PIMCO to Obama: Tough economy awaits next president

By John Parry

NEW YORK (Reuters) - The world's biggest bond fund manager anticipates that Barack Obama will be the next U.S. president, and warns that he will face stern economic circumstances.

Bill Gross, chief investment officer of Pacific Investment Management Co, or PIMCO, manages the $130 billion PIMCO Total Return Fund.

In his monthly "Investment Outlook" letter for July, he says the next president will inherit a swelling budget deficit that's likely to hit $1 trillion during his administration.

Gross, reputed for his quirky style and eclectic asides, often fashions his market outlook letters around literary or other popular culture analogies. They have ranged from Erich Maria Remarque's World War I classic "All Quiet on the Western Front" to songs by the Beatles.

Gross's July investment outlook letter was addressed to Obama, as if he had been elected.

"Dear President Obama," the letter began. "You have inherited a mess. Your predecessor, fixated on emulating a former Republican icon from a far different economic era, chose to emphasize tax cuts for the rich and excessive consumption for all Americans," Gross wrote. "He promoted deregulation and free markets when, in fact, the markets and their institutions needed tough love."

The next president has little choice but to step up fiscal stimulus to revive the economy, Gross said.

"You've inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender of last resort liquidity provisions," he wrote. "Your administration will produce this nation's first trillion dollar deficit."

Foreign central banks and private investors may not continue to buy Treasuries at the same rate as in previous years, a trend that has kept Treasury yields lower than they would otherwise be. Absent these low interest rates to aid the economy, "what you need now is fiscal spending and lots of it," Gross wrote.

Longer-term U.S. Treasury bond yields have bottomed and will steadily rise because of inflation pressures as the U.S. economy clambers out of the current downturn, Gross wrote.

"Intermediate and long-term yields on government bonds have already bottomed and will gradually rise" during the term of the next president, due to start in January, he wrote. "Your term will not go down in history as investor friendly."

The benchmark 10-year Treasury note's yield, which moves inversely to its price, was as low as 3.285 percent in January, the lowest since 2003, on signs of a weakening economy and escalating credit market strains.

But since then, surging commodity prices and rising inflation expectations have pushed the 10-year yield up about one percentage point, to above 4.30 percent last week.

Over time, negative real interest rates, the Federal Reserve's extraordinary liquidity provisions to the banking system and the government's fiscal stimulus measures should promote reflation, Gross said.

"This economy will need an additional jolt of $500 billion or so of government spending real quick," he wrote.