Investment Outlook

February 2013

Credit Supernova!

William H. Gross

This is the way the world ends…
Not with a bang but a whimper.

T.S. Eliot

They say that time is money.* what they don’t say is that money may be running out of time.

There may be a natural evolution to our fractionally reserved credit system which characterizes modern global finance. Much like the universe, which began with a big bang nearly 14 billion years ago, but is expanding so rapidly that scientists predict it will all end in a “big freezetrillions of years from now, our current monetary system seems to require perpetual expansion to maintain its existence. And too, the advancing entropy in the physical universe may in fact portend a similar decline of “energy” and “heat” within the credit markets. If so, then the legitimate response of creditors, debtors and investors inextricably intertwined within it, should logically be to ask about the economic and investment implications of its ongoing transition.

But before mimicking T.S. Eliot on the way our monetary system might evolve, let me first describe the “big bang” beginning of credit markets, so that you can more closely recognize its transition. The creation of credit in our modern day fractional reserve banking system began with a deposit and the profitable expansion of that deposit via leverage. Banks and other lenders don’t always keep 100% of their deposits in the “vault” at any one time in fact they keep very little – thus the termfractional reserves.” That first deposit then, and the explosion outward of 10x and more of levered lending, is modern day finance’s equivalent of the big bang. When it began is actually harder to determine than the birth of the physical universe but it certainly accelerated with the invention of central banking – the U.S. in 1913 – and with it the increased confidence that these newly licensed lenders of last resort would provide support to financial and real economies. Banking and central banks were and remain essential elements of a productive global economy.

But they carried within them an inherent instability that required the perpetual creation of more and more credit to stay alive. Those initial loans from that first deposit? They were made most certainly at yields close to the rate of real growth and creation of real wealth in the economy.
Lenders demanded that yield because of their risk, and borrowers were speculating that the profit on their fledgling enterprises would exceed the interest expense on those loans.

In many cases, they succeeded. But the economy as a whole could not logically grow faster than the real interest rates required to pay creditors, in combination with the near double-digit returns that equity holders demanded to support the initial leverageunlessunless – it was supplied with additional credit to pay the tab.

In a sense this was a “Sixteen Tonsmetaphor: Another day older and deeper in debt, except few within the credit system itself understood the implications.

Economist Hyman Minsky did. With credit now expanding, the sophisticated economic model provided by Minsky was working its way towards what he called Ponzi finance. First, he claimed the system would borrow in low amounts and be relatively self-sustainingwhat he termedHedgefinance.

Then the system would gain courage, lever more into a “Speculativefinance mode which required more credit to pay back previous borrowings at maturity. Finally, the end phase of “Ponzifinance would appear when additional credit would be required just to cover increasingly burdensome interest payments, with accelerating inflation the end result.

Minsky’s concept, developed nearly a half century ago shortly after the explosive decoupling of the dollar from gold in 1971, was primarily a cyclically contained model which acknowledged recession and then rejuvenation once the system’s leverage had been reduced. That was then. He perhaps could not have imagined the hyperbolic, as opposed to linear, secular rise in U.S. credit creation that has occurred since as shown in Chart 1. (Patterns for other developed economies are similar.) While there has been cyclical delevering, it has always been mildeven during the Volcker era of 1979-81.

When Minsky formulated his theory in the early 70s, credit outstanding in the U.S. totaled $3 trillion. Today, at $56 trillion and counting, it is a monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet, in the process begins to consume itself. Each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result. Minsky’s Ponzi finance at the 2013 stage goes more and more to creditors and market speculators and less and less to the real economy. This “Credit New Normal” is entropic much like the physical universe and the “heat” or real growth that new credit now generates becomes less and less each year: 2% real growth now instead of an historical 3.5% over the past 50 years; likely even less as the future unfolds.

Not only is more and more anemic credit created by lenders as its “sixteen tons” becomes “thirty-two,” then “sixty-four,” but in the process, today’s near zero bound interest rates cripple savers and business models previously constructed on the basis of positive real yields and wider margins for loans. Net interest margins at banks compress; liabilities at insurance companies threaten their levered equity; and underfunded pension plans require greater contributions from their corporate funders unless regulatory agencies intervene. What has followed has been a gradual erosion of real growth as layoffs, bank branch closings and business consolidations create less of a need for labor and physical plant expansion. In effect, the initial magic of credit creation turns less magical, in some cases even destructive and begins to consume credit markets at the margin as well as portions of the real economy it has created. For readers demanding a more model-driven, historical example of the negative impact of zero based interest rates, they have only to witness the modern day example of Japan. With interest rates close to zero for the last decade or more, a sharply declining rate of investment in productive plants and equipment, shown in Chart 2, is the best evidence. A Japanese credit market supernova, exploding and then contracting onto itself. Money and credit may be losing heat and running out of time in other developed economies as well, including the U.S.


Investment Strategy

If so then the legitimate question is: how much time does money/credit have left and what are the investment consequences between now and then? Well, first I will admit that my supernova metaphor is more instructive than literal. The end of the global monetary system is not nigh.

But the entropic characterization is most illustrative. Credit is now funneled increasingly into market speculation as opposed to productive innovation. Asset price appreciation as opposed to simple yield or “carry” is now critical to maintain the system’s momentum and longevity. Investment banking, which only a decade ago promoted small business development and transition to public markets, now is dominated by leveraged speculation and the Ponzi finance Minsky once warned against.

So our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.

Visible first signs for creditors would logically be 1) long-term bond yields too low relative to duration risk, 2) credit spreads too tight relative to default risk and 3) PE ratios too high relative to growth risks. Not immediately, but over time, credit is exchanged figuratively or sometimes literally for cash in a mattress or conversely for real assets (gold, diamonds) in a vault. It also may move to other credit markets denominated in alternative currencies. As it does, domestic systems delever as credit and its supernova heat is abandoned for alternative assets. Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase.

The element of time is critical because investors and speculators that support the system may not necessarily fully participate in it for perpetuity. We ask ourselves frequently at PIMCO, what else could we do, what else could we invest in to avoid the consequences of financial repression and negative real interest rates approaching minus 2%? The choices are varied: cash to help protect against an inflationary expansion or just the oppositelong Treasuries to take advantage of a deflationary bust; real assets; emerging market equities, etc. One of our Investment Committee members swears he would buy land in New Zealand and set sail. Most of us can’t do that, nor can you. The fact is that PIMCO and almost all professional investors are in many cases index constrained, and thus duration and risk constrained. We operate in a world that is primarily credit based and as credit loses energy we and our clients should acknowledge its entropy, which means accepting lower returns on bonds, stocks, real estate and derivative strategies that likely will produce less than double-digit returns.

Still, investors cannot simply surrender to their entropic destiny. Time may be running out, but time is still money as the original saying goes. How can you make some?

(1) Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth, and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don’t fight central banks anticipate them by buying what they buy first; look as well for offshore sovereign bonds with positive real interest rates (Mexico, Italy, Brazil, for example).

(2) Get used to slower real growth: QEs and zero-based interest rates have negative consequences. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico and Canada are candidates.

(3) Invest in global equities with stable cash flows that should provide historically lower but relatively attractive returns.

(4) Transition from financial to real assets if possible at the margin: buy something you can sink your teeth intogold, other commodities, anything that can’t be reproduced as fast as credit.

(5) Be cognizant of property rights and confiscatory policies in all governments.

(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.

We may be running out of time, but time will always be money.

Speed Read for Credit Supernova

1) Why is our credit market running out of heat or fuel?

a) As it expands at a rate of trillions per year, real growth in the economy has failed to respond. More credit goes to pay interest than future investment.

b) Zero-based interest rates, which are the result of QE and credit creation, have negative as well as positive effects. Historic business models may be negatively affected and investment spending may be dampened.

c) Look to the Japanese historical example.

2) What options should an investor consider?

a) Seek inflation protection in credit market assets/ shorten durations.

b) Increase real assets/commodities/stable cash flow equities at the margin.

c) Accept lower future returns in portfolio planning.

William H. Gross
Managing Director

* The terms “money” and “credit” are used interchangeably in this IO. Purists would dispute the usage and I would agree with them, arguing for the usage for simplicity’s sake and the evolving homogeneity of the two.

† Outstanding credit includes all government debt as well as corporate, household and personal debt. Does not include “shadow” debt estimated at $20-30 trillion.

02/20/2013 11:12 AM

Spain and Italy

The Euro Crisis Gnaws at Europe's Underbelly


 Photo Gallery: Spain Stuck in Neutral

The euro crisis may have dropped out of the headlines recently, but Spain and Italy would seem to be doing their best to bring it back. Real estate giant Reyal Urbis' bankrupcy has raised fresh concerns about Spanish banks and many fear that a Berlusconi election victory could drive Rome to seek emergency aid.


It had become a trend among top European politicians to forecast that the worst of the euro crisis had passed. A pledge by the European Central Bank to buy up unlimited quantities of sovereign bonds as needed, promising numbers from Greece indicating that the country was finally getting its budget deficit under control and a reform-minded government in Rome -- 2012 seemed set to go down in history as the year the crisis lost its bite.

This week, the outlook is looking less rosy. And much of the pessimism is focused on the two countries long seen as potentially the most dangerous should the euro crisis grow: Spain and Italy.

The situation looks especially bleak in Madrid, with real estate giant Reyal Urbis filing for insolvency on Tuesday. With debts of €3.6 billion, the bankruptcy would be the second largest in Spain's history after real-estate company Martinsa-Fadesa filed in July 2008 with debts of €7.2 billion. Reyal Urbis has until Saturday to ward off insolvency by reaching a deal with its creditors.

The demise of Reyal Urbis isn't just a problem for Spain. Several German banks are also among the company's creditors. Furthermore, the firm's list of Spanish debt holders reads like a who's who of the country's already wobbly financial industry, including Santander (which holds €550 million in Reyal Urbis debt), Banco Popular (€220 million) and BBVA (120 million).

Tops on the list, however, is Bankia which is owed at least €460 million by the real estate firm, with Reuters reporting that number could be as high as €785 million. Bankia was placed under government control in 2012 and received bailout aid from the European Stability Mechanism (ESM). Furthermore, Spain's "bad bank" SAREB -- set up last year to help absorb a raft of bad real-estate debt from the books of Spanish financial institutions -- is also involved.

Extremely Shaky

Still, the insolvency has not come as a surprise. The Spanish real estate market has shown no signs of improvement in recent months and prices continue to fall -- with property in the country having lost 40 percent of its value since 2007. It is a development which has hit construction giants like Reyal Urbis hard and is largely responsible for the troubled state of Spain's banks. Even worse, experts do not expect things to improve any time soon.

In addition, new regulations from Madrid have forced companies to undertake larger write downs on their property holdings. And the establishment of a bad bank has also meant that it now often makes more sense for financial institutions to pull the plug on bad loans rather than to patiently agree to refinance.

Beyond the country's financial industry, however, the insolvency provides yet a further indication as to just how far away Spain remains from economic health. Unemployment remains at a record high of 26 percent and data from the fourth quarter of 2012, showing a worse-than-expected contraction of 0.7 percent, has cast doubt on a return to growth this year.

Furthermore, the government of Prime Minister Mariano Rajoy is struggling to survive an ever-expanding series of corruption scandals, some involving his own conservative Popular Party. This week, Spanish papers are reporting that King Juan Carlos may even be more tainted than thought by an ongoing scandal involving his son-in-law Inaki Urdangarin.

The Need for a Bailout?

Despite the troubles in Spain, however, it is Italy that has Europe -- and Berlin in particular -- holding its breath this month. The reason the country's general election scheduled to be held on Sunday and Monday -- and the real risk that former Prime Minister Silvio Berlusconi might actually win the vote.

Though public opinion polls are banned in the country for the two weeks prior to elections, the Italian media is reporting this week that the camp of center-left candidate Pier Luigi Bersani's lead over Berlusconi's coalition has shrunk to a mere 3.5 percent. And if Berlusconi returns to the helm, most expect that Rome will return to the abyss it found itself staring into at the end of 2011. Indeed, Italy's largest investment bank Mediobanca said this week that it believes a Berlusconi victory would trigger an investment market shock, ultimately leading to the need for an EU bailout of the debt-laden country.

Berlin, too, has warned of a Berlusconi resurrection, with German Foreign Minister Guido Westerwelle issuing a barely concealed admonition to Italian voters on Tuesday. He was echoed by Ruprecht Polenz, the chairman of the Foreign Affairs Committee in German parliament and a senior member of Chancellor Angela Merkel's Christian Democrats (CDU).

Norbert Barthle, CDU budget expert in parliament, was even starker in his warning. Speaking to Reuters, he said: "If Mr. Berlusconi wins the election, this course (of reforms) could be in danger. Doubts about Italy's solidity could have serious consequences for the euro."

Back to the Drawing Board

Ultimately, those doubts might multiply regardless of who wins the election. Mario Monti, the country's outgoing technocrat premier, was able to shave percentage points off the budget deficit and introduce modest reforms. But the last six months of his 14-month stint was less productive as he began encountering resistance. And the country's next government, whether from the right or the left, likely won't have a mandate sufficient enough to make much headway either.

That such headway is badly needed has been well documented, most recently by the Economist, which noted that Italy is one of only two euro-zone countries which have seen a fall in per-capital GDP since the introduction of the euro. Globally, it ranks 169th out of 179 since 2000 in terms of per capita GDP growth.

The International Monetary Fund recently noted that the Italian economy stands to make huge gains if the country's politicians can agree on a far-reaching package of economic and labor market reforms -- worth up to 10.5 percent growth over the next decade. But if Berlusconi wins next week, the opposite, it would seem, also holds true. Italy could trigger a return of the euro crisis, just when Europe thought it was out of the woods.

The Saver’s Dilemma
Michael Pettis
19 February 2013

 This illustration is by Paul Lachine and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

BEIJINGMost of the international financial crises that have occurred over the last 200 years were the result of strains created by the recycling of capital from countries with high savings to those with low savings. The current European crisis is a case in point. For nearly a decade, capital from high-savings countries like Germany flowed to low-savings countries like Spain. The resulting build-up in debt created its own constraints, and now Europe’s economy is forced to rebalance.
If the rebalancing takes place only in Spain and other low-savings countries, the result, as John Maynard Keynes warned 80 years ago, must be much higher unemployment. Whether unemployment remains confined to countries like Spain, or eventually migrates to those like Germany, depends on whether the former remain in the euro.
Although the relative savings positions of Germany and Spain seem to confirm cultural stereotypes, national savings rates have little to do with cultural proclivities. Instead, they largely reflect policies at home and abroad that determine household consumption rates.
A country’s overall consumption rate is, of course, the flip side of its savings rate. Apart from demographics, which change slowly, three factors largely explain differences in national consumption rates.
First and foremost is the share of national income that households retain. In countries like the United States, where households keep a large share of what they produce, consumption rates tend to be high relative to GDP. In countries like China and Germany, however, where businesses and the government retain a disproportionate share, household consumption rates may be correspondingly low.
The second factor is income inequality. As people become richer, their consumption grows more slowly than their wealth. As inequality rises, consumption rates generally drop and savings rates generally rise.
Finally, there is households’ willingness to borrow to increase consumption, which is usually driven by perceptions about trends in household wealth. In Spain, for example, as the value of stocks, bonds, and real estate soared prior to 2008, Spaniards took advantage of their growing wealth to borrow to increase consumption.

But this is not the whole story. Consumption rates can also be driven by foreign policies that affect these three factors. For example, an agreement in the late 1990’s among the German government, corporations, and labor unions, which was aimed at generating domestic employment by restraining the wage share of GDP, automatically forced up the country’s savings rate. Germany’s large trade deficits in the decade before 2000 subsequently swung to large surpluses, which were balanced by corresponding deficits in countries like Spain.
As Spain’s tradable-goods sector contracted in response to the expansion in Germany, it could respond in one of only three ways. First, Spain could refuse to accept the trade deficits, either by implementing protectionist measures or by devaluing its currency. Second, it could absorb excess German savings by letting unemployment rise as local manufacturers fired workers (because rising unemployment forces down the savings rate). Finally, Spaniards could borrow excess German savings and increase consumption and investment.

Of course, Spain could not legally choose the first option, owing to its EU and eurozone membership, and, not surprisingly, was reluctant to choose the second. This left only the third option. Spaniards borrowed heavily prior to the crisis to increase both consumption and investment, with much of the latter channeled into wasteful real-estate and infrastructure projects.
This continued until 2007-2008, when Spanish debt levels became excessive. But, as long as Germany does not absorb its excess savings and accommodate the desired rise in Spanish savings, Spain is still faced with the same options. Once borrowing is no longer possible, Spain must either intervene in trade – which implies leaving the eurozone – or accept many more years of high unemployment until wages are driven down sufficiently to produce the equivalent of currency devaluation.
This is the key point. Low-savings countries cannot easily adjust without an equivalent adjustment in high-savings countries, because their low savings rates may have been caused by high savings abroad. After all, savings and investment must be in balance globally, and if policy distortions cause savings in one country to rise faster than investment, the reverse must occur elsewhere in the world.
In other words, savings rates in Spain and other deficit countries in Europe had to drop once policy distortions forced up Germany’s savings rate. In theory, excess German savings could have left Europe; but, given high Asian savings that already had to be absorbed, mainly by the US, and the constraints imposed by the euro, it was almost inevitable that excess German savings would be exported to other European countries.
Germany should care about Spain’s difficulty in adjusting, because the resulting rise in European unemployment will be absorbed mostly by Spain unless the Spanish government accelerates the adjustment process by leaving the eurozone and devaluing. In that case, Germany would bear the brunt of the rise in unemployment.

There should be nothing surprising about this. Once deficit countries take aggressive measures, it is usually trade-surplus countries that suffer the most from international crises caused by trade and capital flow imbalances. As political tensions in low-savings countries grow, so will the risk of these countries abandoning the euro, causing the price that Germany will pay for its distorted savings rate to rise.
This article is based on the author's recently published book The Great Rebalancing (Princeton University Press).
Michael Pettis is Professor of Finance at Peking University and a senior associate at the Carnegie Endowment.