Europe, Brains & Markets

 

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Europe in Crisis

As the U.S. economy plods along at a 2% GDP growth rate and the stock and bond markets continue to rise as a result of quantitative easing by the Federal Reserve for five years, the eurozone has not recovered and is facing the specter of deflation, a la Japan in the 1990s.

In the August 30th – September 5th, 2014 edition of The Economist on page 10 is an article entitled “That Sinking Feeling (Again)”.  It states, “If Germany, France and Italy cannot find a way to refloat Europe’s economy, the euro may yet be doomed.”  Mario Draghi, the president of the European Central Bank, said he would do “whatever it takes” to support the currency just a few months ago.  Confidence swept back into the continent but it has been short lived.  It was an illusion.  The collective GDP stagnated in the second quarter; Italy fell back into outright recession; French GDP was flat; and even Germany saw an unexpected large fall in output.  The third quarter looks pretty unhealthy due to an extra drag from Western sanctions on Russia.  Inflation has fallen to a low of around 0.4%, far below the 2% target of the European Central Bank.  German bank yields are hovering below 1% compared to U.S. yields of 2.4% on 10-year maturities.

Without a new push from the continent’s leaders, growth will not revive and deflation could take hold.  Japan suffered a decade of lost growth in the 1990s and is still struggling.  But unlike Japan, Europe is not a single cohesive country.  If the currency union brings nothing but stagnation, joblessness and deflation, then some people will eventually vote to leave the euro.  The political risk that one or more countries decide to storm out of the single currency is rising all the time.  The euro crisis has not gone away; it is just waiting over the horizon.  Europe must be watched closely.  A breakup of the European Union can be very disruptive to the global markets.  Some form of quantitative easing is needed and needed quickly if the union is to survive.

Another problem is that housing prices in Europe are losing touch with reality again.  In Sweden, home prices have more than tripled since 1996 and household debt has reached 124% of after-tax income, compared to below 105% of income after tax in the U.S. and the eurozone’s household debt of 110%.  In May the European Central Bank singled out sky-high prices in Belgium, Finland and France.  Moody’s said that Britain shows signs of a new property bubble.  After the collective pre-crisis boom, European housing markets took two paths.  Denmark, Greece, Iceland, the Netherlands, Portugal and Spain dropped sharply; some continue to fall.  Others including Belgium, Britain, Norway and Sweden only dropped before rebounding with worrying speed.  Central banks cannot use interest rates to deflate the housing bubbles since, asset values aside, the economies of the countries concerned remain so sickly.

Easy money is inflating home prices across much of the globe.  Low interest rates are contributing to rising home prices in 18 of the 23 economies that The Economist tracks.  America looks in pretty good shape.  Prices are rising again, but there are few signs yet of history repeating itself.

Have the Brains Walked Out the Door?

Bill Gross, the co-founder and CIO of PIMCO and lead portfolio manager of the PIMCO Total Return Fund, resigned Friday, September 26, 2014.  As a result Monroe Vos has reached the conclusion that the Fund will be put on watch and that there are compelling reasons to stay invested in the Fund rather than moving to another alternative at the present time.  This conclusion is based on six conference calls with the Fund management starting Friday, September 26, 2014; our internal analysis of the portfolio; our understanding of how investment decisions have been and will be made with the exception of Bill.  The press and other financial advisors have had knee-jerk reactions to Bill's departure.  Although Bill is a powerful personality, who we have known for 26 years, the primary decisions about the portfolio as it relates to asset allocation, sector allocation, country allocation, risk parameters and the types of securities that are in the portfolio have been lead by the Investment Committee at PIMCO.  The Committee, which was established 15 years ago, is intact, and with some additions, except for Bill.  As PIMCO has grown over the years, the investment process had to be more structured because of the size of the total assets of the firm ($2 trillion) and the size of the Total Return Fund ($223 billion).  No one man could run a fund of this size without a lot of help.  Bill has been the face of the firm since it was founded in 1971 and has been used for marketing the firm. 

Morningstar remains positive overall on PIMCO Total Return after the departure of Bill Gross but is downgrading the fund to Bronze because of the resulting uncertainty regarding outflows and the reshuffling of management responsibilities.  When Gross resigned the firm quickly selected Dan Ivascyn as its new “group chief investment officer,” and announced that three PIMCO veterans – Mark Kiesel, Mihir Worah, and Scott Mather – would take over the Total Return Fund, with Mather leading the effort.

It will take some time to see how Ivascyn and the new managers will coalesce as a team in their new roles, but there are a number of reasons to believe they will be successful after the dust settles.  For starters, this is an experienced and well-respected group, with both Kiesel and Ivascyn earning Morningstar Fixed-Income Fund Manager of the Year accolades in recent years.  As sector specialists, they were often credited by Gross for feeding him their best bottom-up ideas.  Meanwhile, changes to the Investment Committee also bode well.  The addition of Kiesel and Ivascyn to the group earlier this year following Mohamed El-Erian’s departure added important feedback from the firm’s best bottom-up investors, while the returning Fed maven Paul McCulley and veteran manager Chris Dialynas provide economic heft from the firm’s macro thinkers.  The challenges posed by outflows from the fund remain a wild card, but a hefty 42% stake in a mix of U.S. Treasury bonds and agency mortgages, in addition to cash flows received from coupon payments and maturing securities, is grounds for cautious optimism that the fund should be able to withstand a significant storm.

The fund’s Bronze Morningstar Analyst Rating reflects Morningstar’s high level of confidence in PIMCO’s resources and overall abilities but also the uncertainty as to exactly how all of these parts will mesh in the wake of Gross’ departure.

Newly appointed managers Scott Mather, Mark Kiesel and Mihir Worah don’t expect any big changes to the funds’ strategy.  The process will continue to be based on macroeconomic forecasting (supported by PIMCO’s Investment Committee) and bottom-up analysis to determine interest-rate, yield-curve, currency, country, sector, and security-level decisions.  The managers plan to defer to each individual’s area of specialization when making security-specific decisions, with Mather ultimately making the final call.

PIMCO has over 240 portfolio managers, offices around the world and resources that no other firm in the industry can come close to.  It has 731 investment professionals and 2,433 total employees.  We do not anticipate any changes to the portfolio or management going forward.  We will be personally visiting PIMCO in Newport Beach in the next 30 days to meet with all of the senior management as we continue our due diligence.  We think that one brain walked out the door but there are plenty of brains left at PIMCO.

The Markets

The stock and bond markets experienced high volatility in September and early October.  A correction in the stock market sent all indexes down with a large bounce back in early October.  The reasons are a stronger U.S. economy that may lead the Federal Reserve to raise interest rates sooner than later; a very weak economy in Europe and globally; Russia in the Ukraine; ISIS/ISIL beheading people in the Middle East and taking territory in Syria and Iraq; and Ebola.  The markets are jittery after a five and a half year rally and are fully priced.

We do not believe the Federal Reserve will raise rates at any time soon.  If and when they do, Monroe Vos will react with a recommendation.  Europe and the global economy will continue to weaken.  Russia wanted Crimea and it has it.  Any further aggression will present serious problems for the U.S. and NATO.  ISIS/ISIL will have to be dealt with as will the Ebola virus.

Conclusion

As a result we are not recommending any asset allocation changes at this time.  We think that a 60% equity/40% fixed income allocation with selected alternatives is the proper allocation under the circumstances.

 

Jamison Monroe
Chairman & CEO