Many investors in Orange County now look back at Black Monday as a fluke. William Gross, who oversees the investment of $17.5 billion for Pacific Mutual Investment Corp. in Newport Beach, isn’t one of them.
Gross warns that the 508-point one-day drop in the stock market, which occurred this week last year, was an early warning that the United States risks economic calamity if it does not get its finances in order.
As a co-founder and managing partner of PIMCO, the 44-year-old Gross manages the biggest pot of investment capital in the county. And the pot is growing.
Under Gross’s stewardship, PIMCO has consistently racked up one of the best bond portfolio performances in the nation since the firm was launched in 1971 with about $2 million. In fact, PIMCO routinely performs among the top five institutional bond management firms in the country.
Last year, in a survey of 100 money managers conducted by the magazine Pension & Investment Age, Gross was picked as the man his peers would most like to have managing their portfolios.
PIMCO invests pension assets for Fortune 500 companies. Among its clients are IBM, AT & T and Southern California Edison. In addition to corporate pension money, PIMCO handles many public pension assets, including $151 million for the Orange County Employees Retirement System.
While the vast amount that PIMCO manages is invested in bonds, the firm has about $500 million in the stock market. And although the firm specializes in handling large accounts, individual investors able to come up with the $200,000 minimum can invest their money in a PIMCO mutual fund.
In an interview with Times staff writer Eric Schine, Gross discusses the challenges confronting the U.S. economy one year after the crash and how investors can best respond.
Q. What would you say is the single most important issue now facing the economy?
A. The twin deficits--trade and budget--are the critical issues. And if you had to focus in on one particular deficit, I’d say the trade deficit is the critical element in the entire equation.
Q. It’s been one year since the market crash. One development contributing to the crash was the release of a monthly report from the Commerce Department suggesting that the trade deficit was getting much worse. And yet, the economy seems to have come through unscathed. So why do you still regard the trade deficit as the critical economic question of the day?
A. It’s just a question of time. Our world trading partners only have so much tolerance in terms of the debt we owe. There are a number of ramifications that result once the United States begins to correct, or once the world demands a correction. In order to balance the trade deficit from this point forward, I think you have the potential for a substantially lower dollar, which leads to higher inflation and a bond market correction. Ultimately, this would move the stock market to lower stock prices.
Or else you correct the deficit through a slower U.S. economy, higher interest rates, and a slowdown in individual consumption. That’s a negative for the economy and potentially for the stock market itself.
Q. So either solution to the deficit would be negative.
A. I think so. You know, there is a lot of optimism on the trade deficit because it has been moving in the right direction. It moved down from $14 billion a month in the beginning of the year to about $9 billion in July and there’s great optimism that we’re going to keep moving in the right direction and solve the entire problem. I think the problem is that we’ve reached the point where no further progress is in store. The progress over the next six to nine months is a result of the dollar decline that we’ve witnessed, at least up until the beginning of this year, for the last 2 1/2 years. Since the beginning of this year, the dollar has actually gone up by 10%, and that will ultimately work in the favor of a higher trade deficit, not a lower trade deficit.
Q. Last week we may have had the first sign that the six-month improvement in the trade deficit has come to halt when the Commerce Department announced the August deficit had moved to more than $12 billion. Do you think this is the beginning of a trend?
A. Well, it’s more of a leveling off--an indication that the prior six-month trend has ended. If the world loses confidence in our ability to make progress with the trade deficit, the dollar could still decline very quickly. The critical point is if the dollar declines rapidly, the U.S. will be forced to raise interest rates sharply. That could lead to a recession and certainly could lead to a stock market decline of another 200 to 400 points at some point in 1989. We’re not out of the woods yet, and I think the trade deficit is the critical measure by which to determine whether the stock and bond markets are appropriately valued.
Q. What would it take to trigger a sharp drop in the dollar? What signs should we be looking out for?
A. A number of months or perhaps even one more month of bad statistics. Once the numbers start moving in the other direction, all of sudden our trading partners begin to sell dollars and that would trigger a dollar decline very swiftly. Once it begins, it would snowball. So, the next few months are critical.
Q. What are the chances of this actually occurring?
A. I was in New York about a month ago to have dinner with Paul Volcker. All night he kept talking about how it would take a potential crisis to bring the American people back to their senses, not only the citizens but also the politicians and the legislators as well. At the end of the evening I asked him what is this potential crisis that you’re talking about and he basically said that he thought the chances are 50-50 that the dollar may decline precipitously and that, as a result, the Federal Reserve would have to increase interest rates dramatically, which in turn would produce a significant recession and the potential for aggravated financial markets in one form or fashion.
Q. Is this view widely shared in the investment community?
A. No. As we approach the first anniversary of the crash, the typical attitude seems to be that all of our problems are in the past. We’ve weathered the storm, so to speak, and it was really a false signal. And to the extent that it is, and we at Pacific Investment certainly hope it’s true, I would caution that the crash may have been as much a signal of future economic volatility as it was a signal of temporary overvaluations of stocks themselves.
Q. So the crash was a warning signal that we need to get our economy on a sound footing?
A. I think that’s true. And despite the fact that today we’re a good 500 or 600 points lower than we were at the top, and despite the fact that these stocks are much more appropriately priced than they were 13 or 14 months ago, there’s no doubt in my mind that the crash was a warning shot across our bow, our economic bow, so to speak, that our financial books are not in order. And that we had better correct them fairly quickly or else other crashes or perhaps mini-crashes are in our future.
And the only way to do that is get our deficits in order. With regard to the budget deficit, it’s still the same old story in terms of spending today and forestalling savings for the future. That’s basically what’s being done by using the Social Security surplus: we’re taking from future generations and applying it to today’s current deficit. And that just won’t work year after year. At some point we have to slow down the spending. We have to slow down defense spending, but also consumption, not only to balance our deficit, but to pay back the world in terms of our trade deficit.
Q. You are addressing a lot of topics here. You’re talking about government policy to reduce the deficits on the one hand, and increasing the personal savings rate on the other. How much does the country’s low personal savings rate concern you?
A. It’s crucial. If anything, if you went back seven years and tried to forecast what would happen because of lower taxes under the Reagan Administration, I think one of the sure-fire things you would have forecast would have been a higher savings rate. Because if tax rates come down, that means that savers have an incentive to save more, because less of it is taxed. Certainly that hasn’t been the case.
Q. Where is the savings rate now compared to when Reagan took office?
A. When Reagan came in it was around 6% or 7% of income. Now it’s down around 4%. So if anything, people are spending more money. To a certain extent, I think that reflects a long-term, almost ingrained, habit of spending money to beat future inflation or try to maintain a living standard that existed back in the ‘70s and ‘60s.
Q. So both the government and citizens are living beyond their means. Do you see anything in the presidential election campaign that gives you hope that, as a nation, we can get our finances in order?
A. Nothing, nothing. No. The problem is that up until this point, the politicking has been very superficial. Neither candidate has a mandate to make dramatic changes in the economy. When Reagan came in, at least in the first term, he had a clear mandate to turn the country in a different direction. But neither (George) Bush nor (Michael S.) Dukakis have a mandate, for instance, to implement a consumption tax or to drastically reorient our spending policies. It’s just not there. And of course Bush has challenged everyone to read his lips. But he’s almost painting himself in a corner. And to the extent that he’s the favorite, then progress on our budget deficit is going to be fleeting at best.
Q. How do you legislate higher savings?
A. You place a tax on consumption, a 25-cent tax on a gallon of gasoline or a luxury tax on Mercedes-Benzes, or place a tax on all consumption if you want. You’d avoid tax on food and necessities, although they have had those taxes in Europe for years. But you either have to do it that way or you have to lower consumption via slow economic growth or a recession. Certainly, the first way is the preferred way.
Q. It sounds like what you’re leading up to is that we have to get on an equal footing with the Japanese and our other trading partners. Is that the bottom line?
A. Not even necessarily to get on on equal footing. The problem we have right now is that we owe the Japanese so much money that even if we don’t make progress in terms of being on an equal footing, we have to pay them back for what we’ve borrowed in the past five to 10 years. In order to do that we have to consume less.
Q. How do individual citizens saving more translate into paying off the federal deficit?
A. Well, the taxes will help to balance the budget deficit and, by taxing our consumption, we buy less from foreigners. If you tax a Mercedes or a Toyota, that makes for fewer buyers of foreign goods. If you placed your tax selectively, you could place it on many imports. So we could cut down on import consumption. That would reduce the trade deficit and bring it closer into balance.
Q. But that tactic brings up the issue of protectionism. Aren’t you really talking about protectionist measures and aren’t these as dangerous as all the other problems we’ve been discussing?
A. If you applied the tax to everything, it would be fair and it would still reduce your purchases of Mercedes-Benzes. It would, of course, reduce the purchases of Fords. Then it wouldn’t be perceived by the world as something selective, and certainly not protectionist.
Q. What should we be saving?
A. As a nation we should at least double our savings rate. It should be 10%. The Japanese, don’t forget, save 20%.
Q. What is your economic forecast for the year ahead?
A. We’re looking for an economy that slows down as we move into 1989 and for the year after that. We are at very high levels of employment, in terms of people, and in equally high levels of employment in terms of plant and equipment. It’s much more difficult to grow when you are starting from high employment than it is when you are starting from very low levels, as we did in 1983 and 1984. Unemployment is 5.4% today, as opposed to 8% a few years ago. So there aren’t that many people out there that are looking for jobs. Obviously there are some, but there are a lot of jobs that are going begging. An economy can’t grow and companies can’t build if they can’t find people to work. That’s an overstatement, but it’s relevant. We just don’t have the numbers of people who are willing to join the work force to grow at a 3% to 4% real rate, as we have in past years.
Q. So what growth rate are you looking for?
A. Over the next 12 months, we’re looking at an economy that grows between 1% and 2%, which would compare to the the entire period of the Reagan Administration of about 4% to 4.5%.
Q. With this slowdown in growth, are you forecasting lower interest rates?
A. Yes. Interest rates should come down. What would be even more positive for interest rates would be for the economy to actually experience some kind of recession or what is often called a growth recession, almost a quarter or two of negative growth. That would be the most bullish scenario for bonds. It produces a slackening of the economy and allows for unemployment to go up to some extent and for inflation to come down.
Q. That’s fine for bond prices. But what about the stock market? In recent years, stock market prices have often closely paralleled moves in bonds. But wouldn’t slower growth or a mild recession be bad for stock prices?
A. No. I disagree with you. First of all, I think in the six months prior to the crash, the stock market and the bond market became significantly delinked. Stocks went up in the six months prior to the crash by about 600 or 700 points from around 2,000, all in a big flurry. Whereas in the bond market, interest rates were going up and bond prices were declining. So there was a delinking during that six-month period.
But I think since the crash, or two or three weeks after the crash, basically stock and bond prices have moved in tandem. People often wonder why. And the reason is that bonds are a competitive investment with stocks. Bonds today are yielding close to 9%. If investors can get 9%, basically they have to sense that they can get at least 9% from stocks, because stocks are a riskier investment. With dividend yields averaging about 3%, you have to look for 6% annual appreciation or more in terms of prices. That’s the reason why stocks and bonds are linked. There’s a direct valuation equation. These days when interest rates go down, that’s positive for stocks because it reduces the competitive alternative of bonds. If investors are only getting 8% instead of 9% on bonds, that makes stocks more attractive.
Q. At a certain point, doesn’t this scenario suggest that the economy might be so sluggish that corporations won’t be able to perform?
A. Yes and that’s a delicate balance. That’s why stock market investors almost pray for 1% to 3% growth, something that will not lower corporate profits but will produce lower inflation and lower interest rates. That’s the perfect equation for the stock market investor. Low inflation, low interest rates and increasing corporate profits. And the way you do that in today’s economic environment is economic growth at 2%, plus or minus. Anything higher than 2%, you start to risk inflation and higher interest rates. Anything lower than 2%, you start to make corporate profits susceptible. That’s the trick. Up until this point, we’ve been right around 2% growth (for the past year). And that’s probably one of the major reasons for a 300- or 400-point increase in the stock market over the last 12 months. It has been perfect for stock market investors. But when you deviate from that, all of a sudden you start to get in trouble.
Q. Where are interest rates headed? Your forecast suggests they are going lower.
A. Interest rates, we think, are going higher near-term. We’ve come from about 9.5% to just under 9% for long-term Treasury bonds in the past two months and we think that’s as far down as they’re going to go for now. Again, it gets back to the trade balance. If the dollar declines, the Federal Reserve may have to keep interest rates high in order to support it. In early 1989, if the economy slows down, interest rates will come back down.
Q. So where will rates be in one year?
A. Long-term Treasury rates should be at around 8.5%. Treasury bills, which today are at about 7.5%, should be at about 7%.
Q. From what you are saying, it sounds as if both stocks and bonds should perform nicely, provided the dollar doesn’t drop sharply. Given everything we’ve talked about so far, where should your typical individual investor be putting his capital?
A. It depends on his or her resources and the access to markets. For the investor who doesn’t have a broker, I don’t think a 2- to 4-year CD is a bad idea. It’s government guaranteed. The rates should be fairly attractive relative to inflation.
For those with access to brokers or to a salesman who can provide them with no-load mutual funds, I think a Ginnie Mae mutual fund or a high-quality corporate or government bond fund would be very attractive as well. But I would only buy a no-load as opposed to a loaded fund, because you pay 6% off the top in load fees. So, look for the ones with no loads, and you can identify those through popular business magazines that have annual or semi-annual issues on the subject. Those would be good bond investments.
At some point over the next 12 months, I think that stocks as well would be an attractive investment. Utility stocks are some of my favorites.