Look at Credit Market, Not Stock Market

An investing environment that PIMCO calls the “new normal” displays weaker economic growth and lower returns on capital, said Mark Kiesel, ’96, managing director and portfolio manager at the firm.

In such a climate, investors should take an increasingly selective approach, he said. Earlier this year a “fire sale” was occurring in the credit markets, but now those markets are tightening, Kiesel said in a keynote speech to the Investment Management Conference November 11 at the University Club of Chicago. The student-led Investment Management and Hedge Fund groups sponsored the event.

Corporate bonds will continue to offer attractive risk-adjusted returns relative to equities, Kiesel said. “I still think money will flow into credit, but it’s going to be less aggressive.”

Despite stock prices climbing 50 percent from March 2009 lows, he said, real turnaround won’t occur until real estate prices bottom out and banks start lending again. “Banks are not lending despite the fact that the government very much wants them to,” Kiesel said. Bank lending has dropped 12 percent on an annualized basis. Supply and demand for credit is contracting.

“If you can bottom asset prices, particularly of those that banks own, you can slow down write-downs,” he said. “And then ultimately capital will be freed up to lend.”

Banks currently remain undercapitalized in comparison to regulatory guidelines. “This is not something that turns on a dime. This is like a super tank. It’s going to take years to recapitalize,” and get to a point where people want to buy a house because it’s a good investment, Kiesel said.

The financial crisis started with an asset bubble in housing. Housing in 2006 was “40 percent over value relative to rents and 35 percent relative to income,” Kiesel said. “The bad news is, it’s still overvalued.”

He doesn’t believe mid- to high-end housing will stabilize soon under tight credit and a tight job market. “What’s amazing about housing is that 90 percent of all new mortgages are pretty much made by the government,” Kiesel said. Central banks are buying $20 billion in mortgages a week, and some 6 million to 7 million homes are 60 to 90 days past due.

“Never before in history have we been in a situation where 12 million homes in the United States are under water,” he said. When people owe more than their homes are worth, “there’s a cultural change going on. People will throw their keys back.”

Kiesel said a “secular deleveraging” in financial markets and of the U.S. consumer has occurred with global repercussions. The consumer comprises 70 percent of the U.S. economy. Consumers face a lack of job and credit creation. Highly leveraged companies are at risk of default. “Never forget in investing the big-picture secular trends because ultimately those powerful sector trends guide where things go,” Kiesel said.

Emerging markets have fared better in the economic crisis than markets in developed countries. That holds true particularly for those who aligned their trade flow with China and other fast-growing Asian countries, Kiesel said.

“China is sailing through this crisis relatively unscathed,” he said. “And it had to do with the initial conditions before we had the crisis.” China’s “major shift toward infrastructure” away from exports served it well by allowing it to build foreign exchange reserves, he said.

Attractive investments can be found in high-quality bonds in such sectors as energy, metals, and emerging markets, Kiesel said.

Daniel He, a first-year student in the Full-Time MBA Program, said it is interesting that Kiesel looks at credit cycles, whereas “a lot of people look at S&P price levels.”

“The media has been covering a lot of recent good numbers like GDP growth, productivity, and industrial production,” He said. “A lot of these things have been better than what the credit picture is showing. Basically, household and business borrowing are negative, because right now they’re in a saving mode.”

— Mary Sue Penn

Read more from the Investment Management Conference about AQR Capital Management’s Cliff Asness, MBA ’91, PhD ’94, on the dangers of governmental overregulation