Wednesday, October 7, 2009


When PIMCO's super-star CIO, Bill Gross, speaks, the bond market always pays attention. This is so, not only because of the stunning track record he has built over many years managing the firm's flagship Total Return fund but also because of the impressive muscle that the sheer size of PIMCO's funds under management allows him to flex in the fixed income markets.

So, Mr. Gross' latest offering (link below) is that he is buying Treasuries as protection against deflation.


His view, and, by extension, that of PIMCO's, has been recently that the economy is likely to experience a below-trend rate of growth over the next few years- in the vicinity of 1% to 2%-, as a result of a new paradigm that he believes is emerging, which will lead to a historically elevated saving rate at the expense of consumption. Under that scenario, the persistent moderation in the pace of GDP growth over the medium-term will sustain a slack built-up, which may convert the year-long disinflationary trend into a full-fledged deflation story.

This is not a perspective uniquely promoted by Bill Gross, as others have also argued that the rise in the savings rate and consumer de-leveraging since the onset of the current recession will prevent the economic recovery from acquiring a strong forward momentum over the next year or two. It is not, on the face of it, a totally irrational argument either.

The trouble though is the "higher savings rate" argument is not nearly as "clean" as those who promote it seem to assume.

To begin with, history is heavily against it, as the Chart below shows. In nearly all of the past recessions depicted, the savings rate has risen, as a natural defense of consumers in the face of an anxiety-filled economic environment. The trouble is that it has almost invariably tended to resume its secular downtrend (at least since the '70s) once the recession is over, households regain their deeply entrenched spending habits under the advertising blitz of an irrepressibly consumerist society, and everything returns to its old, merry ways. Assuming that, somehow, things will be different this time and consumers will adopt more prudent spending patterns on a sustainable basis once the recession is over, requires a leap of of faith- and not a small one at that.

The other problem with the concept of a savings rate as a gauge of recent, current, or soon-to-be-adopted spending habits is that it is an atrociously revisable series, to the point that such revisions can alter in a major way past impressions and end up portraying, in retrospect, an entirely different picture. For example, the savings rate for 1981, after a series of revisions over the years, today shows as approximately 11% but it was originally reported as slightly over 5% at the time; and this is only one tiny example in a long history of consistently upward revisions that the personal savings rate series has undergone in the last 20 years or so. Against that backdrop, one wonders whether the recent rise in the savings rate (to a still unimpressive 3% to 4% range) is credible, or sustainable, enough to build a longer-term scenario around the premise that there is indeed a new paradigm emerging here.

The final grounds upon which PIMCO's bet can be called into question is whether one can expect the disinflationary trend in the U.S. to continue relentlessly in the face of nearly 2% GDP growth (the upper limit of Bill Gross's anticipated range) and a likely upturn in global commodity prices. The latter would be a reflection of the vigorous comeback of the economies in China, the rest of Asia, and parts of Latin America (most notably, Brazil) as well as a moderate rebound in the Euro-zone. That dynamic does have the inherent potential to stem the slowing core rate of inflation in the U.S. moving forward and cause a reversal of the circumstantial decline in the overall CPI in the last 12 months.

Bill Gross has certainly earned his stripes in a notoriously brutal business over a long number of years and his views, at times against conventional wisdom, always deserve a fair hearing. He has also shown a remarkable ability in the past to keep an open mind and recognize his own "off" calls early enough and change tack before disaster hits- a quality that should earn him even greater respect. It is that latter quality that may ultimately come in handy with regard to his latest bet.

Anthony Karydakis

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