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May/June 2002

Episode II

I’m not above bond market (and

pulling a other markets as
“Milton Berle” well) depend upon
and stealing a the secular undula-
good idea or tions of prices –
two – espe- almost always up in
cially if it’s recent decades, but
from myself. over the long course
Fact is, this of history, down-
cartoon high- ward too. So like Mr.
lighted my REFLATION DEFLATION Lucas, we thought it
review of apropos to bring the
PIMCO’s 1999 Secular Forum. George topic front and center for another
Lucas was coming to market with the analysis – a “Second Episode” – and if
second trilogy in the Star Wars series; there be an attack of economic-like
and the battle between good/evil, Luke “clones” then so be it. The fact is, inves-
Skywalker/Darth Vader, and reflation/ tors over the past 5 – maybe 10 – years
deflation all seemed to meld into one or so have gotten quite comfy with the
simple picture posing one giant di- notion of 2% or so inflation; higher at
lemma: would the global economy sink the peak of recoveries, lower towards
into Japanese-style deflation or would the end of recessions but nothing that
“asset” – aka “stock market”-inflation would really fall into either the
propel it forward into a New Age. Well reflationary or deflationary camps.
three years hence, we’ve answered both “Whichever one triumphs,” I wrote
alternatives in the negative, but Mr. back in 1999, “we should know the
Lucas is back for another round aptly winner within a few years. Goldilocks
titled Episode II, and darn if Luke and and Butler Creek (PIMCO’s term for a
Darth as well as reflation/deflation mild inflationary economy) are ap-
aren’t still going at it, to say nothing of proaching old age.” Well, the standoff
good and evil. Timeless I suppose. That continues, but there may be changes
the themes fascinate us should come as ahead. Let’s take a look at this Second
no surprise. The fragile fortunes of the Episode, fresh from last week’s Secular
Investment Outlook

Forum discussion which included the let Peter do it. I will however
likes of legendary thinkers Peter resummarize the dilemma - adding a
Bernstein and Henry Kaufman, relative little PIMCO flavor along the way.
newcomer on the block Stephen King,
as well as a myriad of global-minded Since the fall of the Iron Curtain in the
PIMCO participants. late 1980s and until 2001, the global
economy (and the U.S. in particular)
Historical Secular Summary experienced a period of sustained
Having introduced Peter Bernstein, an disinflationary prosperity based upon
author more noted for his commentary the following:
on risk than secular economic trends,
let’s lead off with a paragraph from his 1) Globalization – Globalization has
Economics and Portfolio Strategy induced competition, limited
summarizing his thoughts in 1999 that pricing power, and promoted a
closely mirrored our own “Star Wars” strong dollar as the primary
concerns: beneficiary of cheap emerging
market labor.
“We then identified those (dominant 2) Technology/Innovation – Led by
secular) forces as ‘the extended and the Internet mania, the 1990s
persistent patterns of disinflation, deregu- promoted a rarely seen surge in
lation, intense competition, and a shrink- investment and related equity
ing share of government in GDP. The market prices. Productivity may
global character of the economic environ- have moved slightly higher but
ment has contributed to its durability and corporate profits did not directly
suggests that (these forces) are not going benefit – the consumer did via
to be easily dislodged…” lower prices. It was, as we head-
lined last year, the New Age
Now for his update, written pre 9/11 Economy’s “Weakest Link” but
in early 2001: disinflationary nonetheless.
3) Shrinking Government/Defense
“Every one of these forces is now on the Expenditures – With the Cold War
defensive, exacerbated by spreading gone and capital gains on the rise,
international frictions and questions the private sector surged while
about the quality of American world citizens and Presidents ques-
leadership,…a looming energy crisis, and tioned the need for big govern-
the apparent end of health care ment. Supply-side economics
disinflation.” reigned supreme, inflation melted
We couldn’t have said it much better 4) Favorable Demographics – The
ourselves, which is why I suppose, I just ascendancy and maturation of the

May/June 2002
boomers in their quest for early/ tion effects on prices and interest rates.
comfortable retirement, fed And as Bernstein questioned last year,
401(k)s, markets, and a wealth we in turn put it to our other guest
effect unparalleled since the speakers and the PIMCO Forum – Are
roaring ‘20s. these disinflationary forces on the
5) Financial Engineering – Technol- defensive? Have we reached an inflec-
ogy, innovation, and the greed for tion point from which deflation or
Wall Street investment banking reflation will dominate? Is this the
profits revolutionized finance, beginning of a Second Episode repre-
transferred control of money senting demonstrable change?
creation from the Fed to private/
semi-private entities and in Current Outlook
the process, lowered the cost of Our answer was YES. Over the past
credit to almost every U.S. home- twelve months, there have been
owner while creating a corporate changes in secular forces so obvious
and consumer debt bubble in that it will be difficult to elaborate on all
the process. of them here without losing your fo-
cused attention. September 11th and its
The Peace Dividend? myriad of ramifications comes immedi-
U.S. Defense Outlays as a % of GDP ately to the forefront, but it unfortu-
nately must share the limelight with
ENRONITIS and what PIMCO’s own
Chris Dialynas labeled “fiduciary
4 enlightenment” which encompasses
Percentage of GDP

Andersen, GE/corporate disclosure,

and potential changes in SEC and FASB
2 regulations. Because of ENRON and its
aftermath, reregulation instead of
deregulation now seems to be gaining
the upper hand. To that must be added
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 the quick and unexpected reversal in
Source: Congressional Budget Office
the Federal fiscal surpluses into three-
figured deficits, and increased moves
Together, these five secular forces towards protectionism ushered in by
form/formed the foundation of our U.S. tariffs on foreign steel and Cana-
New Age Economy, now partially dian lumber, as well as the entry of
discredited by 2001’s recession and China to the WTO with potentially
equity market hangover, but by no deflationary impact in the opposite
means dead and buried, especially with direction. To ice this secular cake, how
regards to their disinflationary/defla- about the high probability that we will
Investment Outlook

experience additional domestic terror- as a percentage of GDP are perhaps the

ist attacks and the perhaps 50/50 odds easiest to agree upon. War, or prepara-
for an invasion of Iraq over the next tion for war, is inflationary – always has
12-18 months. See what I mean? Talk been, always will be.
about a Second Episode! This is a
first-rate secular blockbuster in its The “fiduciary enlightenment” card is a
own right, an instance where the sequel little bit harder to categorize but be-
stands to rank right up there with the comes easier when it is melded into an
original screenplay. observation on the overall reversal of
public attitudes towards control of our
As with any movie however, the economy – from the trust in the infinite
characters do not all wear the same beneficence of capitalism, to the reli-
colored hats – and that is the case with ance on the more protective benevo-
the aforementioned secular changes. lence of government. With ENRON, the
What we called the “China card,” for and telecom busts, the failure
instance, might visually resemble a of the “markets” to rally substantially
face card, but in this tale a “Jedi” not off their recessionary bottoms, and the
a Jack with a very large deflationary ongoing reverberations from the 1990’s
sword at its side. Guest speakers corporate debt overhang (evidenced by
Jonathan Spence and Andy Xie headline bankruptcies and last minute
forecasted that over the next 5+ years, terming out of commercial paper), U.S.
China will become the largest exporter citizens and in fact global stock and
in the world – upwards of one trillion bond holders are becoming a lot less
dollars – and that their goods will confident in the American model of
remain cheap if only because of the laissez-faire capitalism. While
300 million agricultural workers that reregulation may eventually restore
may migrate from farm to factory over order to the asylum over the next
the next decade or so. The China card several years, the net result of the
will keep a lid on prices for globally growing suspicions will be an increas-
manufactured goods for years on ing cost of capital for U.S. corporations:
end if trade wars and tariff increases lower stock prices than at previous
can be avoided. peaks; wider bond spreads than at the
ridiculously narrow margins of several
But almost all of the other secular cards years past; more long-term debt that is
fall into the reflationary, as opposed to two or three times more expensive than
the deflation camp. Their “Jedis” bear three month commercial paper, to say
the swords of potential inflation. nothing of the magnified cost of ven-
September 11th, domestic terrorism, ture capital and business start-ups.
a potential Iraqi invasion, and the When the cost of finance goes up
upward reversal in defense expenditures for a finance-based economy such

May/June 2002
as the U.S., then so do prices to the bolstering nominal corporate profits; by
eventual consumer. levering up the public sector (federal
deficits) and in so doing delevering the
Venture Capital Dries Up, relative debt of the private sector. Bingo.
Cost of Capital Goes Up
Inflows into venture capital funds
The fact is that every G3 central bank –
and there are only three – has seen the
specter of Japanese 1990’s style defla-
tion, and will make all efforts to avoid

a replay. The invigorated monetary
$40 ease of the Japanese over the past year
$20 or so is evidence of that; as is the
$0 stabilization of their property market
1991 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02*
deflation in Tokyo as shown in the
*Q1 results annualized
Source: National Venture Capital Association following chart.

Another inflationary card in the global Leveling Off

economic deck bears the image of G3 Average per-unit sale price of existing condos
in central Tokyo, in thousands of U.S. dollars.*
central bankers standing right behind
Luke Skywalker and acting in unison to
save the world from deflation. They do
this by putting interest rates down to
near 0% levels and keeping them there
for what seems like an inordinate
amount of time. This is not a PIMCO
forecast for Greenspan and the ECB to
mimic The Bank of Japan – they don’t
have to do anything more than they’ve
done already – but it is a recognition 1990 '92 '94 '96 '98 '00 '01
that central bankers understand that * Figures have been converted from yen to dollars
using current rate
the battle against inflation has been Source: Tokyo Kantei Co.

won and that a little bit of mild infla-

tionary pressure might actually do this While the ECB has been the mildest
system - characterized by low pricing mannered and most conservative of the
power and too much debt – a little good. three, the near inevitable and almost
After all, think of the obvious – how immediate inclusion of a host of Central
does a government ease its way out of a European countries into the Eurozone
debt crisis? By eroding the real value of will require the ECB’s inflation target to
debt with a bit of unanticipated infla- move higher if only because Poland,
tion; by cheapening its currency; by Hungary, and the Czech Republic have
Investment Outlook

higher inflation rates themselves. This economy primarily based on produc-

will be a disguised form of monetary ease. tion, to one substantially reliant on
growth via debt and new derivative life
In sum, the secular evidence falls forms. We now live in an age of paper,
significantly in the reflationary camp and this paper maché facade is not a
symbolized in our cartoon by Luke permanent nor lasting one.
Skywalker. China and Darth Vader’s
deflation are formidable foes, but Investment Policy
movie goers and global citizens love to How should one invest in such an
see the good guy win and so it should environment? First and foremost,
be this time, at least for the next 3-5 reflationary economies are rarely the
years. While the global recovery will be bond market’s friend. Although infla-
anemic by historical standards, a tion should stop at 4% at the peak of
recovery it will be, and that will at least our next cyclical upturn, current long
buy the financial system some more bond yields do not reflect this risk. We
time. Still, there will be negative conse- may see 61/2% long Treasury yields or
quences over the same period from this more before we are done, but remem-
superficially successful reflationary ber this is a 3-5 year forecast so bond
Episode II. Although inflation itself price erosion should be mild and barely
should be contained at 3-4% levels, new resemble a “bear” market. Still, PIMCO
bubbles, particularly in housing, are a durations should be at index or shorter
distinct possibility. Lengthy periods of over most of the time period with a
low, short-term interest rates are an recognition that “carry” and “roll-
inducement to lever and take risk that down” are potent mathematical con-
may or may not bear fruit. We and structs during periods of sharply
others see potential bubble risk in positive yield curves. Barbell strategies,
housing prices, and the growing domi- dear reader, fall into Darth Vader’s
nance of the GSE’s. We see risk in the camp, not Luke Skywalker’s, and Luke
increasing use of hedge funds to stretch prefers “bullets” for that Star Wars gun
returns in what is really only a 6-7% of his. We must be cognizant as well of
asset return environment. We see the the risk that a significant decline in the
risk of a U.S. current account deficit dollar leads to a withdrawal of foreign
“unwind” from near historic levels, investment in Treasury and corporate
which may be precipitated by a more holdings. Reduced durations and front-
than gradual decline in the dollar. This end strategies are an excellent hedge for
reflationary world of Luke Skywalker is that possibility, assuming the Fed
by no means a safe and secure one doesn’t rise to the challenge and defend
economically, to say nothing of the the dollar via rate hikes instead of the
increasing risk to life itself. It has more likely O’Neill-style rhetoric. And
morphed through the years from an potential financial accidents ala LTCM

May/June 2002
in 1998 are of course a significant term, due to the ongoing rapidity of
possibility in such a levered-up, finance technological change which produces
dependent economy. too many “black hole” losers when
compared to “par at maturity” winners.
Speaking of the dollar, should it decline Mortgages will continue to fulfill the
(as we think it will) by over 10% during “safe” spread dictum as will emerging
the forecast period due to 1) its current market bonds of the highest caliber.
purchasing power mispricing, 2) the
inevitability of a current account deficit Farewell
reversal, and 3) the shaken faith in U.S. And as we wrap-up our rendition of the
stock market dominance, then interna- Episode II, we readily acknowledge that
tional/non-dollar denominated bonds there will be a Third, Fourth, and an
should do relatively well. As of this Umpteenth Episode if God in his
writing, they yield almost exactly what wisdom will permit. That’s the movies
U.S. Treasuries do and should therefore folks, and so it is with life, economies
benefit from their relatively lower and investing as well. Cycle after cycle,
(strong currency induced) inflation as well cycle within cycle, an enormous spi-
as financial flow reversals when foreign raled galaxy of moments, strategies,
investors return to their own markets. and secular dialogue leading to what
hopefully results in stellar performance
Lastly, in terms of macro secular bond within a universe of star-like managers
strategies, the next few years should be – some of them Novas, some of them
an attractive period for “safe” spread Dwarfs, but all trying to capture your
products. That critical adjective, of eye and ultimately, of course, your
course, opens up a piece of the galaxy confidence. We hope to be your North
so wide that you could steer a starship Star for years to come, an object so
“freighter” through it. “Safe” these days visible and constant in the sky that you
means companies that will not only can steer by us, as well as sleep soundly
remain solvent, but will not be subject under the illuminated nighttime sky.
to SEC investigations or overnight Until next year when we meet again,
ratings downgrades by the major rating may the Force be with you, and with
agencies. Hard to find. Nonetheless, us as well.
on-site credit research, and an
investor’s sense of value can hopefully William H. Gross
help ferret out the good guys from the Managing Director
Darth Vaders of the bond universe. We
shall see. Due to wide current spreads
840 Newport Center Drive
we recommend an average index
P.O. Box 6430
weighting of corporate bonds for now
Newport Beach, CA
but remain cautious of the sector long 92658-6430
Past performance is no guarantee of future results. All data as of 4/30/02 unless otherwise noted and is subject to change. The return on both
individual securities and mutual fund investments will fluctuate and the value of an investor’s shares will fluctuate and may be worth more or less
than original cost when redeemed. This article contains the current opinions of the manager and does not represent a recommendation of any particular
security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes and
should not be considered investment advice. The credit quality of the investment in the portfolio does not apply to the stability or safety of the
investment. Duration is a measure of the Fund’s price sensitivity expressed in years. These 3 charts are not indicative of the past or future performance
of any PIMCO Fund.

Mr. Gross is the Manager of PIMCO Total Return Fund. The stock securities mentioned in the article are not holdings in the PIMCO Total Return
Fund. The fund may invest up to 20% in foreign securities, which may entail greater risk due to foreign economic and political developments.
Investment in high yield, lower rated securities generally involves greater risk to principal than investment in higher rated securities. Mortgage-backed
securities may be sensitive to changes in prevailing interest rates, when they rise the value generally declines. There is no assurance that the private
guarantors or insurers will meet their obligations. All holdings are subject to change.

Each sector of the bond market entails some risk. Municipals may realize gains & may incur a tax liability from time to time. Treasuries & Government
Bonds guarantee is to the timely repayment of interest and does not eliminate market risk, shares of the funds are not guaranteed. Mortgage-backed
securities & Corporate Bonds may be sensitive to interest rates, when they rise the value generally declines and there is no assurance that private
guarantors or insurers will meet their obligations. An investment in high yield securities, lower rated securities generally involves greater risk to
principal than an investment in higher-rated bonds. Investing in foreign securities may entail risk due to foreign economic and political developments
and may be enhanced when investing in emerging markets.

For additional details on PIMCO Funds, contact your financial advisor to receive a prospectus that contains more complete information,
including charges and expenses. Please read the prospectus carefully before you invest or send money. Pacific Investment Management Company,
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