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“It’s been a long time since I rock and rolled” ¹
– Led Zeppelin

In December 2007, a much-anticipated and highly acclaimed reunion concert in London sparked speculation about a Led Zeppelin world tour. Will 2008 bring us Led Zeppelin’s long-awaited return to the world stage? They have not announced any tour dates yet, but many (including me!) are hoping that a full-blown Zeppelin reunion is in the works.

As recently as 2007, the markets were convinced that the bad old days of stagflation were “Over the Hills and Far Away.” ² Unlike Led Zeppelin, stagflation is no longer merely rumoured to be making its comeback. Stagflation is here, leaving many market participants “Dazed and Confused.” ³ This is a different version of the 1970s stagflation, but “The Song Remains the Same.” ⁴ Inflation in any form, combined with subpar economic growth, is no “Stairway to Heaven.” ⁵

Investors in the credit markets are wondering, “…What Can I Do?” ⁶ The current environment, which includes the housing market decline, tightening consumer credit, and weaker employment, together with rising inflationary pressures from various sources, is leaving many investors “Trampled Under Foot.” ⁷ While valuations in the credit markets have become increasingly attractive, PIMCO remains focused on high-quality investments. Let’s review this economic environment and better understand the implications of today’s version of stagflation, and the resulting opportunity and risk in the credit markets.

“Heartbreaker” ⁸
The U.S. housing market has become a “heartbreaker” for consumers. During the ten-year period from 1994–2004, the home ownership rate rose from 64% to 69% due to easy access to credit and rising confidence in the belief that housing prices could only go up. ⁹ These two trends caused housing prices to rise dramatically and, as we have written about in “Triple Play,” “Still Renting” and “For Sale,” to levels far exceeding those justified by fundamentals.¹⁰ In analysing the fundamentals, housing prices are set to fall further due to high inventories, tight credit, rising mortgage rates, overvaluation of housing versus rental property and weak employment growth.

Housing inventories are now soaring due to excess supply caused by forced selling by speculators, over-levered consumers and years of easy credit and over-building. Demand for housing is also falling sharply now that consumers have realised that housing prices can indeed fall. Today’s massive supply and demand imbalance in housing has led to price declines of 14% year-over-year (Chart 1).

Not surprisingly, housing price declines are negatively impacting the value of collateral, causing banks’ willingness to lend to consumers to fall sharply. Consumers are experiencing credit contraction not only in real estate, but across multiple sources including credit cards, auto loans, student loans and home equity lines of credit. The combination of sharp housing price declines and significantly tighter consumer credit has led to a material rise in delinquencies and foreclosures (Chart 2) as leveraged homeowners simply walk away. This trend will only add houses to a market that is already over-supplied: the current inventory of new and existing homes of 11-12 months’ supply is over twice that of normal historic inventory levels. ¹¹

In addition to tighter credit and rising inventory, the U.S. housing market faces another challenge: Longer-maturity interest rates are now rising due to increased concerns over inflation. Mortgage rates for 30-year fixed conforming are up roughly 60 basis points so far this year with current conventional and jumbo 30-year mortgage rates now at an average of 6.27% and 7.41% respectively. ¹² Higher mortgage rates reduce housing affordability. Unfortunately for consumers, housing was already significantly over-valued. Higher mortgage rates will only increase housing’s unattractiveness, particularly versus rental property. A recent study done by Lehman Brothers ¹³ concluded that at 6% mortgage rates, housing prices are 28% over-valued versus rental property nationwide (Chart 3).

In higher-priced housing markets such as New York and San Francisco, housing prices are 44% over-valued versus rental property at 6% mortgage rates. A one-percentage point increase in mortgage rates from 5% to 6% widens housing’s price disadvantage versus rental property by roughly 7–11%. Clearly, higher mortgage rates are an additional headwind for U.S. housing prices.

U.S. housing prices will likely continue to fall throughout this year and into 2009. Falling housing prices have already negatively impacted consumers’ net worth, which is now in decline for the first time in five years (Chart 4). According to Federal Reserve data on consumer net worth, real estate net worth fell last quarter for the first time in over 25 years. Continued housing price declines would be a further hit to consumer balance sheets and confidence.

Falling housing prices and tighter credit conditions are not the only “heartbreaker” for U.S. consumers. Employment growth is now heading south. Not surprisingly, the combination of falling housing prices and rising unemployment is causing consumers to pull back. Auto sales are falling sharply, and consumers have had to make tough choices, leading to less spending on non-discretionary purchases. While retail sales at discounters have slowed modestly, consumers have materially slowed their spending at department stores (Chart 5). Weaker employment, declining housing prices and tighter consumer credit virtually ensure subpar U.S. economic growth for the foreseeable future.

“You Shook Me” ¹⁴
Consumer prices are rising across the globe (Chart 6), shaking consumers’ purchasing power in both developed and developing countries. Today’s inflation shock is coming primarily from a rapid rise in food and energy prices. Why are commodity prices rising? As we wrote in “Got Energy?,” ¹⁵ the industrialisation of emerging market countries is leading to soaring global demand for resources at a time when supply is becoming increasingly scarce. This secular trend is leading to a relative price shock, causing a large rebalancing in the terms of trade, benefiting commodity producers and exporters at the expense of commodity importers.

Excess demand for commodities is also a product of government policies. There has been extensive discussion about the role of U.S. government subsidies for ethanol production in the United States. In emerging market countries, government price controls have helped encourage the strong demand growth that has helped boost global prices. Governments in many countries are now moving to reduce subsidies or lift price caps. In the long run, this should help moderate energy demand growth. But in the short run, this will contribute to higher headline inflation levels in many parts of the globe.

Monetary and exchange policies have also played a key role. Again, there is considerable debate about the role that a prolonged period of 1% short-term rates in the United States played in inflating the housing bubble. In the emerging world, a number of key countries – China being the most significant – have intervened heavily to manage the value of their currencies vis-à-vis the U.S. dollar in recent years. Doing so has required maintaining a looser monetary stance than may have been appropriate given the strong aggregate demand growth in their economies, contributing some of the seeds for future inflation.

We are now seeing emerging market countries tighten monetary policies and raise short-term nominal interest rates. However, the increases so far have been less than the increases in inflation, thus pushing real interest rates down – and into negative territory in some key countries (Chart 7). To fight resurgent inflation, some countries like China are also appreciating their currencies more rapidly. That means higher prices for countries that import from them like the United States, as global factors become inflationary headwinds rather than the disinflationary tailwinds they were for much of the time since the early 1990s.

“Over the Hills and Far Away” ¹⁶
While the U.S. economy is likely to experience subpar economic growth for the foreseeable future, a 1970s-style inflation looks “over the hills and far away.” While producer and import price trends have accelerated, inflationary expectations are, so far, relatively contained. Most importantly, U.S. labour remains a price taker in terms of its ability to gain wage increases due to weak domestic economic growth, which is leading to limited unit labour cost gains (Chart 8). Unions are far less prevalent in the United States due to increased trade and globalisation where competition ensures high efficiency and maximum cost control. Subpar U.S. economic growth and weak unionisation mean higher producer and consumer prices are not yet translating into rising U.S. wages.

The outlook for U.S. economic growth and inflation remains closely tied to trends in housing prices, wages, consumer spending, corporate profits and global monetary and fiscal policy. As long as housing prices are falling, credit availability from banks and lenders will be increasingly restrictive, leading to pressure on consumer’s balance sheets, confidence and spending. Labour will also remain a price taker in this environment, as companies cut headcount and costs. Consumer spending is set to pull back materially, as housing prices continue to fall and credit tightens. In this environment, companies will have a difficult time passing through higher input (food and energy) costs. As a result, corporate profit margins should come under pressure, particularly for U.S. firms that sell primarily to domestic consumers, as weaker top-line revenue growth and rising producer prices hit profits. Companies selling primarily overseas, particularly in emerging market countries, will see healthy top-line revenue growth, though this may soften amid efforts elsewhere to slow economic activity to rein in inflation.

“Your Time Is Gonna Come” ¹⁷
While a significant rise in U.S. inflation is unlikely given the above outlook, we cannot ignore the basic facts that inflationary pressures and risks have increased. PIMCO’s secular outlook for higher inflation, if not a 1970s-style inflation, has led us out of Treasuries and into high-quality spread sectors. For credit, the time has come to overweight high-quality investment-grade credit risk. High-quality credit spreads now look attractive, particularly versus what we believe are relatively unattractive real Treasuries yields (Chart 9). Real ten-year Treasury yields, using the year-over-year change in the core consumer price index (CPI), are under 2%. In comparison, investment-grade corporate bond spreads are now over a two percentage point pickup over nominal Treasury yields. Over the past 18 years, rarely have credit spreads been greater than 100% of real ten-year Treasury yields. With inflation risks rising and credit spreads attractive, we believe selective high-quality investment-grade credit investments should outperform Treasuries.

“Hey Hey What Can I Do” 6
The rising risk of inflation has led many investors to wonder how to navigate the current credit market environment. While our outlook is for subpar U.S. economic growth and rising inflation, we do not believe the 1970s-style stagflation, which leads to materially higher inflation, will come back. Nevertheless, there are significant risks inflation may rise faster than we are anticipating. These risks include:

• Policy mistakes by developed or emerging market policymakers that allow inflation expectations and wage pressures to get out of control.
• Developed country labour markets regain pricing power due to re-regulation, rising populist sentiment and unionisation.
• U.S. housing and credit markets stabilise, allowing for a pickup in U.S. consumer spending.
• Conflict in the Gulf Region leads to an escalation between Iran, Israel and the U.S., possibly causing a more complex war which drives the price of oil sharply higher.

Given the above risks, we continue to favour high-quality sectors in the credit markets, which should outperform in a rising inflation environment. An analysis of the correlation of industry groups in the S&P 500 versus CPI highlights potential winners and losers during rising inflation (Chart 10).

The energy, materials and metals and mining sectors remain areas we continue to favour in our credit selection process. In the case of energy, fundamentals tend to improve as price levels rise because higher inflationary periods typically result in strong top-line revenue growth for energy companies where demand is relatively inelastic. The industrialisation of the emerging markets has led to significantly stronger demand growth for energy and put pressure on already tight resource supplies. Not surprisingly, gross margins for energy companies have expanded over the past several years as revenue has grown faster than costs (Chart 11). Our firm’s cautious outlook on U.S. housing has similarly led us to under-weight cyclical companies that are highly dependent on consumer spending.

PIMCO’s credit strategy over the past several years has been to favour companies that have pricing power and avoid and under-weight those which lack pricing power. Our top-down secular outlook has been critical in helping to identify industries in which revenue growth and pricing power are set to accelerate due to rising global demand, such as in the energy and metals and mining industries. Our top-down cyclical outlook has also been important in identifying sectors where a large change in the outlook for revenue growth and pricing power may materialise. Over the past two years, our cautious outlook on housing and U.S. consumer spending led us to underweight homebuilders and, more recently, the retail sector. Our team of 30 global credit analysts has been instrumental in leveraging our firm’s top-down themes of subpar U.S. economic growth, healthy developing country economic growth and rising inflationary pressures to help identify the specific bottom-up opportunities and companies that are most likely to see pricing power improvement and deterioration.

No “Stairway to Heaven” ⁵
The outlook for subpar U.S. economic growth and rising inflationary pressure is no “stairway to heaven.” Nevertheless, PIMCO’s global team of portfolio managers and credit analysts has been analysing both the risks and opportunities in today’s stagflationary environment. Weak consumer spending should continue to put pressure on most cyclical companies, particularly those dependent on U.S. consumer demand. Housing prices will likely continue to fall leading to very tight consumer credit.

U.S. inflation, while above the Federal Reserve’s comfort zone, should not accelerate materially from current levels due to labour’s limited price power. However, resource prices should remain elevated as a result of healthy growth in emerging markets countries. Finally, while our outlook is not for a 1970s-style stagflation, we acknowledge the growing risks that further pressure on U.S. inflation is possible.

Our growth and inflation outlook, and the risks around it, support our high-quality credit bias in portfolios and a credit strategy which focuses on favouring companies that supply scarce resources primarily to faster-growing developing economies, while avoiding U.S. consumer-sensitive industries where margins are under pressure due to falling housing prices, tighter consumer credit and rising input costs.

Ultimately, credit market investors are hoping that breakout inflation does not return. However, the risks of such an outcome, while relatively low, must not be ignored. Our emphasis on high-quality credit in portfolios reflects this risk. It’s been a long time since a 1970s-style stagflation rocked our financial world. Let’s hope the only thing that rocks us in the near-term is Led Zeppelin’s world reunion tour.

Mark Kiesel
June 23, 2008

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1. “Rock and Roll,” Led Zeppelin, released November 8, 1971 on the group’s untitled fourth album.
2. “Over the Hills and Far Away,” Led Zeppelin, released on March 28, 1973 on the album Houses of the Holy.
3. “Dazed and Confused,” Led Zeppelin, released on January 12, 1969 on the album Led Zeppelin.
4. “The Song Remains the Same,” Led Zeppelin, released on March 28, 1973 on the album Houses of the Holy.
5. “Stairway to Heaven,” Led Zeppelin, released on November 8, 1971 on the group’s untitled fourth album.
6. “Hey Hey What Can I Do,” Led Zeppelin, released on November 5, 1970 as the B-side of the “Immigrant Song” single.
7. “Trampled Under Foot,” Led Zeppelin, released on February 24, 1975 on the album Physical Graffiti.
8. “Heartbreaker,” Led Zeppelin, released October 22, 1969 on the album Led Zeppelin II.
9. Home Ownership Rate, U.S. Census Bureau.
10. "Triple Play,” January 2008, U.S. Credit Perspectives. “Still Renting,” July 2007, U.S. Credit Perspectives. “For Sale,” June 2006, U.S. Credit Perspectives.
11. National Association of Realtors and U.S. Census Bureau.
12. Bankrate.com
13. “Bringing Down the House,” Lehman Brothers, Fixed Income Research, June 4, 2008.
14. “You Shook Me,” Led Zeppelin, released on January 12, 1969 on the album Led Zeppelin.
15. “Got Energy?,” October 2005, U.S. Credit Perspectives.
16. “Over the Hills and Far Away,” Led Zeppelin, released on March 28, 1973 on the album Houses of the Holy.
17. “Your Time is Gonna Come,” Led Zeppelin, released January 12, 1969 on the album Led Zeppelin.