Bill Gross -- On Consuelo Mack July 3

July 3, 2009

Consuelo Mack WealthTrack - July 3, 2009

CONSUELO MACK: This week on WealthTrack's Great Investors series: the man the investment world has crowned the bond king. PIMCO's Bill Gross runs the world's largest bond fund, advises governments and moves markets. He'll share his outlook and strategies next on Consuelo Mack WealthTrack. Hello and welcome to this edition of WealthTrack. I'm Consuelo Mack. This weekend we are celebrating the launch of our fifth season and we are doing so by introducing a "Great Investors" summer series. For this week's interview, I sat down for a lengthy discussion with PIMCO's bond king Bill Gross in Newport Beach, California. Next week I'll be talking to First Pacific Advisors stock and bond fund legend Robert Rodriguez from Los Angeles. Meanwhile, as we close the first half of the year and embark upon the second, a couple of observations: the first rule among many of our great investors is don't lose money. We are finding out first hand why it is extremely difficult to recover from the kind of big losses investors have experienced over the last year. Although the S&P 500 rallied nearly 35% from what many, including Gross, are calling the bear market low of March 9th, it is still 41% below its all time high reached in October of 2007. One of the reasons that Bill Gross is so exceptional is he manages to avoid losses most of the time. Last year his Total Return Fund, now the largest mutual fund in the world, delivered a positive 4% plus return, beating the competition in its bond fund category by an astounding nine percentage points. Over the last ten years, Total Return has clocked in average annualized returns of nearly 6.5%, also ahead of its peers. My second observation is how involved the government now is in the financial world. Independent research firm ISI Group points out that at the peak of the mortgage boom in 2006, only 3% of mortgage originations were explicitly backed by the government. Today that figure is 94%. You heard that right, 94% of mortgage originations are government backed. That dominance was not lost on Gross and his colleagues. A major investment theme of PIMCO's has been "shake hands with the government" and he has done so big time. At the end of May, 61% of the Total Return Fund was invested in mortgage bonds. However, after the Chrysler and General Motors experience with the government changing the rules for investors, Gross told me he is backing away from a firm handshake with the government, now preferring comedian Howie Mandel's germophobe version of touching fists and protecting yourself. My final comment is how low returns have become, especially on the least risky investments, namely cash. How low? Would you believe it will take 360 years to double your money at current rates on three month Treasury bills? As Merrill Lynch's Michael Hartnett pointed out in his recent report, "360 Years Is A Long Time." Gross will share his views on how low he expects returns to be in the future. That said, in a world awash in debt, I asked Gross if it is an exciting time to be a bond manager?

BILL GROSS: Oh, it couldn't be more exciting. Not just a bond manager but an investment manager of all sorts whether it's real estate, equities, private equities. The whole world is changing to what we call a new normal. And in trying to decipher when we renormalize and where the new normal is perhaps the biggest challenge in my career. And that's a 35 year stretch.

CONSUELO MACK: So talk to me about the new normal that PIMCO is talking about. What is the new normal going to look like?

BILL GROSS: The new normal to our way of thinking is a world of slower growth, certainly in the U.S. A world that is delevering as opposed to levering.

CONSUELO MACK: Right.

BILL GROSS: Taking on more debt. A world in which the consumer is forced to save money as opposed to spend it. And a world in which the government plays a more significant part relative to the private sector. For all of those reasons, the new normal in terms of growth, in terms of an unemployment rate, in terms of returns on stocks and bonds and other investments may be substantially different than what we're used to.

CONSUELO MACK: So that if it's slower growth in the U.S. in particular and does this extend to the rest of the world? I mean certainly the advanced economies, for instance?

BILL GROSS: Right, for most of it. Certainly for G-7, G-10 developed types of economies that you just suggested. Those countries are faced not only with high debt levels but with a demographic problem for the most part where many of their people are aging, are boomers, basically are typical of many other countries. And so these two headwinds so to speak, the headwind that forces more savings is not just a function of the leverage that was built up over the past 20 or 25 years but the fact that boomers now are thinking at least of retiring and will require more and more services in the form of health, in the form of pensions and so on.

CONSUELO MACK: That tells me it is going to be a much lower standard of living. You just said we're to the going to be the economic drivers of the world. So this transition, you know, what is this going to mean for the investment environment?

BILL GROSS: Sure. It will be not a lower standard of living but a slower growth in our standard of living. We basically expect growth. We're not in the Rubini camp or old Rubini camp, expecting disaster, deflation and the like. But we expect growth to be one to two percent. And that, Consuelo, basically translates into profit, very small levels of profit growth. We are delevering, uncertain as to how much we are delevering. And of course the government is trying to fill the hole by writing checks. But we're delevering and on that basis, real growth, really can't be assumed to match what we have grown used to over the past 20 to 25 years which has been 3 to 4% in terms of real GDP. To the extent it only grows at 1 to 2% than profit growth, it is barely above the line. And stocks, of course, would barely, you know, creep higher as opposed to mimicking the double-digit returns that many economists told us were our destiny.

CONSUELO MACK: Right.

BILL GROSS: I mean the seagull stocks of the long run.

CONSUELO MACK: This 11% return that we've learned, been taught to expect over the long run, you're saying that's over.

BILL GROSS: That's over. And of course the government will be doing all they can, and have about over the past six months to reflate this economy, to produce inflation. Because that's one of the ways to get out from under the 16 tons of the old Tennessee Ernie Ford song that spoke to the burden of debt.

CONSUELO MACK: How concerned are you about the rate of inflation, really being profoundly, you know, different going forward considering the amount of cash that governments all over the world are putting into the system?

BILL GROSS: Well, it's still a big question mark. And to be fair, if your viewers remember this piece 12 months down the road, they probably won't have seen much on the inflationary front. I mean we've had what's called a liquidity trap in which debt and equity and wealth has been destroyed. Just vanished, 10, 20, 30 trillion dollars worth of wealth. And for policymakers to try and fill that gap, to fill that hole, it's a very difficult proposition. So over the next 12 to 24 months, probably not. But if they keep on keeping on, if they produce monetary and fiscal stimulation in the trillions, which is what we're seeing now in the United States, with a trillion and a half dollar deficit and with check-writing programs from the Federal Reserve close to a trillion and a half dollars as well, then the potential for reflation is there.

CONSUELO MACK: So what's your biggest concern as far as the stimulation that we've seen? And I'm particularly concerned about the U.S. and the fact that foreigners own over half of our Treasury supply and that we're dependent upon them to finance us. So I mean, how big a risk is that with this continuous issuance of government debt?

BILL GROSS: Well, I think that is an enormous risk. And one of the reasons why the Fed has been buying 3 or 400 billion of Treasuries and by the way, a trillion and a quarter of mortgages; I means that's a check for a trillion and a half plus that has been used to fill the gap for buyers that just haven't shown up. Those, of course, would be the Chinese, would be other holders of Treasuries that at the moment are beginning to signal that they've had about enough.

CONSUELO MACK: Chinese, Russians, Brazilians.

BILL GROSS: Of course. And it's connected to the dollar, but also to the returns that they're getting from their Treasury investments. I mean the Chinese, if they're investing in Treasury bills are only earning 0.15 or 0.25%, that's a beggar's portion and they are, to a certain extent, unwilling to continue that. What the Fed and the government then have to do is either cut the deficit which looks to be problematic, especially in the face of new health-care programs, or else keep on writing checks. It's that check writing that is causing some problems. We saw the problems first of all in terms of the TARP, the public, the Congress, basically, had had it up to here and wanted no more.

CONSUELO MACK: Right.

BILL GROSS: Less obvious has been the trillion and a half of check writing by the Federal Reserve. It's not well understood. But it's certainly true that they can't keep on writing checks in those amounts and expect not only the Chinese to buy, but the PIMCO's of the world as well.

CONSUELO MACK: Is there any investment area that are you excited about long-term?

BILL GROSS: No. To get excited over an investment that would return 5, 6, or 7%, that wouldn't be the proper adjective, I guess. And it's not to suggest that we're moving back into bear markets and that an investor will be more concerned about the return of his or her principal as opposed to the return on it. But nonetheless, those are not excitable types of returns going forward. There's still some attraction in our opinion with what we call hybrid preferreds that yield 9, 10, 11%. That is where some of my personal money would go, and some of our PIMCO money as well, of course. But there's not much there from this point forward that would produce the double-digit returns that we have grown so used to.

CONSUELO MACK: Bill, I'm going to quote you: "Capitalism is about risk-taking. And if you are not a risk-taker, you should have your money in the bank or T-bills or a savings bond." Those are fighting words. And you know, you and I growing up, for the last 30 years of our professional careers, I, at least, have been taught that investing is part of savings. And you're making a very important distinction that investing, which is risk-taking, is separate and distinct from savings.

BILL GROSS: Well, it is. I mean savings to the extent it is government-guaranteed. And most savings are. You know, it provides a risk-free environment which is comforting and wonderful quantity to go to sleep with and to know that when you wake up, your money is there. In this environment though, with money market yields close to 0, it is akin to stuffing that money in a mattress. And so an investor, an investor willing to take some risk with their money, you know, basically must move out on the risk spectrum in order to earn a 6, 7, 8% return- lower than double digits, of course, but much higher than 0%. So the investor today is caught between 0% money market yields and the risk, you know, of losing some capital and some principal in this delevering, very volatile type of environment.

CONSUELO MACK: So what do we do?

BILL GROSS: Well, I think some cash is helpful. I mean it is good to know that you have got some money to pay the bills, to pay for education when and if, you know, that becomes required. But in order to keep up and to at least mildly prosper in this type of environment, you've got to extend out on the risk spectrum in the bond world. You know, there are examples, typically in what are known as closed-end funds that can be bought on the New York Stock Exchange.

CONSUELO MACK: And PIMCO runs--

BILL GROSS: --runs some of those. And we work them and work at them, you know, very hard in order to produce as high a yield as possible with the lowest risk. But they yield in many cases 10, 11, 12, 13% for investment grade types of corporate bonds. And so there's the contrast. Yes, some risk in terms of corporate bond space but a much higher return for those that require something more than mattress stuffing money.

CONSUELO MACK: When your poorer relatives come to you and ask you what should they do with their money in the new normal, what do are you telling them?

BILL GROSS: My wife Sue has basically said no mas on the poor relatives. Because whenever I recommend something and it goes down they are on the phone immediately. But if that policy were still to be followed, you know, I would recommend, yes, the corporate closed-end funds. I would recommend some bank preferred stocks which, you know, have been written up recently in some of the periodicals just this last week in Barrons. But those are double digit types of returns that I think are relatively safe going forward. And as well, you know, if are you interested in equities, in the common stock world of risk, you know, there should be and there are in fact, companies with very steady cash flows, steady income streams and reliable dividend streams. And they would be companies, the old standards that we know, the Procter & Gambles, the AT&Ts, the Verizons of the world where you can project forward even in a new normal slow-growth type of world, a reliable flow of dividends and perhaps some growth as well.

CONSUELO MACK: If we've learned anything in the last couple of years, it is that stocks were by far the riskiest asset in our portfolios. And that bonds, in fact, balanced many of the losses that we saw in the stock part of the portfolio. And one of the things that you've written about as well that, I guess 40 years ago, that bonds were the preferred investment and that stocks had to give you much higher yields in order to convince you to put a portion of your investments in stocks. Are we going back to the days where bonds will be the core holdings in the portfolio, do you think going forward?

BILL GROSS: Well, I don't think back to the '40s and the '30s. I mean those are the very conservative periods of time following the crash in '29. But to the extent that the policy portfolio- that being 60% stocks, 40% bonds or if you are young, 90% stocks, 10% bonds- I think that's disappearing, that's what has to be questioned. The policy portfolio, the standard thinking that basically suggested that stocks will always return more than bonds or that real estate will always perform better than Treasury bills, you know, really has to be questioned because, you know, up until at least the first quarter of 2009, bonds for the past 10, 25 and 40 years, that's a long time, had outperformed stocks.

CONSUELO MACK: Treasury bonds.

BILL GROSS: Treasury bonds. You know, it's hard to suggest that from this point forward with a 30-year Treasury at 4-and-3/4% that that should outperform a good stock. But it should awaken investors to the fact that stocks and risk-oriented investments don't always, and even for long periods of time, don't always outperform less risky investments. And so the public policy portfolio, the standard thinking that you should have inflation protection with stocks, that the only way to accumulate wealth within a portfolio is by taking risk in these areas, I think it has to be questioned going forward.

CONSUELO MACK: So, Bill, what are you going to do differently going forward? Are you going to invest differently now after the experience we've had in the last year and a half, and given the fact that you think there's going to be a new normal? What are you going to be doing differently?

BILL GROSS: I think you have to. For instance, in the high-yield area, you have to focus on industries and companies that have less financial and operational leverage. Example: General Motors had huge operational leverage to the extent that they had to keep those factories running, that they had to keep employing those people. You know, they depended upon a 15 million annual sales rate in order to generate a profit. Now we're below 10 million and you are seeing what happens. They were also a company that was financially levered. They took on too much debt and so as car sales dropped, paying the lender, so to speak, became an unbearable burden. So you want companies that have a minimum of operational leverage, that can basically reduce capacity, can layoff people without having to pay unreasonable amounts of money. And in addition are not financially levered so that when the big "R" comes, the big recession, the great recession, they can continue to make those interest payments as opposed to default. So yeah, there's a substantial transition underway in which what worked before in the past 10, 20, 30 years, leverage and operational leverage based upon a faster and faster rate of consumption, where that's moving now to just the opposite. And so you want to look for industries that are less levered operationally and financially.

CONSUELO MACK: And you touched on it earlier but let me ask you to elaborate. So what are you doing with your personal portfolio that's different?

BILL GROSS: Well, I think now I've got some cash, some of that 25 basis point or .25% cash by is eating at me. You know, you like to earn some money. In my personal portfolio, I have a lot of corporate closed-end funds that yield 10, 11 and 12%. And I have a substantial holding in those bank preferreds. These are preferreds issued by JP Morgan, by Wells Fargo, by Bank of America and in some cases Citi, you know, the big four or five. They yield 10, 11 and 12% and much of it because they come in the form of dividends or tax sheltered. They get the same treatment as a dividend from common stock. It's not exactly a municipal bond but it comes close in terms of the tax advantages and the tax sheltering, at least for now. So those are attractive returns in this type of a world, certainly when the government is investing in banks as well with their TARP preferred and with their guarantees. And now that banks are, in many cases, issuing stock and recapitalizing, it appears to be a relatively safe investment with certainly an attractive rate of return. So that's where my money is going.

CONSUELO MACK: Basically the investment future, is it overseas and how should we skew our portfolios much more to internationals?

BILL GROSS: Oh, I think so. Ultimately, you know, a domestic investor, a U.S. investor has two things working against him or her. One, slower real growth. And those low-interest rates on the short end of the curve and the cash account. Secondly, though, in terms of the fact that those holdings are denominated in dollars, the long-term future of the dollar is suspect. I mean I have talked in recent months about the potential for the reserve currency status of the dollar to disappear. That won't happen for five to ten years. But it may happen in mild gradations all along the way as countries such as China and Russia and Brazil put together separate currency types of arrangements. So if the dollar declines, an investor in the United States basically feels that as prices of imports begin to increase, that's the natural result of a declining dollar. So ultimately, yes, an investor has to go overseas, hopefully in the emerging market countries, in the BICs- Brazil, India, China and the look-alikes in Southeast Asia. Those will be countries with strong currencies. Those will be countries with much stronger growth and that combination provides a much higher, positive return than what you get here in the United States. So in your portfolios, look from the standpoint of equity and from the standpoint of bonds. Look to some of the developing countries as opposed to the United States. Brazil, for instance, Brazil, this morning I bought for PIMCO 50 to one hundred million of the Brazilian five year bonds and they yield 10 to 11 to 12%. Brazil perhaps is not the United States but 10 to 20 years from now, you know, it would be looking pretty good relative to the United States. And so that type of return with that type of prospect becomes an enticing possibility.

CONSUELO MACK: Bill Gross, co-CIO of PIMCO, thank you so much for joining us.

BILL GROSS: Thanks, Consuelo.

CONSUELO MACK: Next week, in our Great Investors series, another investment phenomenon- this one with the exceptional distinction of running both a top performing stock and bond fund for 25 years. I'm going to sit down with First Pacific Advisors outspoken contrarian and Porsche racing portfolio manager, Robert Rodriguez. We also want to welcome our new sponsors to the WealthTrack family: New York Life, Loomis Sayles and Annaly Capital Management. We are delighted to have you. Until next week, have a happy Fourth of July weekend and make the week ahead a profitable and a productive one.



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