Midday Musings: A Chat With Paul McCulley, Part 2
When PIMCO's Bill Gross talks, prudent traders pay heed. PIMCO manages more than $250 billion in fixed-income assets, and Gross' track record is legendary. Increasingly, similar deference is being given to Paul McCulley, who works side by side with Gross as a managing director and overseer of PIMCO's short-term securities, which recently totaled $90 billion.In part two of our Q&A with the bond fund manager, we continue the discussion about inflation and delve into other areas such as PIMCO's newfound bondholder activism and General Electric (GE) - Get Report. (Part one of the Q&A can be found here.
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Task:
Those who are hawkish say you have higher oil prices, there's inflation in the service sector, if long-term rates rise that could pressure the dollar, and try to build this case we could be at the beginning of an inflationary cycle. What's your response to that?
McCulley:
Absolutely. I wouldn't vehemently disagree with the notion inflation is probably going to cyclically drift up, but there's a difference between cyclical ebbs and flows and an incipient inflation problem. Twenty years ago, life was revolving around inflation. Inflation is a cyclical variable, and don't think the
Fed
should try to outlaw all cyclicality. Over the last 20 years they loved cyclicality on the downside of inflation. That was the essence of opportunistic inflation -- take your recessions when they happen, get a disinflationary dividend, and as soon as the economy recovers, slap it upside the head with pre-emptive tightening so as to lock in the lower inflation wrought by preceding recession.
Do that enough times and you come to what the Fed said repeatedly during the 1990s: that "we're one recession away from price stability." Well, we had the one recession, and we're at price stability. Once you reach that, the Fed is supposed to let inflation show its inherent cyclicality on both sides of the business cycle. Because if the Fed stops inflation from going up and you get hit with another opportunistic recession, that takes inflation lower than you want to go.
Task:
Speaking of which, there seems less concern about it now than six months or a year ago, but there have been people who worried about a Japanese-style deflationary cycle in our economy. Do you see any risk in that?
McCulley:
I think Greenspan worries about it enough that he's willing to underwrite a cyclical increase in inflation. If you're at price stability, and then a recessionary grenade comes over the transom, it takes you lower than you want to go. There is such a thing as having a little bit of cushion there to take a shock. Greenspan has to be very careful about that, because any central banker who ever said a kind word about any increase in inflation whatsoever is presumed to be the weighted average of a boob, a wacko and a buffoon.
In actuality, in the academic field, and in the practical world, there is such a thing as needing to have some positive degree of inflation, both for corporate profits as well as relative price adjustments in a world of sticky wages.
Credit Crunch or Credit Squeeze?
Task:
You mentioned
in part one the issue of corporations shoring up their balance sheets. Do we have a credit crunch or squeeze going on right now?
McCulley:
I'm not sure if it's a credit crunch or a squeeze. What we're having is the corporate bond market and the banking market basically saying we have been too liberal in our provision of credit. The banking system and the corporate bond market together basically are saying we were underpricing credit, particularly underpricing liquidity, and if you're a triple-B company, you better term out your damn debt.
Task:
Is that realization going to inhibit the balance sheet restoration that you talked about earlier?
McCulley:
Well I think it inhibits business investment more than it inhibits the rehabilitation. If companies want to rehabilitate their balance sheet, I think the market is willing to accommodate that as long as they're willing to quit doing crazy things in their business. Meaning that you've got to start thinking hard about where you're going to spend your cash. It's the banking system, and the corporate bond market basically saying that you have to effectively generate more free cash flow, and that business plan borrowing is no longer the coin of the realm; that you do actually have to have a bona fide business that has reasonable prospects sometime in our adult lifetime of generating free cash flow.
It's a headwind for effectively aggressive corporate expansion, particularly for the triple-B sector, but even higher up. I went through how we approve companies for commercial paper in our April piece
at PIMCO.com; we're saying companies need to improve liquidity and look at commercial paper and bank back-up lines as complements, not substitutes. We want the sobering-up process to be a sober process.
Task:
That brings us to Bill Gross' recent comments about GE, and PIMCO's stance on not owning GE paper. I was wondering if you could talk about what GE has done since then, and some of their efforts to shore up their liquidity.
McCulley:
First and foremost as Bill has commented, this whole thing wasn't about PIMCO being in a blood feud with GE in any sort of way at all. It was a statement on his behalf, and on PIMCO's behalf to corporate America. GE is a triple-A credit -- Bill doesn't think it deserves a triple-A rating -- but unequivocally, GE is a top-tier credit and is an A-1/P-1 issuer of commercial paper. He was using GE as a case study in the upper tiers of credit quality of what has happened in recent years with companies levering their balance sheets, particularly to short-term debt. GE is in the process of reliquifying their balance sheet, and indeed we applaud those types of capital market structure improvements.
Again, it has never been an issue of a blood feud between us and GE. It is an activist role that Bill is taking and PIMCO is taking, which is that bond investors must be considered in the context of how companies run their balance sheet.
Within that framework we have taken strong positions not in a company-specific sort of way but in the difference between Tier-1 and Tier-2 commercial paper. I run the commercial paper desk here, and we are very rigid on the standards of bank backup lines.
Task:
Is there a particular parameter or level of backing that you would say, "OK, now we feel more comfortable"?
McCulley:
For a Tier-2
issuer, it is unambiguously that I want to bank backup lines in excess of commercial paper outstanding, and likely under program. I want 100% or more coverage on a Tier-2 issuer, which is effectively a triple-B issuer, or a A-2/P-2 commercial paper. There we are unambiguous that we want to see more than 100% coverage.
For Tier-1 we do not have a hard and fast rule. However, in the case of GE, obviously we felt that
coverage was not sufficient, and GE has agreed with that proposition and is increasing the size of its bank backup lines. They're not going to 100% coverage, but they are going in the right direction from where they have been. Within Tier-1 we have a judgmental approach, our judgment is that more is preferred to less, but we don't have a hard and fast line in the sand, whereas Tier-2 issuers we do.
It doesn't mean that we will not be involved in securities issued by Tier-2 companies, but with respect specifically to commercial paper underwriting standards, we are quite straightforward about that. It's what we call around here our "trust and verify" policy.
Task:
It seems to me from watching various interviews on television and from your comments here that you guys were surprised by the reaction that these comments about GE got. I'm wondering if you could talk about that, and the general environment where people have such a visceral reaction: What does that say about the environment we're in, and how you approach the market, given that information?
McCulley:
Bill has publicly commented in a letter to the editor at
The Wall Street Journal
that he was somewhat surprised at the intensity of the reaction to his comments. His investment outlook that just hit the Web site last week comments to the same effect.
Task:
Right. What does that say to you about the environment we're in, and how do you change your approach as money managers knowing that there is that much fear and emotionalism out there in the market?
McCulley:
As Bill has publicly said, and as a man that works beside him day by day, I know he deeply respects and honors his role in the marketplace, and knows that part of that role is as a statesman, and statesmen have to choose their words carefully. Bill is cognizant of his role as a statesman, and as a citizen in our financial firmament, and he acts accordingly. We at PIMCO are strong believers that companies need to be forthcoming, and what their game plans are with respect to their capital structure. We haven't apologized about that, and I don't think we ever will. We are lending our clients' money to companies, and we have a fiduciary responsibility, since we are acting on behalf of our clients, that whomever we lend money to pays us back.
Task:
How do you think this whole situation is playing overseas? How is a fund manager in Europe looking at PIMCO apparently taking on GE, even if that wasn't your intent?
McCulley:
I do think corporate America has to appreciate the notion that corporate transparency has some black marks on it right now, and when international investors see black marks, they don't like it. In the last six to 12 months you've had company after company restate earnings and take special charges and
witnessed a rise in the concept of pro forma earnings. Corporate America does have some heavy lifting to do to restore the proper prestige of our accounting and financial disclosure matters. It used to be when you said "documents prepared to U.S. GAAP standards" it meant more than it does now.
Task:
Is there a risk of that translating into weakness in the dollar?
McCulley:
Conceptually yes, but I would certainly not forecast it in an A-leads-to-B scenario because there're so many influences in shaping the valuation of the dollar. If you're going to list items as plus and minus, I would not put the current state of affairs in corporate America's disclosure and transparency in the plus column. You can't say one item is the straw that stirs the drink, but sentiment about the dollar is tarnished when we have accidents, mistakes and miscues.
Task:
So looking at the big picture, what is your outlook for the dollar over the next six to 12 months?
McCulley:
It really is a unique period of time in that the dollar is overvalued, and from that perspective you think of the dollar being weaker over time against the euro. At the same time the yen is overvalued, and it is bizarre to say the dollar and the yen are both overvalued. But the yen is overvalued because the current valuation of the yen creates deflationary pressures in Japan. If you look at the big three currencies, you tend to say that the euro should go stronger, and the yen should go weaker, and on balance you would like to think in terms of the dollar most likely in the years ahead is probably going weaker on a trade-weighted basis.
Task:
But it doesn't sound as if you're looking for any dramatic moves.
McCulley:
We're not looking for something precipitous. But the fundamentals would augur for a somewhat weaker trade-weighted value of the dollar, a somewhat stronger euro, and a somewhat weaker yen.
Task:
Given that outlook are you more bullish now than perhaps you had been on European corporate bonds?
McCulley:
Suffice to say that Europe is starting down the path that we did in America many years ago of disintermediating credit from their banking system to their capital markets, and their corporate bond market is in its adolescence. It is a positive structural development to have a broader, deeper, more expansive capital market that effectively intermediates credit in parallel with the banking system, as is the case in the United States. But from the standpoint of bottom-up assessment I'd defer to one of my credit colleagues in Europe.
Task:
You might answer similarly, but I wanted to ask in general where you're seeing opportunities internationally. A lot of equity investors are looking overseas, and emerging markets were the best-performing stock sector in the first quarter. Are there similar opportunities in bonds?
McCulley:
We have been publicly in favor of allocations to emerging markets' sovereign bonds, and continue to be involved in that arena. We've stressed with fists on tables that emerging markets are bifurcated, not all ducks waking in a row. Stronger credits are getting stronger and weaker credits are getting weaker. Selectivity and discrimination are critical, and we have the best in the business in Dr. Mohamed El-Erian in running that business.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.
