Systematic Relative Strength

Bill Gross has an extended discussion of what he calls the “new normal” in his most recent commentary. A couple of things stood out to me. First, he pointed out the tendency of all current investors to think that the way markets have worked in the past is the way they will always work. He writes:

“This “new” vs. “old” normal dichotomy was perhaps best contrasted by Barton Biggs, as I heard him on Bloomberg Radio in early 2009, when he said he was a “child of the bull market.” I thought that was a brilliant phrase, and Barton is a brilliant phrase-maker. He went on to say though, that his point was that for as long as he’s been in the business – and that’s a long time – it has paid to buy the dips, because markets, economies, profits, and assets always rebounded and went to higher levels. That is not only the way that he learned it, but that is the way, basically, that capitalism is supposed to work. Economies grow, profits grow, just like children do. I think that’s why he said he was a child of the bull market, not just because he had experienced it for so long, but also because economic growth and higher asset prices are almost invariably a natural evolution, much like the maturation of a person. That’s how people grow, and so I think Barton was saying that capitalism just grows that way too.

Well, the surprise is that there’s been a significant break in that growth pattern, because of delevering, deglobalization, and reregulation. All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it’s time to grow up and become a chastened adult; it’s time to recognize that things have changed and that they will continue to change for the next – yes, the next 10 years and maybe even the next 20 years. We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave.”

The point here is what if this time it really is different? What new tricks will need to be learned to navigate if certain things in the financial markets have changed materially? (One thing that most assuredly will not be different, for example, is investor behavior.)

Not surprisingly, Mr. Gross has some speculations on what might be different. One never knows if his crystal ball will be any better than anyone else’s, but I’m sure he’s devoted as much time thinking about the changes in the global economy as the next guy. He thinks that “The investment implications of this New Normal evolution cannot easily be modeled econometrically, quantitatively, or statistically. The applicable word in New Normal is, of course, “new.” The successful investor during this transition will be one with common sense and importantly the powers of intuition, observation, and the willingness to accept uncertain outcomes. As of now, PIMCO observes that the highest probabilities favor the following strategic conclusions:

1. Global policy rates will remain low for extended periods of time.
2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
5. The dollar is vulnerable on a long-term basis.

The section that is of most interest to me is his belief that future investment returns will come from across a multitude of domestic and global asset classes. He guesses to some degree where those might be, whereas we do not. In our Global Macro product, we have simply tried to include as many asset classes as possible in the investment universe, then allowed our systematic process to rotate to the asset classes that are strongest.

Click here for disclosures from Dorsey Wright Money Management.

It’s not so much that the dollar has been notably weak in the very recent past—it’s more that the dollar is being assailed as the world’s reserve currency. Now it’s not just the central bank of China that is complaining.

The U.S. has benefited massively since World War II with the dollar as the de facto reserve currency. Because the dollar has become the world’s reserve currency, there is always tremendous demand for dollars. Huge demand for dollars has allowed businesses to borrow dollars cheaply—benefitting mainly U.S. businesses. It has made funding for American companies far more readily available than funding for other international companies, which primarily have to rely on their home market.

The strong demand for dollars has allowed the U.S. government to borrow as much as it wants whenever it wants. While it can be argued that this has been too much of a good thing, it has made financing the U.S. deficit much, much easier than it would otherwise have been.

Foreign creditors are now looking at the current administration’s deficit coming at them like a tidal wave and are beginning to get a little nervous about holding so many dollars and so little of any other currency. If the dollar begins to decline in earnest, I suppose there is the risk that U.S. investors may also decide it would be nice to have a slug of Swiss Francs, Euros, and Aussie dollars, or whatever. If you think the budget deficit is a problem now, just imagine what will happen if the dollar becomes unglued.

American investors aren’t used to thinking about currency exchange rates, but this is one of the consequences of globalization that needs to be considered in your asset allocation.