips, IO’s/PO’s, CMO’s, and CDO’s, which are then “repo’d” – we have “O’d” or “owed” our way to prosperity in more ways than one it seems. Whatever the reason, whoever is at fault – whether it’s PIMCO for buying it or Greenspan for blessing it, or Wall Street for pushing it – we are at a point where there’s a lot of it. That point no one can deny. And the fact that our economy has prospered in the midst of it cannot be refuted either. What is up for debate is whether our economy has prospered because of it and whether it will continue to. New Agers would basically argue that yes we have a lot of debt, but it’s because we as an economic society have made wise choices – borrowed the money to invest in productivity-enhanc ing innovations, or from the government’s side, to protect our way of life from the ravages of terrorists around the globe. They would also argue that because of today’s low yields, the servicing burden of that debt remains under control.

But so-called vigilantes would counter by pointing to consumerism and the ongoing cycle of buying ephemeral “things.” They would suggest that we have hardly invested wisely – witness the millions of miles of still unutilized fiber optic cables and the farcical parade of the “dot coms” as recently as a few years past. They would then top it off with an observation that Republican Bush with his Republican Congress seem to observe no limits whatsoever in the budget. $500 billion may only be a start if in fact we’re going to the Moon, Mars, and beyond. The CBO in fact has jus t conservatively estimated a $2 trillion addition to the national debt over the next decade.

Who’s right? Each side scores some points I suppose, but what seems obvious to me is that if debt stops growing at the same rate – if the slope of the trend line in Chart II tips over, then our economy will slow down, stagnate or worse. Who could argue that if debt as a % of GDP were still at 1980s levels as shown in the chart, that our consumption of things, our purchases of homes, our investment in technology, or our current government deficits would not be much smaller and our economic growth much lower. We are hooked on debt; we are a finance-based economy.

And so? Why not just keep on going. So far so good the New Agers would claim. What’s wrong with 400% of GDP or 500% of GDP? What’s wrong with dropping it from helicopters if we have to as good Ben Bernanke has suggested? Well, let me tell you what’s wrong. Debt levels and debt ratios have limits. When and if interest rates do go up, the servicing costs of an accelerating debt economy eventually bite the hand of its master. A true bond vigilante is a vigilante that knows that buying a bond, mortgage, or any of the innovative “O’s” that have popped onto the scene in recent years is really lending someone some money, someone else’s hard earned cash that they expect to get back in inflation-adjusted terms and then some. Lending is not mimicking some index or buying a hot new issue with the intention of flipping it to some other sucker when the spread narrows. It’s not gloating about being in the top decile of the money manager universe while producing less negative total returns than 90% of your competition. And it’s certainly not buying dollar denominated bonds with the ulterior motive of putting 20-30 million of your citizens to work a year à la the Chinese, or better yet, the Japanese. These investors may be clever, but they’re not vigilant. A bond market vigilante makes loans, she demands a fair inflation adjusted return and when that visibility shrinks, she seeks alternatives. My point is that at some point on this seemingly never ending ascent of debt/GDP, someone will say “no más.” Maybe it’ll be PIMCO and PIMCO think-alikes; maybe it’ll be foreign holders of bonds grown tired of currency/inflationary erosion of principal; maybe it’ll be risk takers in high yield/emerging market/levered hedge funds scared to death from a future LTCM crisis. Hard to tell, but I’m telling you it’ll happen, helicopter or no helicopter and with it will come an economic slowdown/recession unseen since at least the early 1980s when Volcker began his vigil. High noon.

Chart III

So far, I’ve confined this “finance-based economy” treatise to the growth of debt and the willingness of lenders to go along for the ride. The second rather simple explanation for our ongoing prosperity is that during this period of accelerating growth, the cost of the financing has gone down, down, down as shown in Chart III. Talk about productivity! 

In a finance-based economy this IS productivity. Instead of cheaper and cheaper labor per unit of output, we have cheaper and cheaper interest rates per unit of debt . Long-term real interest rates have dropped from an estimated 9% in 1980 to 2.5% now. I hearken back to my argument about 0% loans and historically low mortgage financing rates. How much consumption would have taken place without these trends? The undeniable answer is “not as much.” Perhaps even “a lot less.” My point is that yields are about as low as they’re going to go. When you have negative real interest rates, even a half awake vigilante will “someday” demand redress, or a half awake Fed Chairman will “someday” be forced to rebalance, or a half asleep foreign central bank will “someday” switch to a basket of currencies which offer more protection via higher real rates of interest.

As real short rates climb from negative to only slightly positive (PIMCO’s longstanding forecast), this reversal in trend will be enough to call a halt to the higher and higher productivity of debt in a finance-based economy. Simply put, it means that borrowers will pay more in real terms, affecting consumption, home building and buying, business investing, and government deficits alike. The lower real interest rate “wind” at their backs will instead turn into a mild headwind. The economy will slow. It may falter. The timing is uncertain. For contrary thinking, pessimistic investment managers or economists, “someday” is often frustratingly “out there” like some phantom force in the X-Files. Still, it suggests caution as we move inexorably closer to our High Noon.

Readers wishing me to get to the bottom line or even jumping ahead of me to draw their own conclusions may find this “High Noon” parallel a little bit hard to digest even in PIMCO terms. Have I not been preaching the inevitability of “reflation,” recommending TIPS and commodities, advocating shorter than average durations filled with intermediate maturities to take advantage of the carry trade? That I have – but reflationary attempts by Fed Chairman and Presidents alike do not presuppose successful reflation in terms of economic growth. The pace of future growth is the true conundrum, not the obvious reflationary efforts of governmental authorities to generate it. Believers in past Keynesian successes and promises of future helicopter droppings are confident it can be done – that our U.S. and global economy can ultimately exhibit stable long-term growth rates with the government’s wind at its back. I have my doubts. Keynes like Volcker conjured his magic in a simpler manufacturing/agricultural based world. In a finance-based economy it is the growth in leverage as well as its costs that call the shots. And a true vigilante, a lender who lends money not as a participant in some money management game or contest, but with the expectation of getting his or her money back in inflation-adjusted terms and then some, will demand that the growth of leverage cease and/or that its cost increase to reflect the increased risk. Either demand will force this economy to retreat. Risk markets will be at “risk” should we move towards this outcome. And too, Treasury interest rates may then ultimately fall instead of rise as reflation fails and debt deflation takes hold. But that is a story/movie for another year and that tale’s telling demands the reincarnation of a host of vigilantes long since stripped of their common sense and their ability to say no.

William H. Gross

Managing Director