Thursday, May 14, 2009

PIMCO’s Mohamed El-Erian on "A New Normal" : Part two.

This is a continuation of the summary of PIMCO’s secular outlook, "A New Normal". For part one, please click here.

On the international economy:

  • Financial rehabilitation in the U.S. to occur in the context of low growth and eventual inflation down the road.
  • The U.K. faces greater vulnerability to domestic and/or external financial instability.
  • Core Europe will be limited by its historical inflation phobia and concerns for the integrity of the European Union.
  • Japan’s growth will be hindered by fiscal and demographic issues.
  • Emerging economies: Those with weak initial conditions will alternate between austerity and financial instability, while those with strong initial conditions will maintain their development breakout phase at a slower rate.

The new normal: A world of muted growth, in the context of a continuing shift away from G-3 and toward the systemically important emerging economies, led by China. (This shift towards domestic consumption in emerging economies becoming another global growth engine is something he advocated pretty strongly in his book "When Markets Collide")

On Risks: El-Erian states that the "balance of risk" picture is tilted to the downside.

  • Will low global growth result in stagflation?
  • Will the current efforts to repress real interest rates through quantitative easing succumb in a disruptive fashion to higher inflationary expectations and sovereign risk spreads?
  • Will political feasibility (rather than economic desirability) dictate economic policy responses?
  • The set of implicit contracts required for functional markets and societies are being subjected to major shocks. A disturbingly large number of parameters that anchor key behaviors have become variables. The longer it takes to restore normalcy, the higher the risk of recurrent financial instability.
  • The management of public debt in industrial countries will be a delicate process. The average maturity of outstanding U.S. debt is at its lowest. Large unfunded entitlements (Social Security and Medicare) will start to significantly hit the budget.
  • Any further erosion in the autonomy and mission of key economic institutions, including the Fed and FDIC would be terrible.
On the investment baseline :
  1. El-Erian favors the front end of yield curves in many countries, as the authorities overstay with negative real policy rates.
  2. Income-generating instruments instead of pure equity premium.
  3. International orientation.
The new normal:
  • Exploit periodic anomalies associated with clumsy internal and external handoffs.
  • Favor credit spreads higher up in the economic and capital structure and on an international basis.
  • Premiums across risk factors and markets will go up to reflect the disruption to the sanctity of contracts, the capital structure, as well as to the autonomy of key economic institutions.
  • Renewed depreciation of the dollar, though the magnitude of depreciation against other currencies could be outpaced by that of real assets.
  • Equity risk premium will now reflect a permanently higher threat of subordination
In his discussion of the "new normal", I’m reminded of this Peter Bernstein article which came out shortly after the credit crisis broke out. In summary, El-Erian raises several excellent points and the article is definitely worth perusing carefully. Certainly puts the whole “green shoots” euphoria in context!

Further reading:

Peter Bernstein
The Shape Of The Future

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