Post-Crisis Wealth Management

October 4, 2010

Douglas Hodge
, Chief Operating Officer, PIMCO

Wilbur Ross, Chairman & CEO, WL Ross & Co., LLC; Chairman, Japan Society

Douglas Hodge of PIMCO spoke at Japan Society about the "new normal" in the post-financial-crisis world.

The decade between the end of the Asian debt crisis in 1998 and the collapse of Lehman in 2008 was characterized by three big trends: globalization, deregulation and financial innovation, Mr. Hodge said. The emerging economies became "the largest contributors to global growth in the world." The repeal of the Glass-Steagall Act allowed banks in the U.S. once again to combine commercial banking and investment banking activities under one roof. Investors snapped up subprime mortgage-backed securities, CDOs, CLOs and other financial innovations, convinced, as during the earlier tech-stocks bubble, "that technology, whether it be financial technology or otherwise, was going to deliver extraordinary growth and results in perpetuity."

There was an ample supply of cheap funds, which "drove a lot of the debt creation." But "as the Federal Reserve and other central banks around the world began to raise interest rates, that liquidity began to be withdrawn from the system, and ultimately it all came tumbling down."

In the wake of the financial crisis, these trends have been reversed, he said. The world's economies are experiencing de-globalization, witness the heightened discussions of currency manipulation and tariffs; re-regulation, exemplified by the Dodd-Frank Act, which is "probably the largest change in financial regulation since the Great Depression"; and a "de-leveraging, de-risking process" that "is still under way, and that has some significant implications for global growth and for the financial markets."

The new normal--the term originated at PIMCO, he noted--means "that the range of outcomes in the financial markets and in asset prices is wider than it was believed to have been, that the mean return is lower as a result, and there's just greater uncertainty, a much bumpier path than what we have been accustomed to in the past."

"We are now in a period of what we would characterize as asymmetric recovery," where "initial conditions count," Mr. Hodge continued. The emerging economies are growing again as they had prior to 2007, but after 30 years of piling up debt, the developed economies face structural challenges. America's 9.6 percent unemployment rate reflects not a recycling of people who leave the workforce and then return, but large numbers who "are indeed semi-permanently, or perhaps even now permanently, out of the workforce." The U.S. consumer savings rate, which was zero for nearly a decade, is now about 6 percent--a positive development, but "very painful, and we've got a long way to go."

The Dodd-Frank Act "has brought about a great deal of uncertainty" for the U.S. financial industry. Next to come are revised bank capital requirements, known as Basel III, which will apply to banks around the world. At the height of the financial crisis, the G-20 nations exhibited a spirit of consensus and a unanimity of purpose, but these have since been lost, and "what we have now seen is much more of a nationalistic approach to re-regulation."

Japan's geographic location next to the fastest-growing region in the world is a very positive factor, "but Japan itself faces many structural headwinds, just as the United States does," including "large amounts of indebtedness, certainly the demographic challenges, deflationary pressures, the lack of foreign direct investment, [and] government involvement," he said. Around the world, individuals, corporations, and in some cases governments "are beginning to practice what I would characterize as self-insurance. They are beginning to hoard more money and more savings." Individually this makes sense, given the painful experience with excessive debt; "but taken collectively [it] has severe implications for global growth, for jobs and ultimately for public policy."

Governments in both the U.S. and Japan have not made the hard choices that are needed to deal with the structural problems in both the financial economy and the real economy, Mr. Hodge declared. International cooperation is weak. The burden of excessive debt has been shifted in part from individuals to governments, which has consequences for tax policy and job creation among other things.

To succeed in this new world, investors "need to be more forward-looking." The capital asset pricing model, which holds "that prices tend to revert towards a mean and correlations across asset classes and asset prices tend to remain stable," can no longer be relied on as an article of faith; "there has been a consistent belief that the future will replicate the past," but this belief "is not a good guide for the future." The chances of earning a mean or median return will be lower than CAPM contemplates. So will the absolute return, "probably across all asset classes."

"We think it's important that you look globally rather than locally," he emphasized. "The home markets may not be the place of the highest expected or risk-adjusted return."

Finally, "we are seeing increasingly investors think about the downside" and about how to hedge against tail risk, Mr. Hodge concluded. "For 30 years in the U.S., people believed that the value of their home could never go down, and obviously we have learned a very harsh lesson in that respect. But the individual whose 401(k) became his 201(k), and now perhaps is his 301(k), is saying, 'I can't go through this one more time.' And that searing experience tends to influence people's behavior for a very long period of time, measured not in quarters or years, but oftentimes in decades. And we would contend that that is the new normal, the world in which we live in today."

*** Presider Wilbur Ross of WL Ross & Co. began the Q&A:

You talked about debt migrating from the private sector to the public sector. How worried are you about there being a sovereign debt default?

"By no means are we out of the woods," Mr. Hodge replied. "Greece is probably, in terms of their fiscal balance sheet, safe for another couple of years, but ultimately they have an enormous amount of debt which they will be called upon to refinance." There are pressures elsewhere as well, for example in the Irish banking system.

We don't go long Greece? "Not yet, although the yields look very compelling. I would say don't be fooled," he said.

Audience members posed their questions:

  Are emerging markets caught up in a super bubble, or are they just experiencing higher growth and happy days are here again?

  "It's not happy days are here again," Mr. Hodge answered. Their economies' "ability to consume what they produce is much better than what it has ever been. But nevertheless, without the U.S. and European consumer, the growth rates of the emerging economies in all probability will slow."

What is your view of China in terms of interest rates, debt and growth rates?

China's wealth class is rising and its middle class is rapidly growing, "which is something that in the longer horizon is going to be very important for the Chinese economy," Mr. Hodge responded. In PIMCO's view, China's growth trajectory will remain strong. Because the Chinese have a closed capital account system, "they have perhaps more control over their domestic economy than just about any other country in the world." But "the flipside to that is they absolutely do rely on the developed world to be the consumer of their goods. Anyone who would tell you that the Chinese are ready to assume that mantle I think is just premature, if nothing else."

When will we arrive at a sustainable equilibrium in terms of leverage?

"History, as a guide, will tell you that it takes about seven years" to come out of a recession like this, which is led by debt rather than inventory cycles; Japan and Latin America are both examples, Mr. Hodge replied. He recommended Carmen Reinhart and Kenneth Rogoff's This Time Is Different as a good resource on these issues.

What kinds of policy prescriptions would reduce the U.S. unemployment rate and promote growth?

  "There are no good ones," said Mr. Hodge. One school of thought, which can be called the UK camp and is being pursued by the new Tory government, "is focused on deficits and promoting austerity." Another is the growth camp, "which in some respects might describe the United States and the Obama administration. It's not clear which one is better or worse than the other." Too much austerity ups the chances of another downturn, yet government spending and quantitative easing have only a modest multiplier effect.

"The test case is the Japanese economy.... The entitlements that have been built up over time, the credit quality of the private sector borrowers, which has been excused for many years by very lenient regulations and banking systems, these are things which take time to address--but, nevertheless, that's where we should be headed as compared to deciding whether we should raise taxes or not."

How will PIMCO and other Western firms persuade Japanese investors to take their money out of low-yield savings accounts and seek higher returns overseas?

Japanese investors do know "that in a deflationary world, zero is not a bad rate of return," Mr. Hodge commented. "That doesn't mean that it's where you would like to be, but facts of the matter are there is an enormous pool of deposits in the Japanese banking system, which is earning very low nominal rates of return, but indeed is earning some small real rate of return."

Most individual investors aren't financial experts, and "the best advice I can give is to get professional advice. I know that sounds like a very hackneyed phrase, but to do it yourself is probably not very smart."

Wilbur, how you are adjusting your investment model when you hear these rather gloomy forecasts?

"We never adjusted to the old normal," Mr. Ross answered. His firm is doing more in emerging markets, both relocating factories and setting up ventures within those countries. He doesn't make much use of leverage, "so some of those more horrible pitfalls were not going to particularly bother us anyway. I guess the biggest change is we are making a big push into buying and rehabilitating banks and other financial institutions, sort of fitting the punishment to the crime."

Does PIMCO plan to open a branch in China once the Chinese government opens up the market there?

"Like many emerging economies, [China's] equity markets have been opened to foreign investment more readily than the debt markets," Mr. Hodge said. "But as the regulations change in China, I expect PIMCO will be right at the front edge."

--Katherine Hyde

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