Mohamed El-Erian, CEO and co-chief investment officer of PIMCO, is one of the most knowledgeable people you can find on global financial issues. Prior to joining Bill Gross as co-CIO at PIMCO, El-Erian managed the Harvard University endowment fund, was a managing director at Salomon Smith Barney/Citigroup and spent 15 years at the International Monetary Fund.
He is in his second stint at PIMCO, formerly serving as a senior member of PIMCO’s portfolio management and investment strategy group before taking the reins of the Harvard endowment. His 2008 book, “When Markets Collide,” addresses global capital shifts before the dramatic events of that year confirmed them.
We spoke with El-Erian regarding PIMCO’s outlook for bonds and attempts to navigate the “new normal” global financial landscape.
Futures Magazine: Sprinkled throughout various speeches and commentaries by you and PIMCO founder Bill Gross is the term the "new normal." Generically it refers to an era of less robust growth due to lower leverage and more regulation. Explain what you mean by it and the implications of it on the investment landscape.
Mohamed El-Erian: The new normal is a world in which industrial countries face sluggish growth, persistently high unemployment, private sector de-leveraging and sovereign debt issues. It is also a multispeed world that sees an acceleration of the migration of wealth and growth dynamics from industrial to emerging economies. And remember, the new normal speaks to what is likely to happen given current conditions, rather than what should happen.
FM: What are the implications for industrial economies of this migration and, seeing that you note this is what will likely happen rather than what should happen, what do you think should happen?
ME: Industrial economies must adjust to this migration, and do so in a manner that is consistent with high global growth and an appropriate domestic retooling. In most cases, this involves a mix of structural measures aimed at strengthening international competitiveness, compensating for past resource misallocations (such as underinvestment in infrastructure and education), strengthening social safety nets and placing budgets and deficits back on more sustainable paths.
FM: In analyzing the U.S. and other Western nations' response to the financial crisis, you talk about winning the war and losing the peace. Please explain what you mean and tell us what needs to be done to win the peace.
ME: A bold and coordinated global response succeeded in avoiding a worldwide depression in 2009 that would have devastated output, demand, investments and employment around the world. Policymakers thus won the war. However, the peace is yet to be secured. As a result, the global growth outlook is still fragile, unemployment remains stubbornly high, investors are waiting on the sidelines, the risk of protectionism is increasing, sovereign debt crises are periodically erupting and global policy coordination has given way to fragmentation, frictions and, even, talk of “currency wars.”
FM: You praise the reaction by policymakers to the initial crisis. Are you referring specifically to TARP or the multiple Fed actions beginning in 2007? As a trader are you worried about the level of government intervention in the markets? How has that changed, if at all, your decision making?
ME: It goes well beyond a specific measure. The six-month period, October 2008 to April 2009, will go down in history as an amazing time of global policy coordination. National policies in both industrial and emerging countries were aligned by the trio of common analyses, purpose and focus. The effort involved many countries, coordinated via the G-20. It also included multiple national agencies, acting jointly in an unusually cooperative and constructive fashion.
FM: One thing PIMCO noted after its 2009 forum and reiterated in its 2010 forum is that the United States will de-lever. How much of this has occurred and how much is yet to come?
ME: The best way to think about this is in terms of both stocks and flows. Certain sectors, such as large companies, have completed the de-leveraging and are building robust balance sheets as they are also cash flow positive. Others, including consumers, are cash flow positive but still need to de-lever. And then you have the government, which is cash flow negative and adding to a debt stock that has already risen significantly due to the 2008-09 global financial crisis.
FM: So in a sense, businesses and individuals are de-leveraging and government is taking on more leverage. How sustainable is this?
ME: Governments had no choice in 2008 and 2009 but to step in with their balance sheets to compensate for what was a disorderly private sector unwind. The alternative would have been a global depression. It is critical that this exceptional use of the sovereign balance sheet, including that of the central bank, be a bridge to the resumption of high sustained growth led by the private sector. Otherwise, what was a private sector balance sheet problem will become a sovereign balance sheet problem.
FM: You have said QE2 is likely to backfire. Why?
ME: There are both domestic and global dimensions. By buying securities, QE2 seeks to push investors and consumers out the risk curve. History suggests that when people are being pushed to do something they would not do on their own, they either resist or end up making unsustainable decisions.
Globally, QE2 is flooding emerging economies with liquidity at a time when many of these economies are already very close to overheating. And then there are the unintended consequences. The involvement of the Fed as a non-commercial player in markets that are functioning normally can cause distortions.
FM: The Fed has become significantly involved in markets since the end of 2007, from creating special auction facilities and opening up the discount window to non-commercial banks and brokerages to QE 1 and 2. At some point do they need to be less involved?
ME: Yes, definitely. Like fiscal stimulus, this aggressive use of the Fed’s balance sheet is a bridge and not a destination. And the longer the Fed stays in this unusual mode of unconventional policy activism and experimentation, the greater the risks to its institutional integrity, to the proper functioning of markets and to efficient price signaling that is so key for proper resource allocation.
FM: Most critics of QE2 feared a larger devaluation of the U.S. dollar. The dollar is much higher since the November QE2 announcement. While initially this could be attributed to “buy the rumor, sell the fact” activity, it has gone beyond that. What is going on? What is your outlook for the dollar?
ME: A couple of things. First, starting with Chairman Bernanke's Jackson Hole speech at the end of August, the markets positioned for QE2 over many weeks and ended up overdoing it. Second, we should never forget that the dollar's exchange rate is a relative price. As such, it is impacted by the crisis in Europe's periphery which has weakened the euro.
FM: Has the nearly 20-year bull market in U.S. Treasuries ended? What is your outlook for Treasuries?
ME: Given how far yields have come down during the last 20 years, there is no longer the same room for U.S. Treasuries to rally. Where we go from here is mainly an economic call. On the one hand, a rebound in growth would translate into a backup in yields. On the other hand, a weak growth outlook would see yields go lower.FM: What is your outlook for the yield curve for 2011 and beyond?
ME: Range bound, with a tendency to flatten. The front end will be anchored by the Fed pinning policy rates essentially at zero. The long end will be a tug of war between the impact of sluggish growth and concerns about medium-term inflation and the erosion of the global standing of the United States.
FM: Fixed income investing in general, and U.S. Treasuries in particular, have been seen as a safe haven. Is that still the case?
ME: U.S. Treasuries play an important role in any portfolio, and especially so given the fluidity of the global and national outlooks. Their overall effectiveness over time of is a function of the U.S. credit standing and the robustness of its role as the largest provider of global public goods, including the dollar as a reserve currency.
In most instances, nominal Treasury bonds will continue to provide investors with some offset against the harmful impact of deflation on equities and other risk assets. TIPS (Treasury Inflation-Protected Securities) will continue to assist in positioning for the possibility of unanticipated future inflation. And, ladders of shorter terms Treasuries will continue to form the basis of many [investors'] liquidity management.
FM: One of the implications of the new normal cited by you and Mr. Gross is that the assumption of 8% growth in pension plans is unrealistic. Many pension plans are underfunded as is, let alone in a world of significantly lower growth. How big of a problem is this? What is the solution?
ME: This is part of a general phenomenon that we expect will attract greater attention in the years ahead. There are several sectors – such as pensions and insurance companies – that will be challenged because of historic promises that are no longer consistent with the realities of lower return expectations and historically low interest rates.
FM: Is it likely than many of them will not be able to meet their obligations? What will be the fallout of this?
ME: Those that are both underfunded and experiencing negative cash flow will require timely capital injections if they are to meet their promises. If they fail to secure these injections, the situation would constitute yet another headwind to consumer confidence, demand and the ability to sustainably reduce unemployment.
FM: One of the guiding principles of PIMCO is taking a long-term approach to investing. How much of the financial crisis can be attributed to a lack of long-term perspective, be it in business, politics or investing? How do we reverse this tendency?
ME: The run-up to the crisis, and its aftermath, are best seen in terms of balance sheets. They are part of a secular process characterized, first, by a "great age" of leverage, debt and credit-entitlements and, now, by a multi-year adjustment process.
Unfortunately, both the political and financial systems are not sufficiently hard wired to take longer-term views, and they find it difficult to sustain focus on balance sheet and structural issues.
FM: Can a long-term sustainable recovery be achieved without government and industry gaining this focus?
ME: No. Especially in this evolving global economy, it is critical that tactical thinking be urgently supplemented by strategic positioning and a greater ability to undertake timely midcourse corrections.
FM: On the eve of the Irish bailout you stated that if the EU didn't act promptly there was risk of contagion. Where does that risk stand now? What is the chance that the EU, ala the U.S. Treasury and Lehman Brothers situation, will say no and let sovereign debt fail? What will it mean to the global bond market if that happens? How do you see the situation with the peripheral European nations (PIIGS) playing out?
ME: European officials have repeatedly failed to get ahead of the crisis. They are viewed as being too reactive and not sufficiently proactive. And they are too focused on liquidity solutions for solvency challenges. As such, further contagion is a risk.
At some stage, Europe will have to deal more directly with two issues: The debt overhang in peripheral economies and their inability to grow robustly. Unfortunately, there are no easy and risk-free approaches to dealing with these two difficult challenges.
FM: Is it possible that the EU will allow a failure on the sovereign debt of one of its members?
ME: That is indeed a key question. And by kicking the can down the road through a series of liquidity rescue operations, Europe is telling us that they are not ready to do so at this stage. Yet, if the problems of the peripherals persist and expand, debt restructurings for some countries will go from being an option that can be undertaken in a relatively orderly fashion, to one that is imposed on them in a potentially disorderly fashion.
FM: You said in an interview that PIMCO is moving into equities because to be relevant you need to be in a space that contributes to an overall solution. Can you expand on the reasons for moving into equities and given what you said, is PIMCO contemplating moving into the managed futures space?
ME: We believe that, going forward, a growing number of our clients will shift their attention from products to investment solutions. In the process, they will become more global in their investment approaches, and more holistic in their risk management. Our goal at PIMCO is to provide our clients [with] first-mover advantages, and do so by delivering to them PIMCO quality through complete investment solutions. We believe we can successfully harness PIMCO's proven investment process across more asset classes and risk exposures to help our clients achieve their investment objectives.
FM: I am not sure what you mean by "more holistic in their risk management." Does this involve creating multiple diversified return streams?
ME: Yes and, importantly, supplementing it with cost-effective tail hedging.
FM: PIMCO has always been synonymous with bond trading; is there a risk in altering that focus?
ME: We are very committed to not diluting the PIMCO focus and quality that we have provided to clients for almost 40 years, and that has stood the test of time [through] market cycles and global secular change.
FM: What is the most prudent investment approach given your outlook for flatter distributions with fatter tails?
ME: First, be aware of both what you know and what you do not know. Second, ensure that the major investment theses are robust in view of a bigger range of potential outcomes. Third, scale investment positioning consistent with a bumpy journey to a new normal. Fourth, expand risk management to ensure that diversification is supplemented with cost-effective tail hedging.
