William Gross is one of the world’s smartest investors alive. Mr. Gross has made his living managing bond investments. He co-founded PIMCO in 1971, and runs multiple mutual funds that focus on bonds. His largest fund, PIMCO’s Total Return fund is the world’s largest bond fund and fifth largest mutual fund.
Even though Mr. Gross now has sufficient wealth that he need not ever worry about money, I do sympathize with him. Gross made his career investing in bonds, and has more invested in bonds under his management than anyone else alive. Yet he now realizes that bonds are a lousy place to be invested. He has been actively writing about the need for government policy change for quite some time, but his writings are getting more agitated.
This week, Mr. Gross wrote one of his most blunt articles, entitled Skunked. Here are some quotes:
That adorable skunk, Pepé Le Pew, is one of my wife Sue’s favorite cartoon characters. There’s something affable, even romantic about him as he seeks to woo his female companions with a French accent and promises of a skunk bungalow and bedrooms full of little Pepés in future years. It’s easy to love a skunk – but only on the silver screen, and if in real life – at a considerable distance. I think of Congress that way. Every two or six years, they dress up in full makeup, pretending to be the change, vowing to correct what hasn’t been corrected, promising discipline as opposed to profligate overspending and undertaxation, and striving to balance the budget when all others have failed. Oooh Pepé – Mon Chéri! But don’t believe them …in all cases, citizens of America – hold your noses. You ain’t smelled nothin’ yet.
I speak, of course, to the budget deficit and Washington’s inability to recognize the intractable: 75% of the budget is non-discretionary and entitlement based. Without attacking entitlements – Medicare, Medicaid and Social Security – we are smelling $1 trillion deficits as far as the nose can sniff. Once dominated by defense spending, these three categories now account for 44% of total Federal spending and are steadily rising. … After defense and interest payments on the national debt are excluded, remaining discretionary expenses for education, infrastructure, agriculture and housing constitute at most 25% of the 2011 fiscal year federal spending budget of $4 trillion. You could eliminate it all and still wind up with a deficit of nearly $700 billion! So come on you stinkers; enough of the Pepé Le Pew romance and promises. Entitlement spending is where the money is and you need to reform it.
The incredible reality is that the $9.1 trillion federal debt that constitutes the next-to-tiniest ball in our chart is nothing compared to unfunded Medicaid and Medicare. It is like comparing Pluto to Saturn and Jupiter. The former (the $9.1 trillion current Treasury debt) does not even merit planetary status in our solar system of discounted future liabilities. It’s really just a large asteroid.
Look at it another way and our dire situation becomes equally revealing. Suppose that the $65 trillion of entitlement liabilities were fully funded in a “lockbox,” much like Social Security is falsely imagined to be. Just suppose. And say the cost of that funding (Treasury debt) was the same CPI + 1% that was used to produce the above discounted present value in the first place. Actually, that’s not a bad guesstimate for the average yield of all Treasury debt. If so, then the interest expense on the $75 trillion total debt would equal $2.6 trillion, quite close to the current level of entitlement spending for Social Security, Medicare and Medicaid. What do we pay now in interest? About $250 billion. Our annual “lockbox” tab would rise by $2.35 trillion and our deficit would be close to 15% of GDP!
Previous Congresses (and Administrations) have relied on the assumption that we can grow our way out of this onerous debt burden. Perhaps we could, if it was only $9.1 trillion, as shown in Chart 2. That would be 65% of GDP and well within reasonable ranges for sovereign debt burdens. But that is not the reality. … This country appears to have an off-balance-sheet, unrecorded debt burden of close to 500% of GDP! We are out-Greeking the Greeks, dear reader. …
If I were sitting before Congress – at a safe olfactory distance – and giving testimony on our current debt crisis, I would pithily say something like this:
“I sit before you as a representative of a $1.2 trillion money manager, historically bond oriented, that has been selling Treasuries because they have little value within the context of a $75 trillion total debt burden.
Unless entitlements are substantially reformed, I am confident that this country will default on its debt; not in conventional ways, but by picking the pocket of savers via a combination of less observable, yet historically verifiable policies – inflation, currency devaluation and low to negative real interest rates. Our clients, who represent unions, cities, U.S. and global pension funds, foundations, as well as Main Street citizens, do not want to be shortchanged or have their pockets picked. It is incumbent, therefore, in order to preserve the integrity of the U.S. Treasury market along with its favorable global interest rates, and to promote a stable U.S. economy, that entitlement spending be reduced, and that future liabilities be addressed in terms of healthcare and Social Security cost containment. You must attack entitlements and make ‘debt’ a four-letter word.”
The world’s even better-known investor, Warren Buffet (Chairman of Berkshire Hathaway), is voicing similar concerns. Buffet continues to be negative on investing in fixed rate securities because of inflation concerns. This last week, buffet was reported as saying
I would recommend against buying long-term fixed-dollar investments. … If you ask me if the U.S. dollar is going to hold its purchasing power fully at the level of 2011, 5 years, 10 years or 20 years from now, I would tell you it will not.
Last August, the International Monetary Fund (IMF) warned that the U.S. is Broke. Economists are known for their dry writing style. Consequently, IMF reports are difficult to read, and are largely ignored by most news agencies. For example, the evening news certainly did not report the understated IMF comment that “a larger than budgeted adjustment would be required to stabilize debt-to-GDP”. Nevertheless, if one carefully parses the IMF commentary, the result is anything but boring. Smart investors (like Gross, Buffet … and maybe you) did not need to be told a second time that American leadership is failing to address an important issue, which will have long-term consequences to American economic strength.
Relative to these investing and economic giants, who would need my input? Nevertheless, I can tell you that I have been practicing this advice for well more than a year. Although someone my age should have a healthy percentage of life savings in bonds, I have been 100% out of bonds and fixed income investments, and am investing a disproportionate amount in overseas. This disappoints me greatly. The reason for my bearish outlook on U.S. bonds (and to a lesser extent U.S. stocks) is simple. U.S. government spending and monetary policy will cause U.S. inflation in the long term, and long-term slower American economic growth. I am not smart enough to predict short-term economic statistics. But, I do know that it is best to get out of the way of a train, and I clearly can see where the tracks are laid.