Thursday, October 22, 2009

2010 outlook

I briefly mentionned PIMCO's New Normal, which is the company's secular outlook, in my last stock market comment (PIMCO is one of the largest bond management companies). Here are some some excerpts from their latest cyclical outlook. I will then criticize one of their points, well, because it's by bettering the master that one becomes a master... (already attempted here and here).

Here is their cyclical outlook:
Consider the notion of an “escape velocity” for the economy – a forward movement that is significant enough for a sustained economic expansion to set in. There are three contributors. The first is the unprecedented amount of global fiscal and monetary stimulus. This is now in play in a big way. The second is the inventory rebuilding cycle, which is starting to take hold. While these two factors are necessary for reaching escape velocity – and are very much in play, contributing to seemingly robust growth numbers for the third and fourth quarters – they are not sufficient. We also need sustainable private sector demand.
In PIMCO’s Investment Committee deliberations, Bill came up with an analogy of a rocket, which has fired two boosters but needs to fire a third in order to escape the earth’s gravitational force. That third booster, which is the final component necessary to achieve escape velocity, has to come from a source of private demand: either consumption, investment or exports.
When we look at the extent to which the major economies, especially the U.S., are challenged by their balance sheets right now, we are not yet expecting that the third booster is going to fire. As a result, we question the expectations in the marketplace for a V-shaped recovery.
I am holding back on using my model to compute 2010 GDP forecasts until next week (I am waiting for the Q3 GDP release), but for now it does paint a similar picture: relatively "strong" growth (around 2-2.5%) in the next few quarters, followed by a drop later in 2010. But more on that next week. What I want to talk about now is the following, from the same PIMCO piece:
The extraordinarily low fed funds rate has pushed money out of low-risk and “risk-free” assets into higher risk assets, which has led to the bounce in asset prices.
This is a classic rookie mistake which has me thinking that maybe Gross and El-Erian (the PIMCO heads) didn't write that piece themselves, but rather had an intern do it for them (I should have his job). You see, there is no such thing has money flowing out or into anything. Consider this: one day, the whole earth population wakes up and decides to buy (flow into) equities. Well if the transaction is to take place, someone has to sell equities to them, and will thus necessarily flow out of equities. And this, by the exact same amount of money. Another way to say this is that supply equals demand, always. To go further, imagine that all this money that the buyers spent on equities was previously in money market funds. When they sold these money market funds, someone had be there to buy them: in the end, no net amount of money whatsoever has left the money markets. What can change though, is the price at which buyers and sellers can agree to make the transaction, which depends on their respective eagerness to hold (or not hold) equities.


  1. Rafael, have you ever seen transactions actually taking place on a screen? Markets move in response to news but also supply/demand. Trust me, or ask any trader.

  2. Piotr, I am not saying otherwise. All I am saying is that prices need to adjust so that at each transaction, supply equals demand. If not, then no transaction would take place.

    I am not an economist so I cannot make a mathematical proof for this but it seems pretty straightforward.

    You can read John Hussman (2006) "There's no such thing as cash on the sidelines" for a more detailed explanation (