Investment
Bill
Gross
Outlook
The WEAKEST Link
Well we warned
you didn’t we?
Last year’s
PIMCO Secular
Forum that is.
Only a month or
so after
NASDAQ 5000,
we came up with
this UNBELIEV-
ABLE forecast
that maybe over
the next few years the U.S. and other
global economies might suffer a break-
down of sorts. We suggested a better
than 50/50 chance of a recession during
our secular timeframe due to a number
of “lightning bolts” that individually or
in concert could put an end to
Goldilocks, if not yank the halo right off
of the head of our New Age Economy.
The popping of the U.S. equity bubble,
central bank overreach and Japanese
economic malaise were three promi-
nent precipitating factors that the
PIMCO girls and boys believed might
lead to the big R, which would in turn
cast investors onto a deserted island or
the Australian Outback a’la “Survivor.”
We adopted that theme for our
Investment Outlook and it influenced
our investing style as well – winning
lots of immunity challenges by purchasing
predominantly high quality bonds
and extending duration with the long
Treasury bond at 61/2%. Instead of
May/June 2001
a $1 million prize,
though, we bagged
the Morningstar
Portfolio Manager
of the Year award
for the second
time in three years
which went a long
way towards
proving that
surviving well
can best be
accomplished through the use of the
PIMCO tribe’s 3-4 year secular outlook.
But hey, who’s counting (besides us)
and anyway, Richard and Tina, the
winners from Survivor I and II are
already has-beens and not even on the
talk show circuit anymore. What’s new,
what’s hot, what have you done for me
lately? Well, we’re still into surviving
of course, but for this year’s theme we
thought we’d switch networks and
feature a reality game show that’s
captured the imagination of Americans
and the English alike. Let’s play – The
WEAKEST LINK! To do so probably
involves more wit and indeed sarcasm
than yours truly can muster. I’m no
match for the dominatrix of London,
Anne Robinson, who emcees the TV
version. Every so often, PIMCO portfolio
managers liken our trading floor to the
Tower of London, but that’s another
story. The show’s title and theme
 Investment Outlook

though, is a great lead-in to our own view Senator. Yeah, right. But as long as that
of the next 3-4 years that there are more was the accepted tautology then stock
than a few weak links in our global P/Es at 2 or 3 times historical norms
economy that could result in slower made sense, as did that well-worn
growth for years to come, so I thought phrase “it’s different this time.” Turns
we’d use it and hope that you dear out perhaps it wasn’t so different after
reader could at least half comprehend all. Take a look at Forum guest speaker
what we came up with this year. Admit- (Mr. Irrational Exuberance himself)
tedly that might be as difficult as using Robert Shiller’s chart displayed below.
an ashtray on a motorcycle, but give it
at least a pathetic go, will
you? We’ll even answer U.S. Stock Market: A New Era or Irrational Exuberance?
some of the questions 1600 120
Major Innovations
for you if you promise S&P Composite Prices (Left)
1. National Railway
1200 S&P Composite Real Earnings (Right) 2. Car 90
to BANK SOME OF 3. Factory Assembly Line
THE MONEY! Are you 4. Nationwide Telephone
800 5. Radio 60
the unpopped kernel 1 3 5 6. Rural Electrification

in our bag of popcorn? 400 2 4 6 30

Let’s start the clock.
0 0

Secular Review 1871 1882 1894 1906 1918 1929 1941 1953 1965 1976 1988 2000

Our current secular stopwatch actually Source: Robert Shiller, Yale University, Morgan Stanley Economic Research

began sometime in the early to mid ’90s

with the blossoming of the New Age
Economy, fed by visions of endless
technological productivity advances
and realities of New Age stock markets
that ascended to unprecedented
heights. You all know the story by now.
Computers, the Net, biotech, agritech
and countless other breakthrough
innovations would lead to a doubling of
historical productivity growth rates and
therefore double digit, even 30-40%
annual increases in some corporate
earnings. Cisco, at one point last year
the world’s largest corporation in terms
of market capitalization, was going to
double in size every two years for as
long as Strom Thurmond has been a
Now there’s a real secular chart with some
meat on its bones. Lots of “new eras” are
displayed over its 130 years – from the
railroads, through the development of
the automobile, to national electrifica-
tion. None of them produced a signifi-
cant blip in real earnings growth which
forms the basis of stock price and P/E
expansion. Should we really believe it’s
different this time? NASDAQ investors
and S&P owners alike (as seen in
Shiller’s chart) did – and still do. So did
business corporations who invested in
an accelerating amount of dot.com,
telecom, and high tech equipment,
much of which now lies unused or at
least underutilized. So did American

May/June 2001
workers who found jobs down to an experts, shows a pronounced disparity
astounding 3.8% unemployment rate between what is known as “labor” and
and spent wages, capital gains, and “total factor productivity” or TFP.
freely given “in the money”
options at an accelerating rate. Growth in Productivity
3.5
So did foreign investors who Percent change from
3.0 year ago, smoothed
managed to accommodate a
2.5
near 5% of GDP current ac- Labor Productivity
2.0 Capital
count deficit and pump the Deepening
1.5 Impact
dollar to unforeseen heights Time-varying (TFP)
1.0
by purchasing U.S. stocks and
0.5
corporate bonds, reflecting the
0.0
same belief in New Age 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
miracles. Source: Morgan Stanley Dean Witter

These were more than likely all
bubbles, folks – and still are. But the
dream lives on. And all these dreams
perhaps somewhat simplistically rest
on one singular assumption: the belief
in higher than average productivity in
our New Age Economy. Greenspan
believes it, stock market investors
believe it, and corporations chase it like
the Holy Grail. It is the link that justifies
all these bubbles as well as much of the
world’s faith in the American capitalistic
model as the economic paragon of the
21st century. But, just how strong of a link
is it? As Anne Robinson might query,
have we all been IDIOTS to believe in it?
What’s New
Shiller’s chart would suggest as much,
but there is additional theoretical smoke
here to be concerned with. The following
chart, advanced by Secular Forum guest
speaker Stephen Roach, who along with
Northwestern’s Robert Gordon ranks at
the top of the world’s productivity
It’s the labor productivity that markets
and corporations have been focused on,
and that productivity measure has
indeed accelerated in recent years,
rising at a faster rate than at any time
since the 1960s. But TFP, which includes
not only labor but plant and equipment,
has barely produced a ripple – in fact, it
has gone down over the past few years.
That means that labor productivity is
up and corporate profits are up because
of “capital deepening” (the amount of
capital employed per worker) – not
necessarily higher total factor produc-
tivity (the efficiency with which both
capital and labor are used). It means
that Americans have invested in more
machines but not necessarily ones that
are any more productive than during
the past 130 years – to cite Shiller’s
example again.
So? Why don’t we just keep on buying
more machines? We will, but not as
many, and that makes all the difference.
 Investment Outlook
Because prior levels of investment have
been made possible via increasing
amounts of debt as well as IPO, venture
capital, and other equity financing
which now is much harder to come by,
the ability of corporate America to
“deepen” capital at anywhere close to
recent levels is more than suspect. This
link of the New Age Economy’s chain
falls under the category of “all good
things must end” or at least slow down.
Productivity’s recent downturn, based
upon serious disruptions in business
investment has begun to influence the
economy and investment markets alike,
suggesting that the peak has been seen,
even if the end is not near.
But is it a cyclical or a secular peak
you imbecile? Good question, Anne.
Because if the Fed can pump up the
economy with its 250 basis points of
cheaper money, then why not party-
hearty for another 10 years. Maybe, but
not likely. With private consumer and
corporate debt at historically high levels
and with investors finally believing that
stocks are not just a one-way winning
U.S. Private Debt % GDP
2000: 4Q 135.3%
140
130
120
110
100
90
80
70
1960 1965 1970 1975 1980 1985
Source: ISI Group
May/June 2001
lottery ticket, the next cycle is almost
certain to be less exuberant than the
last. And there is after all not only
business investment but consumer
spending that must slow down.
America’s (–1%) personal savings rate
must eventually rise to higher levels as
suggested in our March Investment
Outlook. We look for 2% U.S. GDP
growth over the next 3-4 years instead
of the 4% growth experienced since
1997, largely due to the return to earth
of productivity growth rates, and the
need to rebuild consumer savings rates.
If productivity is a fragile link then
there most assuredly are others – many
of them outside the borders of the U.S.
of A. This is a global economy these
days and a global chain, even if America
has been the strongest link up until
now. Japan is a basket case and a valid
candidate for the weakest link. It awaits
serious structural reform and monetiza-
tion via a weaker YEN. No believable
steps have as yet taken place, although
new Prime Minister Koizumi’s mod
hairstyle is as heartening as anything
we’ve seen in the past few
years. We’ll need more than
makeovers to fix Japan how-
ever. Elsewhere, emerging
nations have strengthened their
balance sheets and reserves
over the past few years of
prosperity, yet disasters await
in Argentina and Turkey to cite
1990 1995 2000
the weakest of the links in the
emerging chain. Contagion can
 likely be isolated if the G-10 is 2% or
more growth positive, but it is not there
now and may not be for six months or
longer. This is a global tender spot and
a weakest link possibility.
There is more hope elsewhere. Europe,
to point out the obvious, might be a
stronger relative link than in the ’90s
simply because it’s been less bubblish.
IT Spending
Europe May Catch Up
28
26
Percent of Nominal GDP
24
22
20
18
16
14
90 91 92 93 94 95 96 97 98 99 00E 01E 02E 03E 04E 05E
Source: Morgan Stanley Dean Witter
It’s had its telecom and MP3 fiascos
and its banks are in deeper hock to
emerging nations than are ours, but
its private market balance sheets are
still in better shape and structural
reforms are on the way – lower taxes,
Sunday shopping in Germany – who
knows what’s next? According to
Morgan Stanley’s Roach, Europe
should become the world’s largest IT
buyer over the next 3-4 years, coming
close to match our own IT capital stock
as a percentage of GDP. Look for
Europe’s economic growth rate to
match or exceed that of the U.S. for
the next few years.
China too promises to prosper, but its
economy is no global engine simply
because it’s internally driven and still
too small to pull a weakened U.S. back
to normal. It prefers to export rather
than import just like Japan, just like
Korea, just like about every other
country with the exception of the
United States. This export/import
disparity is crucial for analyzing the
global outlook for the next 3-4
years. The world’s biggest pool
of potential consumers lie in
China, India, Mexico and
South American nations with
demographically younger
citizens. Yet getting the goods
U.S. to these potentially voracious
Europe
consumers is no easy task
Japan
what with internal policies
geared towards exports. In
turn, the financing of internal
consumption is still light years away
from the U.S. model which utilizes
credit cards, individual home mortgages
and securitization of assets to keep the
spending campfires burning. This weak
and almost missing link between the
developed world’s savers and the
emerging nations’ potential consumers
is at best an opportunity lost for global
prosperity over the foreseeable future,
and at worst a deepening drag on
global growth as the G-10 nations
continue to age demographically
over the next 3-4 years.
The inability to get the goods and
financing to match demographic demand
is but one faulty link or transmission
 Investment Outlook
mechanism that characterizes the
world’s economies today. Back in the
U.S., it’s become apparent for years that
the banks are not as influential as they
used to be in cooling or speeding up the
economy. The elimination of Regulation
Q in the ’70s was the first in a series of
steps that elevated a host of disparate
entities such as FNMA, GE Capital and
its look alikes, hedge funds, mutual
fund investors, vendor financiers, and
of course PIMCO and institutional
pension funds, towards a pinnacle
of influence on interest rates, quality
spreads and the availability of finance.
The old foundation of bank reserves as
the primary influence over the domestic
economy is not only hardly debatable,
it’s near laughable. The Fed’s and
Treasury’s control over the domestic
financial balance sheet therefore has
been seriously weakened by time,
deregulation, and technological
progress. There is no significant linkage
or control over investment preference
other than via the blunt hammer of
short-term interest rates and the increas-
ing attempts at moral suasion – some
call it cheerleading – by the Federal
Reserve. In such an environment the
weakest financial link, whether it be
LTCM in 1998 or some fresh overag-
gressive candidate in the future is
bound to increase the possibility of
major financial accidents and with
it the volatility of interest rates and
credit spreads.
Fiscal policy was a link that drew close
PIMCO inspection as well. The cult of
May/June 2001
the budget surplus has characterized
U.S. and European government behav-
ior for a few years at least. Rarely over
a secular time frame have politicians
fought to assume the mantle of the
“most frugal” but we came close during
the U.S. elections and our current $300
billion surplus is proof of this political
pudding. Our Forum concluded, how-
ever, that this fiscal “tightening” of
sorts, in the U.S. and Europe, may in
fact have contributed to the existing
or upcoming recession more than most
realize. Not only was the secular move
contractionary by reducing government
spending’s influence, but as PIMCO’s
Paul McCulley put it, we managed to
delever the good credit (the U.S. Trea-
sury with a printing press) and lever the
bad credit (the private sector) at the
same time. The tipping of the growth
scales towards private overexuberance,
as we’ve pointed out, resulted in an
Austrian School boom of private invest-
ment, which is now culminating in an
Austrian School bust. Better to have
less of a surplus than more at this point
we concluded, a direction which seems
more than possible given the decline of
tax receipts on both a national, state,
and local level.
Investment Implications
But enough of these discussions of weak
economic links. How many readers
know what the Austrian School is,
Mr. Gross? You, Sir, are the idiot for
going on so long. OK. OK. On to the
investment conclusions. As I told our
100+ Secular Forum participants from
literally the four corners of the globe,
we cannot invest in GDP futures or
productivity options. When all is said
and done, the task of the FORUM is
to tell us where to invest our clients’
money – domestically or internationally,
long duration or short, high quality or
high yield. If we can’t translate an
economic outlook into a portfolio of
bonds then the three days of discussion
could better have been spent on the golf
course. So here are some investment
nuggets that hopefully will turn into
gold for your portfolios:
1) Sub par U.S. and global growth
will continue to prolong a
disinflationary environment in the
U.S. and Europe that leaves infla-
tion in a 1-3% range over the next
several years – lower in Europe,
higher in the U.S. due to the even-
tual weakening of the dollar and the
ultimate strengthening of the Euro.
The relative technological “deepen-
ing” of Europe should be a factor
as well, as their productivity is
temporarily raised.
2) Interest rates will be range bound
but volatile – especially in the U.S.
due to our riskier transmission
mechanisms. Ten year U.S. Treasuries,
now at 51/4% should move between
41/2 and 61/2% from now until 2005.
Euroland rates could average 50 to
100 basis points less due to its lower
inflation, more attractive currency
and ECB focus on inflation as
opposed to growth.
3) Quality spreads should continue to
have a bias towards widening in the
early portion of our secular period
as sub par economic growth trans-
lates into subdued corporate profit
growth in the U.S. and Europe.
Opportunities for high yield and
corporate bonds will be better in
2002 and beyond. PIMCO remains
committed for now to higher quality
investments with mortgages forming
the centerpiece of our yield product
despite higher volatility. If 10-year
Treasuries remain within our
forecasted range, prepayments
will ultimately subside and render
optionality in mortgages relatively
impotent.
4) The higher forecasted volatility of
yields in the U.S. should impart a
steepening bias to the yield curve
over time.
5) Stock and bond total returns over
the secular time period will be
fortunate to reach 6% annually.
Stocks have a better chance of
negative returns than do bonds.
6) Emerging market bonds will be
more attractive next year than
currently. We will opportunistically
pick up the pieces and put together
the emerging market chain should
an opportunity present itself over
the next 12 months.
So there you have it. And what is
PIMCO going to do differently as a
result of our three days of work? Not
that much you half-wit! Not just yet at
least. Didn’t you know this year’s output
was more of the same? PIMCO bearish
on the economy. Clowns! Well, yeah
maybe Anne, but at least we’re in there
pitchin’, trying to figure out secular
answers to longer-term questions. In the
process we’ve managed to bank a lot of
money for our clients. And look at it this
way, baby – bond people are supposed to
protect principal – you wouldn’t want us
to ever bet the farm or get up to that
$125,000 question would you? That’s
better left for a riskier game called,
“stocks for the long run.”
In the meantime, and if you stayed with
us this far, aren’t you dying to know which
is the weakest secular link? After all,
we’ve discussed a bunch – including
U.S. productivity, Japan, emerging
market contagion, export/import imbal-
ances, faulty financial transmission
mechanisms, fiscal surpluses, and, of
course, a continued deflating of the U.S.
equity bubble. Not even mentioned has
been the price of energy and a potential
credit crisis in this country’s most
populous state, California. Which one
should we be most concerned with?
Well it should be obvious you limping
snail that we devoted most of our
attention to the existence of the U.S.
productivity miracle. Would we have
devoted only a few sentences to our
choice of the weakest link? Obviously
not. If productivity comes back from its
current cyclical depths and regains its
1995-2000 heights, then stocks soar,
investors’ animal spirits return, and
bears go into hibernation. If U.S.
productivity has been primarily a
cyclical, over-investment mirage, then
super-bulls prepare for thy matador.
PIMCO sides with the latter not the
former. AMERICAN PRODUCTIVITY
IS THE WEAKEST LINK! GOODBYE.
William H. Gross
Managing Director
840 Newport Center Drive
P.O. Box 6430
Newport Beach, CA
92658-6430
(949) 720-6000
Past performance is no guarantee of future results. All data as of 4/30/01 and is subject to change. The return on both individual
securities and mutual fund investments will fluctuate and the value of an investor’s shares will fluctuate and may be worth more or
less than original cost when redeemed. This article contains the current opinions of the manager and does not represent a recommenda-
tion of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is
distributed for educational purposes and should not be considered investment advice. This chart is not indicative of the past or future
performance of any PIMCO Fund. The NASDAQ Composite Index is a broad-based capitalization-weighed index of all NASDAQ
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Mortgage-backed securities & Corporate Bonds may be sensitive to interest rates, when they rise the value generally declines and there
is no assurance that private guarantors or insurers will meet their obligations. An investment in high yield securities, lower rated
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entail risk due to foreign economic and political developments and may be enhanced when investing in emerging markets.

For additional details on PIMCO Funds, contact your financial advisor to receive a prospectus that contains more complete
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PA816.5/01