Thursday, May 14, 2009

PIMCO’s Mohamed El-Erian on “A New Normal”

I’ve written quite often in the past about PIMCO’s Mohamed El-Erian and Bill Gross. In particular, I had reviewed El-Erian’s book "When Markets Collide" which I highly recommended. It still remains one of the must read well-researched books of 2008.

El-Erian recently came out with an excellent write up discussing PIMCO’s 3 to 5 year secular outlook from their annual forum, titled "A New Normal". He has characterized the current situation as a "bumpy journey to a new normal" for a long time now. While both Gross and El-Erian have discussed in detail several of the factors below, this article neatly captures PIMCO’s thought process from a secular perspective.

The new normal: El-Erian calls for a prolonged pause, or a violent reversal, in certain key market concepts currently taken for granted. They call it the demise of the “great age” of private leverage, asset and credit-based entitlements, self-regulation, policy moderation, and shrinking direct government involvement. With the magnet of the Anglo-Saxon model in retreat, he says that finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time towards higher sovereign risk, growing inflationary expectations and stagflation.

On context: The critical events which provided the context for this year’s forum were:
  • The global system became unable to continue on its recent path due to debt exhaustion and poorly capitalized activities, yet also incapable of embarking smoothly on a different path as the ravages of de-leveraging resulted in disruptive overshoots and considerable collateral damage.
  • The disorderly failure of Lehman Brothers was a “sudden stop” (a cardiac arrest) to the global economy and markets.
  • The new normal: Recent events broadened the de-leveraging dynamics with longer-term consequences, a self-reinforcing mix of de-leveraging, de-globalization, and re-regulation
On public sector: El-Erian calls the unconventional government responses as uncertain in their effectiveness yet consequential in disrupting long-standing relationships. He compares this to a drug trial.

The public sector has become a notable price setter in certain markets. El-Erian finds it discomforting to see it own and control some modes of production, exchange and distribution that normally reside only in the hands of private enterprise. The public sector’s role as major supplier and allocator of credit is also unsettling. The socialization of losses has ignited popular anger, confusion and “a morality play” in parliaments around the world. Click here to read about the Top 10 political fat tail events due to the banking crisis.
The new normal: The public sector will overstay as a provider of goods that belong in the private sector.

On Financial sector: According to El-Erian, the central banks will find it difficult to undo smoothly some of the recent emergency steps.
The new normal: The banking system will be a shadow of its former self. The financial system will be de-levered, de-globalized, and re-regulated.

On structural changes to the economy: There exists insufficient demand buffers and fast-acting structural reforms to provide for a spontaneous and sustainable recovery in the global economy.

El-Erian predicts lower global growth on a structural basis. He cites several reasons for this:
  1. Obsolescence of entire economic sectors/structural change.
  2. Excessive regulation, taxation and nationalization reducing productivity.
  3. Legislation reducing factor flexibility and mobility.
  4. Existence of zombie institutions.
  5. Decaying capital stock due to subdued investment activity.
  6. Destruction of endogenous credit factories which fooled people into believing that the increase in leverage-based economic activities was sustainable.

According to El-Erian, other structural changes to note would include:
  • How savings are mobilized and allocated, nationally and across borders.
  • The shifting balance between the public and private sectors.
  • The erosion of trust in basic market parameters like the sanctity of contracts and property rights, the rule of law, and the robustness of the capital structure.(I can’t believe something like this has become a factor to watch out for.)
    The new normal:
  • Lower global growth.
  • Higher unemployment.
  • Price formation influenced by the legacy and continuation of direct government involvement.
  • Burden sharing to become a feature of government's hand in economic life.

On US Inflation: Given the severity of the collapse in global demand and the resulting output gap, inflation may not be an imminent concern. Yet, supply also matters.

Unknown: Will the massive US fiscal and monetary stimulus erode confidence in the public goods that the country provides to the rest of the world – namely, the dollar as the world’s reserve currency, and deep and predictable financial markets to intermediate excess savings?

The new normal: The U.S. faces the prospect of a shift in sovereign risk and the return of higher inflationary expectations .

For the second half which summarizes El-Erian’s take on the international economy, risk factors and the investment baseline, please click here.

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