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.