FINANCIAL REVIEW

Bond King Exits

Sinclair Noe — September 26, 2014

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Financial Review

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DOW + 167 = 17,113
SPX + 16 = 1982
NAS + 45 = 4512
10 YR YLD + .02 = 2.53%
OIL + .53 = 91.83
GOLD – 2.50 = 1220.40
SILV + .16 = 17.76

This week proved quite a roller coaster ride for the major indices. The Dow Industrial Average moved by at least 100 points in each of the five sessions, and finished the week down 1%. The S&P 500 climbed above its 50-day moving average today after dropping below the level yesterday for the first time since August. The S&P 500 was 1.4% lower on the week, and the Nasdaq lost 1.5% for the week. The Russell 2000 Index of smaller companies extended its September loss to 5.5 percent yesterday after dropping 6.1 percent in July.

The Gross Domestic Product increased at a rate of 4.6 percent in the second quarter, according to third and final revision on GDP; up from the earlier estimate of 4.2% growth, and up from 2.5% growth in the same period a year ago. It represents the fastest rate of growth since the last three months of 2011. Spending on personal consumption increased 2.5 percent in the second quarter, up from 1.2 percent in the first. Durable goods, such as cars, homes and electronics jumped 14.1 percent, compared with an increase of 3.2 percent in the last quarter.

The latest revision of GDP growth for the second quarter showed business investment rose 9.7% in the three months ending in June. That’s better than the 8.4% increase reported as part of the second revision of the GDP numbers, and much better than the 1.6% rate of growth in the first quarter. The improvement was broad-based. Investment in nonresidential construction was revised up to 12.6%, from 9.4% in the second revision. And investment in business equipment was up 11.2%, better than the 10.7% previously reported.

This is good news, because business investment is a big driver of demand. It’s also a crucial part of keeping an economy productive over the long term. On the flip side, it might also indicate a shorter-term rotation; as companies plow money into strengthening long term growth it means less cash for things like stock buybacks and that have helped profit growth look so strong in an otherwise sluggish economy. The gain in business inventories was little changed at $84.8 billion, a high level that could induce companies to scale back a little in the third quarter. The strong dollar could hurt exports. Business investment has generally been soft for more than 6 years now, and one quarter of a bounce in business spending might be considered an omen, but not necessarily a trend.

While the level of real gross domestic product has increased by more than $1 trillion since the beginning of 2008, inflation adjusted spending and investment by the federal government in the second quarter of 2014 was essentially unchanged from the level in the first quarter of 2008. Federal spending and investment has declined in 13 of the past 15 quarters, falling 13.2% since the third quarter of 2010. Investment outlays have dropped 20% and are now as low as they were in 2005. Real spending by the federal government has fallen for 7 consecutive quarters; in the second quarter, real federal spending and investment fell by $2.5 billion to $1.1 trillion, down at an annual rate of 0.9% from the first quarter. In the second quarter, federal outlays accounted for 7% of GDP, the lowest in 12 years.

And whatever money hasn’t been spent by the federal government is about to be spent. Defense Secretary Chuck Hagel said today that conducting a sustained campaign of airstrikes against ISIS will mean the Pentagon’s budget will have to be increased. The new commitments for Iraq and Syria have created a budget shortfall in the Defense Department’s $554 billion request for fiscal 2015, which includes $58 billion for warfighting. The request for the year that begins Oct. 1 is pending before Congress. Meanwhile, Congress is in recess until after the midterm elections.

The final September reading on the University of Michigan/Thomson Reuters consumer sentiment index remained steady at the preliminary reading of 84.6. This is the highest level since July 2013 and well above a final August level of 82.5.

Bill Gross, the co-founder of Pimco, the guy who earned the nickname “Bond King” is leaving the firm. Gross quit his job as Chief Investment Strategist; his timing was excellent because it was rumored that he was about to be fired. Bill Gross will now take his talents to Janus Capital.

Allianz SE, the German insurer that owns Pimco, slid 6.2 percent in Frankfurt trading. Shares of Janus Capital Group rallied 43 percent to $15.89 in US trading. Pimco’s Global StocksPlus & Income Fund slipped 5.7 percent to $23.67 at the close in New York, while the firm’s High Income Fund decreased 6.1 percent to $11.69, the biggest drop in 16 months. The Pimco Corporate & Income Opportunity Fund slid 6.6 percent to $17.18, and the Pimco Total Return ETF declined 0.3 percent to $108.57.

A little background: Bill Gross co-founded PIMCO in 1971. But his star really started to rise in 1987, when he launched the PIMCO total return fund. His timing was excellent. Interest rates were in the early days of a decades long decline, and bond prices were just beginning their very long bull run. Pimco and investors and Bill Gross all prospered. Bill Gross was also well known for his newsletters, or blog posts really. And for a guy who ran the largest bond fund, much of his writing seemed off-topic, even a bit eccentric.

After roughly 30 years of bond markets moving higher, things have changed recently, because inflation has fallen across the globe, and falling inflation means that fixed income securities get more valuable. But interest rates and inflation pretty much can’t go any lower, so bond funds have entered a tougher market. And although being the largest bond fund certainly conveys advantages, generating outsized returns becomes progressively harder, because your trades move the markets.

Gross’ performance at Pimco hasn’t quite lived up to “bond king” aspirations. In 2011, Gross made a very public decision to lighten up on US government bonds in the expectation that interest rates would rise. They didn’t. Last year, the bond market went through a Taper Tantrum, a fit of whining about the Federal Reserve intentions to exit QE that pushed long term interest rates up sharply for a while. Gross didn’t see it coming. Earlier this year, former Pimco CEO Mohamed el-Erian, left the company amid some public squabbles with Gross. The Wall Street Journal published a report describing how El-Erian’s previously close relationship with Gross had soured as the firm’s investment performance deteriorated last year. Then Gross told Reuters that his one-time lieutenant was trying to “undermine” him.

Leading up to today’s departure there were reports that Gross’ behavior had become increasingly erratic and relations with the Pimco executive committee became increasingly tense. Earlier this week, Pimco said the Securities and Exchange Commission is investigating whether it inflated the returns of its Total Return Exchange-Traded Fund, also managed by Gross. Gross recently sold billions in US Treasuries and bought derivatives to hedge against rising rates. Pimco says the investigation was not a trigger for Gross’ departure.

Investors pulled cash out of the Pimco Total Return fund for the 16th consecutive month in August. Sanford Bernstein said in a report today that Pimco could see withdrawals of 10 percent to 30 percent. They expect a “good deal” of Pimco clients to follow Gross to Janus. The departure raises questions about the future performance of the firm, which counts tens of thousands of ordinary Americans and major institutions including the CalPERS pension fund as investors in its mutual funds, exchange-traded funds and other products. There is some concern that Pimco may have to liquidate some positions, but the impact may not be devastating because Pimco is the world’s biggest bond fund. Still, a lot will depend on how Pimco has to sell and at what prices. Bond spreads widened this this morning as dealers prepared for redemptions, again, because being the biggest bond fund in the world moves markets.

A new report from ProPublica and This American Life says the Federal Reserve Bank of New York commissioned a secret internal investigation of itself in 2009, uncovering a culture of suppression that discouraged regulatory staffers from voicing worries about the banks they supervised. And when they got the report, they suppressed it and fired the regulatory staffers that had voiced concerns about the banks. The report covers the story of a former New York Federal Reserve bank examiner who claims she was fired in 2012, after seven months on the job, for examining Goldman Sachs a little too aggressively. Based on nearly 48 hours of secretly taped conversations among Fed officials and Goldman Sachs, the reports make a strong case that bank regulators are terrified of offending the banks they’re regulating. This suggests that, despite the worst financial crisis since at least the Great Depression and financial reform that was supposed to put Wall Street on a shorter leash, regulators still bow to banks as much as they always have. That makes a future crisis seem even more likely, with banks still able to persuade regulators that they’re not taking crazy risks.

Next week’s economic calendar includes the monthly jobs report on Friday. The August payroll gain of just 142,000 new jobs could be revised away in the September report. Looking back at the previous three years, the August payrolls change has been revised up each time, by an average of 42,000 in the second print. The September report is expected to come in around 215,000 net new jobs.

Economists think real gross domestic product is growing at about 3% in the third quarter. One expectation behind that solid rate is a narrowing in the net-exports figure that would be a positive contributor to GDP growth. The Commerce Department will report on August trade flows Friday.

Wednesday brings a report on September auto sales, probably selling at an annual rate of about 17.4 million.

Monday brings a report on personal income and the personal consumption expenditures, which is a measure of inflation. The core PCE price index has been running at 1.5%, well below the Fed’s target of 2% inflation.