Fundmastery Blog

Kurt Brouwer September 29th, 2009

Though inflation fears are popping up all over the place — particularly in ads for inflation-hedging investments such as gold — Pimco’s Bill Gross still believes economic activity is weak and he is warning of deflation ahead, not inflation.  This Bloomberg pieces gives his thoughts [emphasis added]. Be wary though of the headline because I believe it is incorrect as I point out below:

Pimco’s Gross Buys Treasuries Amid Deflation Concern (Bloomberg, September 29, 2009, Thomas R. Keene and Susanne Walker)

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the [yield] curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re-emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

...He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent…

This piece is a good example of why you should be wary of headlines and media reports in general.  The reporters were probably correct that Pimco bought a modest amount of Treasury securities opportunistically when rates hit an attractive level, but they gave the impression that a major move into Treasuries was underway.  And, the headline writer added to that erroneous (I believe) impression.

The piece got it right in the final paragraph above when it pointed out that Pimco is putting more emphasis on government-backed securities (such as Fannie Mae bonds or other government agency bonds) and interest rate swaps and other similar instruments tied to government-backed securities. Government agency bonds are guaranteed by the Treasury, but they are very different from Treasury bonds or notes.

Getting back to the main theme, like Gross, I too wonder and worry about deflation.  It’s not that I do not see a threat from inflation in the future because I do see inflation ahead.  But, inflation is not much of a factor right now whereas deflationary forces are still quite strong.  With the potential for deflation, we also have a higher likelihood of lower interest rates.  Whereas, in an inflationary environment, we would typically have higher interest rates for most fixed income securities.

What is inflation and what is deflation?

Inflation means that we are experiencing a general increase in the price of goods we buy.  Deflation is the opposite, that is, a general decline in the prices of various assets and the goods we buy. Inflation is very common in most developed countries, but deflation is rare.  The last time we had protracted deflation was in the Great Depression of the 1930s.  Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. Overall, the cost of living (Consumer Price Index) is still up a bit, but that is primarily due to recent increases in the cost of energy.

Why is general deflation so scary to our government?

Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation.  A generalized state of deflation is viewed with fear and loathing by the government because it can be very disruptive.  Falling prices for goods and services mean companies struggle financially and are forced to cut spending and employment.  Falling prices for assets such as real estate means that homeowners see their equity vanish and that leads to lower levels of consumer spending.  As real estate prices fall, banks and mortgage holders also suffer.  This leads to a hoarding of capital and decreased lending activity.  And, as economic activity under a deflationary environment falls, more unemployment results, thus leading to yet further reductions in consumer spending.

In short, deflation can become a downward spiral and our government will use every tool it has to quickly root out deflation and prevent it from taking hold because, to paraphrase Sun Tzu from The Art of War:

If the deflation is protracted, the resources of the State will not bear the strain.

As Gross pointed out in his September Investment Outlook,

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 Feds are fighting deflation very hard for the reasons noted above, but the deflationary pressures are such that we are not likely to see inflation for some time.  That’s good. Unfortunately, deflationary pressures also mean that we will probably have a modest, rather than robust, economic recovery in 2010.

See also:

Burgeoning Bond Funds

Economy Turning — slow growth ahead

Full Disclosure:  Kurt Brouwer owns Pimco Total Return (pttrx)

• Economy , Geopolitics , Investing , Mutual Funds , debt , deficit , inflation
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