During the weekend, Barron's published their annual roundtable discussion among some prominent investment experts on the outlook for this year. One expert I respect very much is the founder and money manager of the largest bond fund at PIMCO, Mr. Bill Gross. I respect him even more after I found out he is also a Duke alumni, which of course does not influence my market view at all.
I am not sure that Barron's title "After the Deluge" is appropriate, as some participants pointed out that the worst is yet to come and it is a "slow moving train wreck" which can take many years. "After the Deluge" makes it sound like the worst has happened and is behind us and over.
First of all, Barron's congratulated Bill that he was the only one predicting the credit market crisis last year at this time. Well, maybe for Barron's roundtable, but based on my record, others have successfully predicted this too. One of them is Jeremy Grantham, founder and another well respected money manager at GMO, who has also been regularly featured by WSJ and Barron's.
Jeremy has warned us repeatedly about risk in both equity and credit markets since early last year. Before the now well known subprime and banking crisis surfaced in August, he went so far to predict at the end of this mess, we will see the failure of a major bank or financial institution (similar to Drexel in junk bond and S&L crisis), and one major private equity firm out of business, and half of smaller private equity and hedge fund firms folding their tents. Maybe it sounds far-fetched right now, but let us review his prediction 1-2 years later.
Back to Bill. There are several points he made I feel worth mentioning:
1) The past economy boom is based on asset inflation, but now "there are no large, classic asset categories left to inflate." Well, maybe there are no paper assets left, but how about real physical asset of commodities such as gold (GLD), Bill?
2) Contrary to deposits, banks have no reserves for SIVs (structured investment vehicles). "This isn't going to be a normal cyclical downturn in which inventories are addressed, paving the way for the economy to be rebuilt," he said " The contraction in the shadow banking system will probably be with us for a number of years. It is a unique situation the world hasn't faced in modern times." This reinforces my view that this is a very slow and long crash since with an inexperienced Fed and other central banks to deal with this kind of brand new and large global scale crisis, whatever they do will probably make matter worse and longer to get resolved.
For his detailed discussion on what he calls "shadow banking system", you can also refer to his most recent article "Pyramids Crumbling" at PIMCO website.
In the article, he uses the analogy that, the "creativity" of all these OTC derivatives such as CDS (credit default swap) bypassing any reserve requirement and regulation as shadow products in this shadow banking system, is nothing but pyramid schemes now crumbling.
3) He also indicated that "if U.S. growth drops toward zero, the rest of the world will be affected. But the most affected economies are the finance-based economies -- the ones that depended upon financial engineering." He put it politely by calling it "financial engineering". In several of my previous articles, I called it modern day "financial alchemy".
The behavior of banks has been to "innovatively" structure some exotic SIVs from ordinary products such as mortgages in order to collect higher fees and bonuses, creating a value destruction process which not only no gold is ever created but also ingredients are being destroyed.
However, I do feel the commodity-based economies such as Canada, Australia, Russia, some South American countries will fare better in this crisis than finance-based economies such as US, countries in Europe such as UK and Switzerland, and Japan, Singapore and Hong Kong in Asia.
4) As for 2008, he said "Monetary policy has borne the brunt of the rescue effort, and it is relatively ineffective in this type of market.....This is a very poor year to have a recession." So what to invest in 2008?
As a fixed income guy, he sticks to his area, recommending Van Kampen Select Sector Municipal Trust (VKL), Pimco Corporate Income Fund (PCN) and Pimco Corporate Opportunity Fund (PTY), General Motors (GM) and Ford (F) bonds. He feels that the continuing decline in US dollar will help US auto makers to be more competitive.
If I may, I would also add PIMCO Commodity Real Return Fund [PCRBX] and of course, gold (GLD).
It is always a pleasure to read his views and others and many interesting exchanges at the roundtable every year. Besides Mr. Gross, I found Marc Faber very insightful. At this time last year, he was the one recommending to short large investment banks and buy gold and other commodities, which I will save for another day.