Pimco says 'era of Fed watching' is over, government stimulus must take over to save bull

Published Tue, Oct 25 20162:36 PM EDT

Tony Crescenzi, a market strategist and portfolio manager at Pimco, a global investment firm with $1.5 trillion in assets under management, believes the era of Fed watching might be over. "The bottom line is that central banks have done about as much as they can to help the economies. It's really up to the national governments to start to take the hand off and do more, because central banks, in the end, can only print money. They can't produce growth," Crescenzi said during an interview with CNBC's Mike Santoli . In this wide-ranging exclusive conversation for CNBC PRO, Crescenzi also discusses: The trajectory of rates and the effect on the market. How to jump-start the economy. Investment ideas around the U.S. presidential election. Asset valuations and investment strategy. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Tony Crescenzi is an executive vice president, market strategist and portfolio manager at PIMCO, global investment firm with $1.5 trillion under management, where he also serves as a member of the investment committee. Prior to joining PIMCO in 2009, he was chief bond market strategist at Miller Tabak and has also worked at both Lehman Brothers and Prudential Bache. Tony has written five books, including The Strategic Bought Investor and Beyond the Keynesian Endpoint. He's currently writing a sixth book about the Fed. And he joins us now here at the NASDAQ to talk about the economy-- TONY CRESCENZI: Hi, Mike. MIKE SANTOLI: the Fed, interest rates, the markets. Tony, thanks for being here. TONY CRESCENZI: Thanks for having me. MIKE SANTOLI: Let's start off with this notion, it seems kind of provocative when you say it out loud, given that we've been fixated on central banks and what they might do for years now. But you say the era of Fed watching might be over? Why would you say that? TONY CRESCENZI: Well, think about it. The Fed has acted in terms of making a change to monetary policy only once in three years. There was this taper tantrum in 2013, where markets were fearful the Fed might reverse its policies, its highly accommodative monetary accommodation. And it did, of course. It stopped its bond buying. But since then, all it's done is raise interest rates just once, raising it a quarter of a percentage point. The forecast is the Fed that it will do very little. And the same for the European Central Bank and the Bank of Japan, as an example. So for the Fed, markets think the Fed will have its policy rate at about 1.25 percent or so in the year 2020. And today, it's only about 0.4 percent taking the middle point of the range it targets. For the ECB, the European Central Banks, markets are priced for the negative rate it has in place today to stay negative through 2021. Same for the Bank of Japan. So when we're watching these central banks, what are we really watching? They've already done about as much as they can do. And so, that changes the focus from central bank dominance to potentially fiscal dominance, where we all hope government starts to get into play. So the bottom line is that the central banks have done about as much as they can to help the economies. It's really up to the national governments to start to to take the hand off and do more because central banks, in the end, can only print money. They can't produce growth. MIKE SANTOLI: So-- but if central banks are going to be doing little in terms of the number of moves or really how high rates might go from very low accommodative levels or negative levels, doesn't that maybe raise the suspense of when they might do something or kind of make each potential move a little more important, at least in the short term in the market's mind? TONY CRESCENZI: You're correct. And there's lots of discussion and market movement and volatility based on near term movements in the marketplace. Rate relative to what the Fed will do or this ECB or the Bank of Japan. But markets-- and probably because of the Fed's communications, focus more on the path of interest rates, those long term views where the policy rates are expected to stay low for quite some time. And so, when markets are thinking about the upcoming rate move, if there is one, and there is one, that many suspect will occur in December, December 14th when the Fed meets during that month, markets will take it in stride, as they did to some extent last year. But I'm gonna go back to that in a second because they'll be focused on where the policy rate will be several years from now. And markets will say, "Well, we're not too worried because here's the height, but there may not be another one for a while. This was the first in a year. So let's not worry about it." Now, all that said, in 2015 when the Fed raised interest rates, there was worry. But at that point, markets didn't fully understand that it should focus on the path, in part because the Fed at the time was projecting that it would raise rates in 2016 four times. Here it is, they'll likely raise rates only once, if that. So markets are more suspect about the idea that rates will go up meaningfully. And so, they take rate increases in stride. So there'll be near term volatility when there's a feeling that there could be a change. But no meaningful, lasting volatility unless it's a feeling about the path. That's the key for 2017. Will there be a change in the view about the path on rates, which is currently B9. MIKE SANTOLI: Yeah. And I guess even some of the preconditions, what was going on in the markets around the time of that December rate hike, they don't necessarily seem to be present right now, right? Whether it comes to, you know, the Chinese currency, emerging markets currencies and then building all that in with that expectation of potentially four moves-- TONY CRESCENZI: Well, that's-- MIKE SANTOLI: --by the Fed. TONY CRESCENZI: Mike, that's really important that you mention that because last January, this past January, 2016, there was a, you know, a 10 percent correction in the U.S. stock market. Four-- five months after, there was another 10percent correction. Both times related in part to the Chinese currency moving downward and fear of big outflows from China and instability globally from China, which has become a very big part of the global economy, being the biggest contributor to global economic growth in recent years. A $10 trillion economy that grows 7 percent is $700 billion of new GDP, whereas the United States growing at 2 percent only sees $350 billion of new GDP. So it's a big deal. So there was a worry about China at the start of 2016 in part because of the Fed and this worry that the Fed, by raising rates, would put downward pressure on emerging markets nations and partly China, because higher rates in the United States are a problem for those nations. And so that precondition doesn't exist this year. One final point. There was a G-20 communique, a group of 20 nations got together in Shanghai the end of February and they said, "No more currency wars," essentially. This is what Jack Lew, the U.S. Treasury secretary said the communique essentially told us. "There would be no more currency wars. Don't worry about nations moving interest rates and policy around to move their currencies in ways that draw in exports from other nations." So that G-20 communique, still in place and the spirit of it still in place. A very important force in in creating stability in 2016 that likely persists into 2017. MIKE SANTOLI: So let's get I guess to maybe some of the investment implications to all this. If the Fed sorta doesn't feel as if it's in any hurry to get rates significantly higher over the next couple of years, the economy, you say, can't really necessarily absorb that that well. Or the potential growth is not that great. What does it mean for bond market investors and really, I guess for all sorts of investors? TONY CRESCENZI: Well, for years low interest rates and the promise or the suggestion that rates would stay low has been suppressing volatility in the markets. And, of course, this could be reflected in many ways. It could be reflected in lower options prices than normal, people refer to the VIX, for example, which is a volatility index. Lower interest rate volatility than otherwise. Low interest rates. But low interest rates, what it has done is compelled investors globally to move outward along the spectrum 'cause they're not fearful of higher rates, so they look to move to these riskier instruments, believing rates will stay low. We wouldn't say the gig is up in that trade. The glue that keeps it together though is continuous economic growth. One has to be confident that there'll be enough growth to supply cash flow to companies to pay dividends, to grow earnings, to pay a bond investor his or her or its interest. And, of course, principal back. And so the theory of moving out along the spectrum only holds up if there's continuous economic growth. So we think that'll persist and that's good. But be somewhat careful now, we would say. We would be overweight on credit and believe that equities will continue to move upward over time. But be somewhat more cautious and guarded because the movement in markets from central bank activity is exhausting itself. And they're waiting for a hand off to fiscal authorities globally to promote growth and before they really get more confident again. MIKE SANTOLI: Yeah, that is a big, obviously, topic of discussion in terms of what fiscal response we might get, what we should get, and what it would mean for maybe giving an extra tailwind to develop world economies. Do we think politically it can happen? Do we think that-- what would the effectiveness even be for some of these fiscal-- TONY CRESCENZI: Well-- MIKE SANTOLI: --programs? TONY CRESCENZI: It's vital that national governments get involved because central banks, they can't educate people and they can't invest in the economy. And so, here's a statistic that matters. It's on productivity. The word I use, it'll sound boring, it's a number that economists will commonly say. But a nation's standard of living is defined by changes in productivity. The more productive we are, the more that we could do per hour to build cars and computers, et cetera, et cetera, the better our standard of living will be. Can a central bank do anything about that? No. Now, there're two main sources of productivity. It's people and stuff, as I'd call it. That's infrastructure, it's plants and equipment and software, things of that sort. But the third element in the productivity story is how it all gets used. Economists call it total factor productivity. So it's people's stuff and how it all gets used. That's what boosts productivity. In the last five years in the United States, productivity's gained only 0.5% per year. Normally grows at 2%. And the short fall means we have weaker economic growth. And so, where-- why is it that productivity is so weak? In the data, it shows the people part's pretty good. How we use people and stuff is pretty good. But the weak part's the stuff part. People couldn't just simply drive around and see that infrastructure is not looking so great in America, et cetera, et cetera. We haven't been investing much in the nation. And therefore, we're not not-- can't grow as much. Here's a good example really quick. In the 1950s, the U.S. undertook a project to build an interstate highway system. 50,000 miles of roadway. Roads that we, you and I, still use today-- MIKE SANTOLI: Sure. TONY CRESCENZI: --despite this being built near 60 years ago, over 50 years ago. There're benefits to society from investing that last. In 2009, as a contrast, 60 million checks went out to individuals for $250. Money that was probably spent, going to dinner, clothing, things that have very short term impacts. So politicians have to start thinking about the long term implications of the spending. And that's something that hasn't been done in quite some time. So both sides of the aisle will have to do that. And we would think that they might. There is some support for that. It's a long answer. I don't know. MIKE SANTOLI: Yeah, no, it's-- obviously, there's a gap there, right? And so, the obvious thing I guess would be for governments to try and step in in that matter. Of course, we just don't know politically if it can happen, how big a program and how well targeted it might be. But it's certainly the next step, I'd say-- TONY CRESCENZI: And we would say both sides of the aisle favor some form of infrastructure spending, some re-engagement on the spending side. But there'll be limits in part because no matter who wins, it's likely that neither party will have a 60 seat, filibuster proof majority. Which is another way of saying be very difficult for any president to push through something big because he or she would not have enough support in the Senate to push through something big. There'll be someone ready to block it with a filibuster, unless the party has 60 seats. But it's widely expected that neither party will have 60 seats. And so, whatever we get, we'll probably water down. But there'll be something. Both sides of the aisle want something. And also, corporate tax reform. And maybe immigration. These are forces that can help economic growth over time. And so there will be a little bit of a shift. And the same goes for Japan. It's moving from central bank dominance to fiscal dominance. And it could be helpful for the world to see more growth there. And China looks stable for the next year. So it looks like an okay 2017 right now. But the key, the United States is probably going to be the epicenter of change, perhaps in terms of fiscal thrust, which has been missing for a while. And it's probable we'll get something. MIKE SANTOLI: I wonder what some of this might mean for the inflation outlook. You're starting to see some bubbling up of expectation that maybe inflation can pick up a little bit. We saw some recent number that said, "Not yet," in terms of headline consumer price index. But if you have Fed Chair Janet Yellen suggesting they can "Let the economy run a little hot for a while" and have inflation maybe go above its target, is that a theme that's gonna be emerging in the next year or so? TONY CRESCENZI: Well, the fear of inflation is, of course, quite low. It's reflected in inflation protected securities sold by the U.S. government. In those securities is a ten year maturity. Markets are priced for the inflation rate to average over the next ten years about 1.7 percent, 1.65 percent. That's pretty low. It's lower than the current CPI, which year over year for core prices, which is all prices minus the volatile food and energy components, those are up a little over 2 percent. And so, markets are saying that inflation will run below what we're seeing in the core prices so far. But Janet Yellen in August in the Jackson Hole Summit Annual Symposium hosted by the Kansas City Fed, in her speech about the economy, she said in the last paragraph before her conclusion that, "If there were increases in productivity, in other words, if the nation saw more growth, that it would lead to a higher average level of interest rates." This leads into your inflation question because what she means is if there's more productivity, there's more earnings for company, more money to pay to people, so hourly earnings would rise and wages, etc. Wages and salaries. There'd be more spending in the economy. And that would boost the inflation rate. And, as she said, it would boost the average level of interest rates. And so, it is important, this productivity outlook, for inflation rates. Probably would boost them, oddly, even though it's-- historically, you can't actually bring them down. But if productivity's boosted enough to lift aggregate demand, spending on goods and services, that would help to boost the inflation numbers. And there would probably be somewhat higher level of interest rates. And markets are priced for just one rate hike by the Fed through 2017. One and a half, call it. So it probably would mean something closer to three, in our opinion, if in fact there is a little bit of a pickup in productivity in 2017, which we're betting on right now. MIKE SANTOLI: Do you think that markets are either-- are complacent about that? Are they correct in basically not expecting inflation to get away from us? I mean, I guess I'm trying to get at just asset market valuations and what's embedded in them right now. TONY CRESCENZI: Is it complacent? In all models which we produce today, in fact, by a colleague of mine, who's a former NASA scientist, Nick Johnson, great modelist, very easy for many forecasters on inflation to look outward about one year. It's complex. I can't do it but my colleague can and members of his team. It looks like the inflation rate will probably hold stable, steady in the next year, for the core prices. The headline inflation, which is about 1.5% year over year today probably get into the low twos. Similar to the core prices, all prices minus food and energy. But we think it'll be stable and probably 'cause there's been a pickup in prices this year from the housing sector that we think will simmer down a little bit. The rental component. And that's 40% of the CPI. And so, there're many forces pushing it up and down. But probably not complacent markets now. But there may be-- some are complacent about how low inflation will stay. But very right, we think, to think that inflation will be largely stable, especially in the United States and globally. MIKE SANTOLI: Big debate, obviously, also has been about just how much of these effects, either chronically low productivity that we've seen, but also maybe some short falls in demand and even labor force productivity is about demographics, is about long term structural factors, or is about the nature of this cycle. How do you pull those things apart? TONY CRESCENZI: Well, it's a little bit difficult to look through the employment data to figure out how much of it's structural, versus cyclical. But not that difficult. One could look at-- we know the baby boomers, and including me, those of us born between '46 and '64-- take a guess which-- from '46 to '64, hopefully, you'll say '64. But there're a lot of us. And so, we can quantify how many of us might retire. So baby boomers began retiring, or you could say hitting 65, not all retire, in 2011. So we can pretty much quantify how many people are likely to retire because they've reached a certain age. And then look at how many people have left the labor force for other reasons. And it is quantifiable. It does look like there aren't that many left. There was-- it's another way of-- long way of saying it's the-- there's been a structural decline in the participation rate that likely persists into the 2020s because of baby boomers retiring. But, because of the crisis in 2008, many people left discouraged. And you can quantify that amount. It's maybe a million workers or so left. It's hard to really say. And many more could be pulled off the sidelines, but probably won't. But a lot has occurred in 2016. Janet Yellen's referred to this. This pick up in the labor force, participation. People seeming to show that they're encouraged about their job prospects again has given the economy more room to run. It's actually good news because the more people are available to work, the more it reduces inflation pressures because they're ready to work and fill demand for goods and services that companies want to meet. And therefore, it keeps inflation pressures down. So it's a good story, but it's running outta room. And so, we are close in the United States is to full employment. That's just reflected in rising wages, which is a good thing. MIKE SANTOLI: Sure. You mentioned earlier, just in terms of, you know, investment strategy, to kind of remain committed to credit. So basically corporate debt and things like that look like they're okay at this point. And equities seem like they're okay. But maybe with, you know, kinda keeping it on a short leash. I mean, how would you characterize what we have to be careful of as we look out at the environment as it develops? TONY CRESCENZI: So we would recommend being overweight in credit. But we wouldn't say just, "Load up the boat." It's too easy a thesis to say, "Rates are low, so buy everything," 'cause the glue that keeps it together, as I mentioned, is continuous economic growth. But one does have to leery that certain prices are being driven too extensively by central bank dominance. And that who knows, at some point, things could change. And so, we're moving up in the capital structure, having more bonds with structural seniority. Which is to say we'd be first in line if there were a problem with certain companies, in the high yield market, looking for shorter dated maturities so that if there is a widening of credit spreads, if things change, well, at least we'll have short maturities. And we'll still self-liquidate, so to speak. So as we get closer to maturity, they kinda just go away. So we're being careful about that sort of thing. We want high asset coverage in the bonds that we have. And looking for more structural trades, versus to say rely on the strength of the organization. PIMCO and others have-- can do the same sort of thing. What are your strengths as a manager? And we have a big credit team and a big mortgage credit team and can look at securities, scrub them for us. So good (UNINTEL PHRASE)-- MIKE SANTOLI: So look kind of issuer by issuer and-- TONY CRESCENZI: Yeah, it's grinding-- MIKE SANTOLI: --and bond by bond-- TONY CRESCENZI: --it out. Grinding out the often structural trades though go beyond that. It's macro. There's five big risk factors that PIMCO likes to look at. It's duration, the interest rate sensitivity. It's the yield curve, it's credit, volatility and foreign exchange. And there're structural trades to do. So, for example, in the yield curve strategies, we're careful to be in-- we'd rather be in intermediate maturities. Call them five, six, seven year, than a third year, historically. Makes sense because a five year in a year becomes a four year. It rolls down the yield curve. And typically, five year maturity'll have more yield than a four year. So the yield will fall enough that it'll lift its price more than a 30 year maturity becoming a 29 year. So that's a structural trade. And things like that. And also volatility, one other example. It pays over time to sell volatility, to sell insurance to those who want to buy insurance in the world against various things like interest rate movements and credit movements. A good example is after Brexit, there was a lot of fear in the world. The world wanted to buy insurance against a widening of credit spreads. PIMCO sold insurance to these entities and in good size. And, of course, those fears were unfounded and we collected the premium. So it pays over time to be short volatility because those who want insurance, and that's what they do. They buy options for insurance usually are willing to overpay for that, as you would maybe for a car or for a home. You want a little more insurance. And so that's a structural trade. So to sum it up, for certain strategies, this can yield 30-40% of total returns in a Barclays aggregate styled portfolio. It can be a big part of returns, and has been over time, to be in these trades that are just smart in terms of bond investing. So that's one of the things we're trying to focus on right now. MIKE SANTOLI: One of the things you're kind of clearly saying not to do, or that you wouldn't do, is to go after just the highest nominal yields, right? So that's something that's been perhaps a trap. And I wonder if that is something that, you know, is it one of those lessons that people have to keep relearning? And is it one of those dangers that's out there-- TONY CRESCENZI: They do. In fact, many people don't look at risk factors, which is to say that bond with the highest yield might have some embedded risk in it that they're not thinking about. Typically, it's equity risk. That high yield could be a high yield bond or some other bond that, when the equity market has troubles, and we know how volatile it can get relative to bonds, your bond will be in trouble. So it's very important to think about risk factors, just as equity risk. There's equity risk in some bonds, and there's interest rate risk in some equities. And so, one has to be thinking along those lines when constructing portfolios to ensure that it's very diversified because it's a risk factor thing. It's the interest, look at 60-40. It may not be 60-40 because that 40 of bonds may have a lot of equity exposure in some ways. MIKE SANTOLI: Yeah. So you have to kind of know what you're getting and that's the thing that you mean-- TONY CRESCENZI: Yes. MIKE SANTOLI: --to own, yes-- TONY CRESCENZI: And it's almost like a risk parody idea. Risk parody trades are those, of course, where they look at the typical volatility in instruments and try to construct-- MIKE SANTOLI: Sure. TONY CRESCENZI: --with value based on that-- MIKE SANTOLI: Not just what they're called, yes. TONY CRESCENZI: Right. MIKE SANTOLI: All right, Tony, thank you very much for your time-- TONY CRESCENZI: Right, thanks so much-- MIKE SANTOLI: Appreciate it. TONY CRESCENZI: Thanks for having me. MIKE SANTOLI: Thanks. TONY CRESCENZI: Thank you. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

Tony Crescenzi, a market strategist and portfolio manager at Pimco, a global investment firm with $1.5 trillion in assets under management, believes the era of Fed watching might be over.

"The bottom line is that central banks have done about as much as they can to help the economies. It's really up to the national governments to start to take the hand off and do more, because central banks, in the end, can only print money. They can't produce growth," Crescenzi said during an interview with CNBC's Mike Santoli.

In this wide-ranging exclusive conversation for CNBC PRO, Crescenzi also discusses:

The trajectory of rates and the effect on the market.
How to jump-start the economy.
Investment ideas around the U.S. presidential election.
Asset valuations and investment strategy.

PRO subscribers can also read the entire transcript of the exclusive interview below.