The bond market is said to be populated with worried, glass-half-empty types. And Pimco, the world's largest bond fund manager, is never shy about making the big picture look pretty bleak. The thing is, they keep getting it right.
Not long after the financial crisis hit in 2008, Pimco laid out a gloomy forecast for the years to come. Debt piled up over the boom years would drag down the U.S. and Europe, straining government finances to the breaking point. Markets wouldn't rebound as quickly as in the past. Pimco believed the rules of the game had changed.
Pundits and many investors attacked Pimco's view as overly pessimistic at the time. But a few years later, the European debt crisis, slow-moving economic growth at home and the turbulent stock market have turned Pimco's "new normal" into conventional wisdom.
So what's their view of the year ahead? Much like this year, everything hinges on Europe. In a recent interview with the Associated Press, Tony Crescenzi, a Pimco market strategist says the new year may look a lot like the old one. Investors should be prepared for the worst. In other words, don't rule out a collapse of the euro.
Q: How do you imagine 2012 will be different from 2011?
A: The world is playing a game of hot potato right now. There are more and more banks and investors seeking to sell assets and more assets seen as toxic. So you have more hot potatoes -- such as, European bank debt and European government debt. The only player with oven mitts is the European Central Bank, but it's refusing to be the lender of last resort. And at the same time, there are fewer and fewer places to hide from market volatility. Even gold in recent days has lost some of its luster as a store of value. This environment is likely to linger into 2012.
Q: Even after the recent agreement to put tighter controls on government budgets, you don't think Europe's debt crisis is anywhere near fixed?
A: Europe hasn't sought solutions that fix its current problems. Italy and Spain, their governments and banks combined, need around $500 billion in funding next year. That's a massive need. What if they don't get it? It creates a risky, volatile climate.
Q: This year, whenever Greece or Italy seemed to be struggling with their debts, everybody bought dollars and Treasurys and sold stocks. In 2012, do you expect markets will react like they did this year?
A: Like the second half of this year. That means people will be buying Treasurys. They'll be the big beneficiary again as people flee other assets. You want bonds that will behave well in a risky environment. For instance, Canadian government bonds, the U.K. gilt market, Australia, shorter maturities in the Brazilian market. And German government bonds, still.
In corporate bonds, it means underperformance. The dollar will continue to benefit as it has been recently. The dollar is up about 5 percent since July. We'd expect continued strength in the dollar.
Q: Pimco is buying U.S. Treasurys again. What else are you doing to prepare for this climate of uncertainty?
A: This is a time to be a true guardian of capital -- that's an expression Bill Gross (one of Pimco's founders) likes to use. You want to avoid catastrophic losses. And if there's a breakup of the euro there's a potential for catastrophic losses.
Within portfolios, we're choosing companies with strong balance sheets in strong industries. Second, we're also buying high in the capital structure. Meaning, that if there's a bankruptcy, you're first in line. Third, we're buying companies with hard assets to sell if there's a bankruptcy. Finally, we like to find products that are resistant to swings in demand. This isn't a recommendation but tobacco, for instance. That's a way to fortify a portfolio.
The point is to seek the return of capital not the return on capital. Stretching for additional yield may not be a fruitful endeavor. If you have to choose between a security that yields 3 percent versus one that yields 4, you might think "I'll take the 4 percent." But that's not enough. You need to look at the volatility. If the 4 percent security drops 30 percent in price, then you're burned.
Q: Pimco is widely credited with popularizing the idea that we're in a "new normal." Can you explain it in layman's terms?
A: It's the idea of seven years of abundance and seven years of famine. We had years of debt built up at the household level to buy homes, cars and other things. Now consumers are having to pay down their debts because they have too much relative to their incomes. Banks have had a similar situation. The deleveraging, this process of paying down debt, has shifted from the private sector to the public sector. You see this with the layoffs of teachers and other government workers. You'll see this more forcefully in 2013 when the federal government's automatic spending cuts kick in. There's going to be fiscal austerity that harms economic growth. It'll get worse. It's playing out already in Europe.
Q: Given all this austerity, do you expect interest rates to stay low?
A: Short-term interest rates aren't going anywhere. The 10-year Treasury yield is normally tied closely to the nominal gross domestic product. But the forecast for now is that conditions won't change much. And there's still a flight to safety seen very clearly in this week's Treasury auctions where demand has been extraordinary. I guess that leaves us in the 2 percent range for the 10-year (To put that in context, the 10-year Treasury rate started the year at 3.33 percent and traded at 1.85 percent on Friday).
Q: This is depressing. The new normal isn't the old normal yet, it's going to be with us for a while?
A: We're just in the early stages, in the very beginning of a long process. Look at Europe. People are up in arms about changes to benefits and services and public sector employment. It's the transformation of the century, really. The public sector is set to shrink globally.
It takes many years. But the final product is a much less risky financial system.