Bill Gross runs PIMCO's huge flagship bond fund which, having engaged in an untimely shorting of U.S. Treasuries, has hit a bit of a rough patch in recent times. Some have suggested that the 69-year old might be a few years past the recommended portfolio manager retirement age and that it's no longer as useful as it once was to read his monthly investment newsletters.
While Gross's timing on shorting U.S. Treasuries has been poor, and his revealing in this month's column of memory issues is a little unnerving, his analysis of the fundamentals and medium to long-term sovereign fiscal picture remains sound.
Take his updated "Ring of Fire II" chart, the first version of which he first published a few years back. The chart (below) plots countries by both their annual public sector deficit (y-axis), which is the difference between government spending and taxes, and what is termed a "fiscal gap" (x-axis). The fiscal gap takes into account future expenditures, which in the U.S.'s case include entitlements such as Social Security, Medicare, and Medicaid.
As you can see from the chart Italy appears to be in better fiscal shape than several "Ring of Fire" members like the U.S., Japan and the U.K. How is this possible? Italy has been experiencing what economists refer to as a "speculative attack" from the sovereign bond market, while the three Ring of Fire countries are currently enjoying record low yields on their government debt.
The reason for this seeming paradox is the market currently perceives the risks associated with Italy's inability to print its own currency (due to its membership in the euro) as a bigger short-term credit risk than the unhealthy long-term fiscal position of countries such as the U.S., Japan and the U.K.
This is not to say that Italy's fiscal position is rock solid. Italy's sovereign debt to GDP ratio is roughly 120%, well above the U.S.'s and the U.K.'s (but not Japan's at roughly 220%). Taken with the need for political and tax reform, unfavorable demographics, and the short-term maturity structure of Italy's debt (which in effect forces the country to regularly face a bond market vote of confidence), the country is facing plenty of longer-term fiscal challenges as well. But given the strength of the Italy's longer-term fiscal position vis-a-vis the U.S., U.K. and Japan, the current debt market problems Italy is experiencing can largely be attributed to the country's eurozone membership.
Returning to the U.S.'s fiscal situation, which Gross's column focusses on, he draws the following grim conclusion:
The important thing...is to view the U.S. in comparison to other countries, to view its apparently clean dirty shirt in the absence of its reserve currency status and its current financial advantages, and to point to a more distant future 10-20 years down the road at which time its debt addiction may be life, or certainly debt, threatening.
To keep our debt/GDP ratio below the metaphorical combustion point of 212 degrees Fahrenheit, these studies (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years. An 11% "fiscal gap" in terms of today's economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year!
To put that into perspective, CBO has calculated that the expiration of the Bush tax cuts and other provisions would only reduce the deficit by a little more than $200 billion. As well, the failed attempt at a budget compromise by Congress and the President - the so-called Super Committee "Grand Bargain"- was a $4 trillion battle plan over 10 years worth $400 billion a year. These studies, and the updated chart "Ring of Fire - Part 2!" suggests close to four times that amount in order to douse the inferno.
And the investment implications for the U.S. are all too clear:
IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual "fiscal gap," then we will begin to resemble Greece before the turn of the next decade. Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the "Ring of Fire."
Part of the reason the U.S. is still in this mess is that, as Gross points out, policymakers know that they still have time to turn things around. In fact, Gross suggests that the U.S. may have as many as seven more years before whoever is the U.S. President by then needs to starting learning how to dance to the tune of Zorba the Greek.
We'll just have to wait and see whether or not the U.S. has that much time as no one - absolutely no one - can say with any degree of certainty when things will go pear-shaped for the U.S. The reason is that there is no definitive sovereign debt sustainability model that says with any degree of precision how much debt is too much. To my knowledge the world record holder without a hard deafult is post-WWII Britain, which reached a debt/GDP ratio of 270% in 1946. The U.S. is still a long way off from those heights.
Given the impossibility of knowing how much debt is too much, the important thing to keep in mind is that the policymakers in Greece, Ireland, Spain, etc. all thought they still had time too. And then one day they didn't.
Putting off fiscal reform risks putting a country at the mercy of its creditors. As the European countries who are currently under the bond market's gun can attest that's not a place Americans (or anyone) want to wind up.