Correction Appended: Nov. 16, 2012
Newport beach, Calif., is an unlikely headquarters for the world's foremost bond traders. Its placid harbor is filled with pleasure boats, its beaches with surfers enjoying the waves. You won't find wildly gesticulating traders or bosses in pinstripe suits like on Wall Street. PIMCO's traders look more like diligent graduate students who've taken to the library despite the sparkling sunshine. They sit in academic quiet, collecting rays from their triple-screened Bloomberg terminals in a long room lined with awards and books on investing and economic theory, some of which they've authored. Staffers are encouraged to publish their views to get feedback from the wider world, which can inform their decisionmaking.
The co--chief investment officers of the firm, Mohamed El-Erian and Bill "the Bond King" Gross, keep the same crack-of-dawn hours as the local surfers, whom Gross likes to observe, though not from his modest office, which doesn't have much of a view. He has to go down to the beach, since PIMCO has no privileged corner offices. He likens surfing to investing, which is "dominated by the wave of either public opinion or institutional opinion, which moves prices forward. If you are negative and you refuse to believe in the wave, then you can't surf. The point is that when you are surfing, you want to ride the wave, but you also want to recognize that there's a crest and that ultimately a good surfer has to kick out."
Or wipe out when the wave crashes. And the money wave, says Gross, may be ready to crash.
To understand why, you have to understand how PIMCO, like everyone else in the market over the past few years, has been riding the crest of money funneled into the economy by the Federal Reserve, which has, through its three rounds of quantitative easing, been buying vast quantities of U.S. bonds and, more recently, mortgage-backed securities. That's one reason the stock market took off earlier this year, as the Fed's moves pushed buyers into riskier assets like equities. PIMCO, which manages nearly $2 trillion, has surfed this money wave well: its flagship Total Return Fund has outperformed its category for the past five years, returning 9.7% this year, nearly 3 percentage points better than the category.
Yet PIMCO has grown wary of the wave--and maybe you should too. Gross recently stunned the markets by calling equities a Ponzi scheme and warning investors they will never see 6% real returns again and would be lucky to get 3%. Gross and El-Erian believe there will ultimately be a price to pay for the Fed's money infusion in the form of return-eroding inflation and other economic distortions. When that happens, real growth (already sluggish) will stagnate further, borrowing costs will skyrocket, stocks will swoon, real estate will struggle and consumers will hunker down. It will be like the 1970s but with less room for productivity gains. All this is compounded by the fact that finance as a fuel for capitalism is tapped out. Growth-killing inequality is rising. And the rich aren't paying enough taxes, especially in an era when lower returns will change retirement plans for millions. Without major policy changes, Gross and El-Erian believe, the U.S. won't have the mojo to grow beyond a 2% economy anytime soon.
In other words, some of the world's best surfers are saying, Get out of the water.
The Ripple Effect