Our economy which once feasted, no, binged, unable to stop itself, on debt and leverage, and on the basis that home and other asset prices would rise to the sky, is now fasting, cleansing itself of the fat that accumulated, and it is a long-term process that will take many years to complete.

Click Play to Listen to Bill Gross’ Investment Outlook:
Download audio file (Investment_Outlook_Podcast_07_09.mp3?WT.cg_n=PIMCO-US&WT.ti=Investment_Outlook_Podcast_07_09.mp3)

Here are some of the highlights from the letter, which you may download here:

Gross re-iterates the “New Normal” - Its starting to sound a lot like “The Emperor’s New Clothes“:

Our economy’s lights, if not switched off in a rehash of the 1930s Depression, have certainly been dimmed in a 21st century version likely to be labeled the Great Recession. Much like John McSherry, U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be. Now, however, with financial markets seemingly calmed and an inventory-based recovery in store for the balance of 2009, there is a developing optimism that we can go back to the lifestyle of yesteryear. PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past.

Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking.

Others are starting to wonder about the emperors new clothes, the “green shoots”:

I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, “How do you put together a consumer economy that works when the consumers are out of work?” That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an “old normal.” As unemployment approaches 10%, what is less well publicized is that the number of “underutilized” workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model.

Fifteen Words to describe the era that led us to our current economic crisis:

The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in fifteen words our most recent brush with irrational behavior and inefficient markets. Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum. The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Global estimates are less reliable, but certainly in multiples of that figure. And when potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one that predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3½%. There’s no magic in that number, and no model to back it up, just a lot of commonsense that says this is how people and economic societies behave when stressed and stretched to a near breaking point.

Where do we go from here:

Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the U.S. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk. Investors should stress secure income offered by bonds and stable dividend-paying equities. Consumer Cuisinart consumption is a relic of the past.

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those “make or break” decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or “quantitative easing” as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that “less bad” doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Source: Plexus Asset Management (based on data from I-Net Bridge)

Not surprisingly, a strong historical relationship exists between the Barron’s Confidence Index and the S&P 500’s 12-month rate of change.

Source: Plexus Asset Management (based on data from I-Net Bridge)

The improvement in the Barron’s indicator augurs well for the outlook for equities - specifically for the return of confidence - and provides further evidence that US stock markets are in all likelihood mapping out a base development formation. However, in the short term I still maintain it is quite likely that markets could consolidate further and possibly retrace more of the prior gains.

Rosenberg, one of the most highly respected market economists, is considered by many to be an ultra-bear. However, we found it notable that upon his departure from Merrill Lynch, where he was the Chief North American Economist, Rosenberg said the transition to a buy-side firm, would be an interesting change of pace for him, where the focus tends to be longer term.

“The sell-side firm desperately needs a bull market and the buy-side firm really just has to be on the right side of the trade,” he said.

Generally, Rosenberg believes that investors would be far better off from a risk reward standpoint owning fixed income securities (farther down in the article).

Here is today’s summary, but you can subscribe to his daily notes including the one below in order to see the complete note.

“OH SURE, THE RECESSION IS OVER”

Summary by David Rosenberg, July 2, 2009

Today’s employment report had deflation thumbprints all over it. And you don’t have to take my word for it – have a read of San Francisco Fed President Janet Yellen’s speech on June 30th when she dared to utter the “D” word. And that was before today’s payroll release which contained disturbing signs of weakness on many fronts.

The headline came in at -467k compared with -350k consensus and the back revisions were negligible (+8k). At no time in the 1990 or 2001 recessions did we ever come close to seeing such a detonating jobs figure, not even at the depths of those downturns, and yet we have a whole industry of ‘green shoot’ advocates today telling us that the recovery has already arrived. As always, the devil was in the details. In almost every industry, job losses were deeper in June than they were in May. The diffusion index fell to 28.6 from 31, which means that nearly three-quarters of the corporate sector is still in the process of shedding jobs. The Household Survey showed a 374k job decline, and all centered in full-time jobs. In fact, we have lost a record 9 million full-time jobs this cycle, more than triple what is normal in the context of a post-WWII recession, with over 2 million pushed onto part-time work (and the number of people now working part-time because they have no other choice due to the weak economy has more than doubled).

This in turn has take the total hours worked in the private sector down to a new record low of 33 hours from 33.1 hours in May – in fact, what this means is that if companies had kept hours worked at May’s levels, then to achieve the same labour input that they achieved would have required a 800,000 job slice! Just to put the entire labour market picture into a certain perspective.

When we say that deflation has gripped the labour market, we are not exaggerating. Average weekly earnings – the proxy for wage-based income – fell 0.3% in June and have been flat or down in three of the past four months. During this interval, they have deflated at a 1.6% annual rate – versus a +1.8% trend a year ago and +5.2% two years ago.

Here, courtesy of Zero Hedge are Rosie’s Rules to Remember, which he issued upon his departure from Merrill:

Rosie’s rules to remember:

1) In order for an economic forecast to be relevant, it must be combined with a market call.

2) Never be a slave to the data – they are no substitute for astute observation of the big picture.

3) The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.

4) Fall in love with your partner, not your forecast.

5) No two cycles are ever the same.

6) Never hide behind your model.

7) Always seek out corroborating evidence.

8) Have respect for what the markets are telling you.

9) Be constantly aware with your forecast horizon – many clients live in the short run.

10) Of all the market forecasters, Mr. Bond gets it right most often.

11) Highlight the risks to your forecasts.

12) Get the US consumer right and everything else will take care of itself.

13) Expansions are more fun than recessions (straight from Bob Farrell’s quiver!).

And here in his note from May (a very good read in its entirety, and still highly relevant and timely - again, courtesy of Zero Hedge), is where Rosenberg urges fixed income securities:

Our preference is to stick with fixed-income securities

Be careful about jumping into the stock market with both feet after this monumental rally. Consider whether or not it would be more appropriate to take advantage of the run-up to reduce equity exposure. Our preference is to stick with fixed-income securities, which we believe will work much better from a total return standpoint, as they did for years after the economy hit bottom back in the early 1930s. When we are finally coming out of this epic credit collapse and asset deflation, we should expect that the trauma exerted on household balance sheets will have triggered a long wave of attitudinal shifts toward consumer discretionary spending, homeownership and credit. The markets have a long way to go in terms of discounting that prospect.

Click here or on the table below for a larger image.

The gains/declines mentioned above are all in local currency terms. However, converting the movements to US dollar shows a better picture for the non-dollar countries (see table below).

Click here or on the table below for a larger image.

• There have been 600,000 jobless claims consistently over the last 20 consecutive weeks.
• The pace should slow to 350,000 to 400,000 job losses for now.
• Companies have let go 8 million full time workers - 2 million of those were put on part-time.
• The work week at a record low of 33 hours.
• Therefore, even if the green shoots are real, what you’ll see is part-timers being upgraded back to full-time, and their hours raised by their employers and so the traditional 100-150,000 new jobseekers who come into the labour force each month - I got bad news for them - no jobs.
• We are going to have the mother of all jobless recoveries, and the unemployment rate will make new post WW2 highs throughout the process.
• The market has priced out a recession, and priced in a recovery for the 3rd quarter - its possible that we may show positive GDP by then, its possible to see some re-stocking eg. we know that the auto production schedule is picking up…
• But, we also know that restocking that is not coupled with an increase in consumer demand is not sustainable, so I think that its possible to have a factually positive 3rd quarter.
• My concern is the 4th quarter - I think we’re going to have a relapse in the 4th quarter of what we had in 2002 - we had a gargantuan rally in March of 2002, bonds sold off, it was all good, fiscal reflation, the Fed cut rates doing its job, inventory restocking, infrastructure - none of that happened.
• We had to wait a full year for that - and in the mean time we had a gargantuan credit cycle.
• The market will retest previous lows - that would be normal - but its going to be earnings - so far this market has been P/E multiple driven.
• Now, earnings have to come through.

Click play to watch:

The table below shows the performance of the Index in 15 complete economic cycles since 1921 and part of the current economic cycle. The performance has been broken down into five phases of each economic cycle: early expansion, middle expansion, late expansion, early contraction, and late contraction.

Interestingly, the average and median figures show that most of the stock market performance occurs in the early and middle expansion phases, and in the late contraction phase.

In order for this study to be of use one obviously needs to know where in the economic cycle we are. In this regard, Merrill Lynch (again via US Global Investors) has just published The Global Wave indicator, which quantifies trends in global economic activity. This measure signaled a downturn in September 2007 and troughed in June, suggesting that the global economy could be on the road to recovery. Following troughs in The Global Wave, global emerging markets tend to be the best-performing category with a median return of 39.6% over the subsequent 12 months, whereas the US usually lags with a more pedestrian 10.0%.

Based on past economic cycles, the above studies indicate a favourable environment for stocks over the next six to 18 months, short-term corrections aside.

Source: US Global Investors - Weekly Investor Alert, June 19, 2009.

“The term ‘green shoots’ appears destined to go down in history with other unfortunate themes such as ‘a goldilocks economy’; ‘it doesn’t matter if internet companies have no earnings’; ‘high P/E ratios don’t matter’; ’subprime loans aren’t important’; ‘foreign economies have decoupled from the US’; ‘there’s plenty of liquidity’; and the classic ‘home prices never go down’.

“Whenever a herd of investors latches on to a popular theme, that theme most often proves to be wrong. So far the ‘green shoots’ theory merely signifies that the economy is declining at a slower pace after the global credit crisis that emerged last fall. From this point we will see either continued recession or a recovery so weak it will still seem like recession.

“The key factor to consider is that the current recession was caused by a credit crisis following an artificial boom and therefore bears more resemblance to the great depression following 1929 or Japan after 1989 than it does to the series of recessions experienced in the post World War ll period.

“After the collapse of the dot-com boom in 2000 to 2002 the Fed held interest rates at historically low levels for an extended period of time, and with the help of lax mortgage standards, complex securitized financial instruments and irresponsible ratings agencies, fostered a climate that resulted in a massive housing boom. Households were able to cash out their vastly increased home values through refinancing and home equity loans that allowed them to spend freely and reduce their savings even though wage growth was exceedingly sluggish. The consumer boom also led to the global buildup of capacity to satisfy the demand that was artificially induced by the free flow of credit that was mistaken for an abundance of liquidity by most economists and strategists.

“Now the piper must be paid. Despite the deep recession to date, the consumer is being forced to adjust to a far lower level of spending. When that level is eventually reached the economy can again grow in a robust manner, but we are not near that point now. The massive fiscal and monetary stimulation put into effect over the last nine months has mitigated the credit crisis and prevented a global collapse, but has not avoided the need for the economy to readjust to a new set of circumstances. We are still faced with historically high debt levels, a low household savings rate and a subdued housing industry. Reducing debt and getting the savings rate up will take an extended period of time.

“Furthermore, as a result of reduced consumer spending there is also an excess of capacity that will impede capital expenditures as well. And let’s not forget that foreign nations that have become dependent on the US consumer for growth (read China) will have to find another way.

“To briefly illustrate the nature of the adjustments ahead, consider the following. From 1955 to 1985 consumer spending accounted for between 61% and 64% of GDP. On March 31, this percentage had risen to 70.5%, an amount that is unsustainable given the artificiality of the boom that caused it. For the percentage to drop to a more traditional 65% of GDP, spending would have to decline by 7.8%. While this will not happen all at once, it will be a drag on consumer spending for some time to come.

“Similar reasoning is applicable to household debt and savings. Household debt has averaged 55% of GDP over the last 55 years and was still at 64% as late as 1995. It has since soared to 100%, giving a big boost to spending. Even if debt remains at a high level the absence of any further increase takes away a significant past source of growth.

“The household savings rate mostly stayed in a range of between 7% and 11% of consumer disposable income in the decades prior to 1992, and steadily declined to around zero by 2008 before rising to 5.7% in the current recession. In the absence of rising home values and the virtual disappearance of mortgage equity withdrawals that, at its peak, accounted for an annualized 12% of consumer spending, the savings rate could easily climb back to more traditional 9%. This would be yet another drag on spending.

“All in all the recession we are now experiencing is not a typical post-war decline, but the end of an era, and getting the economy back on its long-term growth trajectory will take an extended period of time. For the stock market this means a reduced level of corporate earnings and subdued P/E ratios. In this light we think that the big earnings increases forecast for 2010 are far too high. It is likely the recent rally has gone about as far as it can go without some proof that the economy can recover at a strong pace, and we think that this proof is not likely to come anytime soon.”

Source: Comstock Partners, June 25, 2009.

Here is the introduction:

“Barry Ritholtz is not a man to mince words. For one thing, he doesn’t have time. Writing is a sideline to his day job as CEO and research director of FusionIQ, an online quantitative research firm and money manager, running about $100 million, long and short, mainly for high net worth individuals. Besides, as the proprietor of a popular financial blog, The Big Picture, he has been chronicling the foibles and follies of financial man for a number of years now and well, just doesn’t suffer fools. His readers know him for clear explorations of even the densest of topics and for honest vitriol when he comes across self-dealing and worse.

“There is plenty of both clear prose and pungent language in ‘Bailout Nation’, as it explores, in gory detail, where we’ve gone wrong in finance and in society. Not to mention who done it.

“My time between its pages left little doubt that Barry, whose legal training at New York’s Benjamin N. Cardozo School of Law focused on economics, anti-trust and corporate law, has more than a few ideas about what should be done.

“So when the unveiling of the Obama Administration’s regulatory reform proposals left me asking, ‘Is that all there is?’ I immediately put in a call to Barry.

“I wasn’t disappointed. Listen in.”

Click here or on the image below for the full interview.

Source: Barry Ritholtz, The Big Picture, June 28, 2009.

In the months since the beginning of March, however, his thesis has been challenged by the market’s renewed embrace of inflation risk, and stocks recovered off brutal lows, as a result of the deemed “risk” trade. By April, Hendry, who is not known for being a buy and hold investor, despite his standing beliefs, reduced his positions in long duration government bonds, treasurys and gilts in the short term, challenged by yields returning to last year’s levels as the economic “green shoots” teased.

We recently posted Hendry’s June 2009 letter to investors in which he re-iterates his view on inflation/deflation, and explains in fair detail that rough waters lie ahead for stocks and commodities as a result of the markets’ over-anticipation of the effects of the whirring central banks’ printing presses. He has avoided investing in stocks for most of the last year, making almost all of his fund’s returns from owning long duration government securities.

Hendry, an avid market historian, believes it possible that we have already experienced the very inflation and hyperinflation the market fears, during the 2002-2007 period where creditor nations (BRIC) amassed enormous forex reserves in the trillions, while gold broke out of a 27-year trend and oil skyrocketed to $147 per barrel. In yesterday’s interview, he also points out that during in the last 7 years the US dollar lost 40% of its value, an occurrence which is often overlooked or underplayed, but that he calls unprecedented. He explains this view in yesterday’s CNBC interview. As usual Hendry’s clarity on the matter is enlightening, as he has a mastery of the complexity of currency effects arising from carry trades and currency crosses.

One year ago, Hendry warned the Hungarian finance minister that the Hungarian economy, and others like it in Eastern Europe, which were financing their growth with Yen and Swiss Franc crosses and/or carry trades, would be unable to keep up with the spectre of cyclical currency fluctuations which could rapidly destroy the monetary liquidity they were awash in during the “strong Euro” era.

Click play to watch the June 29, 2009 interview:

CNBC: Fears about inflation and hyperinflation could create another economic downturn, bigger than the one the world went through, Hugh Hendry, chief investment officer at hedge fund Eclectica, told CNBC Tuesday.

The stock markets are due for a correction after having risen dramatically this year, but this is not likely to come in the summer and another rally is possible, Hendry, who said he was remaining risk-adverse this year, told “Squawk Box Europe.”

“We have a huge intellectual conviction… that this is a more profound downturn that we’re experiencing and markets will be under pressure,” Hendry said.

“People get more get more concerned about government debt… and it sows the seeds of its own destruction,” Hendry said. “We’re actually tightening the screw, we make monetary policy tighter and tighter.”

Long-term yields on government bonds have been rising, as investors fear central banks, especially in the US and the UK, will have to absorb excess liquidity from the system and raise interest rates to fend off inflation once an economic recovery takes hold.

“I think this paranoia today that inflation is happening today I think it puts in place a motion for a decline in the economy,” Hendry said. “I think they’re not printing enough money… with regards to the wealth destruction that has been happening over the past 18 months.”

“We raised interest rates and actually we killed the golden goose,” he added.

Stock Market Correction

A correction in the stock market is likely, but it will not come over the summer, and the S&P 500 index may even hit 1,000 before the downturn, according to Hendry, who admitted he is not stepping in to catch the tail of the rally.

“It’s kind of fun watching it from the sidelines, I must say I’m not participating,” he said. “My flower opens in the winter, not in the summer.”

There is a tight correlation between the oil price and the Chinese currency, the yuan, with oil prices rising as the yuan was strengthening, Hendry said. This is because Chinese speculators had borrowed in dollars as the yuan firmed, and all that liquidity was thrown into the oil market last year.

“The one non-confirmation in the world is that, since July, the Chinese currency has done nothing, it was flat vis-à-vis the dollar,” he added.

Hendry said he still prefers conventional government bonds, and admitted they were the cause his fund was 3 to 4 percent down on the year. But, he added, government bonds were down 20 percent – although he doesn’t think they will end the year like this.

China and other countries with a current account surplus are not as safe as they seem at first glance, because their economies are still hugely dependent on exports to the US, which is still “down on its luck,” he said.

“If that’s the case, the last place you want to be is the surplus countries,” Hendry said.

Source: CNBC, June 29, 2009

http://www.cnbc.com/id/15840232/?video=1167997692&play=1