Ignoring E.F. Hutton

The New E.F. Hutton?

I grew up in the age of classic TV commercials. Who could forget Life cereal’s “Hey Mikey?” Or Wendy’s “Where’s the Beef?” And then there was the E.F. Hutton’s ad campaign with its slogan, “When E.F. Hutton talks, people listen."

E.F.Hutton -- its prestige tarnished by scandal -- is long gone, ultimately swallowed by other competitors. However, if there’s a firm that seems to have inherited the mantle of the slogan, “When E.F. Hutton talks, people listen” it may be PIMCO. When either of PIMCO’s co-leaders, either Bill Gross or Mohammed El-Erian, make public statements about their outlook, those comments are analyzed and dissected by the financial and investing media, searching for clues about what PIMCO may be thinking.

"Don't Care." What did he mean?

Gross posts a monthly newsletter on PIMCO’s site that provides plenty of fodder for the investing media but March 2010’s issue, titled “Don’t Care,” left people scratching their heads. The WSJ’s Marketbeat blog was indicative of the common reaction:

PIMCO bond guru’s monthly letter is usually good for a tidbit/modicum of insight into the mind of the one of the world’s most influential fixed income investors.

Well, this month’s edition from Bill Gross entitled “Don’t Care,” offers a little less insight and a little more drivel than usual.

“Don’t Care”? What’s this all about? Well, if we take a look at his closing paragraph it’s pretty clear: he doesn’t care about mere talk; he wants to see action on the part of governments that promise to deal with their debt load before he lends money to them (emphasis in excerpt below was in the original):

PIMCO’s “Ring of Fire” remains white hot and action, as opposed to cocktail blather, is required to maintain or regain trust in sovereign credits approaching the rocks. Just last week Bank of England Governor Mervyn King said that it would be difficult to cut government spending quickly, but that there needs to be a clear plan for doing so. Not good enough, Mr. King. Don’t care. Show investors the money, not vice-versa. An investor’s motto should be, “Don’t trust any government and verify before you invest.”

However, I speculate there’s a message in “Don’t Care” other than the one laid out plainly in the article. I don’t know for a fact, but suspect it may have something to do with the economic and investing community’s reaction to what Gross wrote in his February 2010 issue, entitled “The Ring of Fire.” In it Gross laid PIMCO’s take on sovereign debt risk around the globe. Being a fixed fund manager, assessing risk relative to return on debt is of paramount importance to PIMCO. Gross presented PIMCO’s concept of the Ring of Fire: countries with debt levels high enough there are heightened risks of seeing diminished economic growth. The countries in “the Ring” were most of the usual suspects: Greece, Italy, Spain, Ireland, France, Japan, and the U.K. Perhaps the shocker was who else was included in the Ring of Fire: the U.S.

Can't happen here!!
Reaction in the financial MSM was swift and generally dismissive --- some by name, some not. A NY Times Op-Ed entitled “Fiscal Scare Tactics” by Nobel laureate economist Paul Krugman captures the heartbeat of this sentiment. The column was posted on February 4, 2010, shortly after Gross’s February issue was posted on PIMCO’s website; although he doesn’t name Gross, Krugman dismissed assessments of the U.S.’s fiscal condition like Gross’ as “scare tactics”:

These days it’s hard to pick up a newspaper or turn on a news program without encountering stern warnings about the federal budget deficit. The deficit threatens economic recovery, we’re told; it puts American economic stability at risk; it will undermine our influence in the world. These claims generally aren’t stated as opinions, as views held by some analysts but disputed by others. Instead, they’re reported as if they were facts, plain and simple.

Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe.

Krugman was not alone in this dismissal. But, then, neither was Gross alone in his assessment. And so, I suspect at least in part, Gross wrote March’s news issue, because it was obvious many didn’t care to hear what he had to say, and he didn’t care what they were offering in response.

In the March issue Gross spelled out what he felt were some of the implications for countries continuing not to care about their debt (emphasis in excerpt below was in the original):

There has even been a developing debate in the press (and here at PIMCO) as to whether a highly-rated corporation could ever consistently trade at lower yields compared to its home country’s debt. I suspect not, but the narrowing in spreads since late November solicits an interesting proposition: Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.

So what does this have to do with the U.S. forest products industry?
There are at least three areas in which the prospect of sovereign risk, and particularly U.S. sovereign risk, could affect the U.S. forest products industry.

• There is a direct linkage between sovereign debt risk and U.S. mortgage rates. Mortgage rates of course are a key ingredient in housing affordability and thus an important component to any lasting housing recovery. Mortgage rates are more closely aligned with longer-term treasury rates than the short-term rates that generally grab the headlines. The perception of heightened risk on U.S. long-term debt will ultimately drive mortgage rates higher. Higher mortgage rates could stall the near-term housing recovery; longer term they could adversely affect the sustainable level of housing start activity.
• Higher long-term rates will dampen economic activity, slowing the pace of recovery, keeping unemployment high, and potentially threatening the U.S. economy with a double-dip recession. A double-dip recession will add to housing inventory through foreclosure (foreclosure and unemployment are correlated; see March 2010 Macro Pulse), creating additional headwinds to eventual recovery in housing and reducing general demand for wood-pulp based products.
• Higher interest rates could mitigate further U.S. dollar weakness and so make U.S. wood-based exports less competitive globally. Early in the current economic downturn exports were an important source of demand for pulp and paper manufacturers to mitigate in part the loss of demand in the U.S. For wood products manufacturers the weaker greenback reduced the share of limited domestic demand met by imports into the US.

Our view for the past 18 months has been that the global debt onslaught the world is facing over the next several years will force U.S. interest rates higher, particularly longer-term rates. That will happen either as a result of:

• Capital rationing between various countries’ public debt, private debt, and equities;
• Central banks expanding the money supply and prompting lenders to demand an inflation-risk, (or in extreme cases default) premium on their debt;
• Both of the above.

And, it will happen, whether the Federal Reserve moves to increase short-term interest rates or not. We believe an increase in interest rates given the fragile condition of the U.S. economy trigger the double-dip recession.
Epilogue
As a post script to all of this we found a Bloomberg news article from this past weekend (March 22, 2010) interesting, particularly as what it described occurred within a month of Gross questioning whether such a thing could occur. The headline and lead paragraphs are shown below, emphasis added:

Obama Pays More Than Buffett as U.S. Risks AAA RatingThe bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

The new E.F. Hutton is talking. Are you listening?