SATURDAY, JULY 23, 2011
Worldly, Wise and Worried
By LESLIE P. NORTON
Pimco's Mohamed El-Erian discusses in an interview his views and investment strategies amid the various global crises.
Mohamed El-Erian has been a busy man this year, traveling to Japan after the Sendai earthquake to check on his staff in Tokyo, receiving an honorary doctorate from the American University in his native Egypt, writing numerous shareholder letters and newspaper columns, and appearing on TV to explain the global economy's challenges—all while running Pimco with Bill Gross, who founded the world's biggest bond manager. Last week was Barron's turn to put a claim on his time, as we sought his incisive analysis of the trials facing both developed and emerging markets.
El-Erian brings decades of experience to the task, including a long stint at the International Monetary Fund, a stretch overseeing Pimco's developing-markets portfolios, and a spell supervising Harvard's endowment. All make him uniquely qualified to judge the merits of various proposals to solve the debt crises in the U.S. and Europe, and forecast their effect on the markets.
Barron's: There is lots of news about debt crises here and abroad. Is the new Greek rescue package a significant step in the right direction, or is Europe still kicking the can down the road?
El-Erian: While details are still coming out, the latest European package represents a significant step forward in addressing the peripheral debt crisis. Through interest-rate reductions and maturity extensions, it reduces the debt-servicing burden for the three countries in the financial ICU—Greece, Ireland and Portugal. It puts in place faster-disbursing credit lines for Italy and Spain, as well as for bank recapitalizations. And it starts to pay greater attention to growth promotion.
"It's likely that the U.S. avoids a recession, but that outlook needs to be reassessed on a high-frequency basis." —Mohamed El-Erian
The jury is still out, however, on whether this package will hold. It lacks an important element, namely significant upfront relief in the stock of debt for the most troubled economies, and Greece in particular. It has to be properly financed. And proper execution will require tremendous political and economic-policy agility. That will cause tremendous day-to-day volatility. [Prolonged delay] would disrupt the markets for a number of other peripherals, put tremendous pressure on European banks and could raise questions about certain money-market funds, resulting in a selloff in risk assets world-wide and a flight to quality.
Back in the U.S., is there any reason to be optimistic about reports that President Obama and House Speaker Boehner are near a deficit reduction/debt ceiling deal?
The debt-ceiling discussions remain very fluid. Signals coming out of Washington are fluctuating between Plan A, the possibility of a significant medium-term fiscal reform package, and Plan B, a stop-gap to give Congress more time. This will go to the wire as leaders of both political parties need to find a compromise while, importantly, retaining a certain degree of unity and harmony within each of their parties. Not an easy challenge in today's highly polarized political context.
What have we learned about how Europe handles its problems?
First is the extent of denial. For a long time, Europe refused to recognize it was having a good old-fashioned emerging-market crisis, a combination of liquidity and solvency problems, which led to contagion and very sharp and disruptive market moves.
Understandably, Europe continued to look at developments from the perspective of advanced economies, which experience reversion to the mean. In emerging markets, you get path dependence and what's called "multiple equilibria," where, in this case, one less-favorable outcome leads to an even worse one.
Second, Europe used the wrong approach to deal with the problem. It dealt with the sovereignty issue by using liquidity instruments. It piled new debt on top of old debt, and every indicator got worse. Sovereign spreads are worse; the economy has contracted more than forecast; debt dynamics have worsened; there has been slippage on the budget, and the balance sheet of the European Central Bank has been contaminated.
Third, making time doesn't mean that time will be exploited. The weaker entities were supposed to have time to recapitalize, but the European banks dragged their feet and didn't take advantage.
Finally, we learned it's difficult to run an economic entity when you have so many leaders. We saw tremendous incoherence. There was disagreement between Frankfurt, where the ECB is, and Berlin, where the German government is. It is very disruptive to the market. The different parts of the European orchestra want to play different music. We saw the lack of a conductor, especially when [former IMF chief] Dominique Strauss-Kahn was arrested. The IMF on its own thinks about this more as an emerging-market crisis than an advanced-economy disruption.
Pimco Global Multi-Asset's Top 10 Holdings
% Net
Holding Ticker Assets
PIMCO StocksPLUS®Fund PSPAX 15.46%
Vanguard Emerging Mkts ETF VWO 10.99
PIMCO EqS Pathfinder Fund PATHX 8.14
iShares MSCI EAFE Index ETF EFA 7.62
PIMCO Global Adv Strat Bond PAFCX 7.36
PIMCO Emerg Mkts and Infrastructure Bond Fund PEMIX 4.92
PIMCO Emerging Local Bond PELAX 4.51
PIMCO Total Return Fund PTTAX 3.50
PIMCO Unconstrained Bond PUBAX 3.48
Canada Government Intl Bond 2.17
Data as of 3/31/11. Source: Pimco
How will the U.S. problems be resolved?
There's a long-term issue and an intermediate issue. We have to undo this age of debt, safely delivering three sectors—the government, the housing market that is paralyzed by foreclosure issues, and the credit market. That's why you have this amazing dichotomy in the U.S. between sectors that are doing very well, like the multinationals, which are very healthy in terms of profitability, cash holdings and balance sheets, and the government, which has a high deficit.
That's very similar to Japan.
I wrote a piece for a recently published Japanese book that says we in the U.S. will have a major rethink about how we've interpreted Japan. We've been quick to blame the Japanese for policy slippages, but we are learning it's really hard to manage an economy that has to deliver. Bill Gross likens it to driving a car in fog. You see it on page nine of the latest Fed minutes. They say 'On the one hand, we may need to do more in terms of stimulus. On the other hand, we may need to be less accommodating.'
The U.S. faces the new normal of sluggish growth, persistently high unemployment and recurrent balance-sheet issues. These are long-term issues that every once in awhile come to the fore because of an event. That event is the debate on the debt ceiling, which accelerated these into medium-term issues.
Is pushing these problems to the fore a good thing?
Depends on how it's resolved. A grand bargain is a good thing. But a stopgap that says we will extend the debt ceiling for three months, then look at it again is problematic, because every three months we will go through this uncertainty. This is consequential not only for the U.S. but for the global economy, which is constructed around a strong U.S. at its core. The world relies on the U.S. for its reserve currency, for the deepest, most sophisticated financial markets. As a result, they outsource to us part of their savings. The U.S. benefits by effectively collecting a rent for providing these public services. There is no one to replace the U.S. How does the system function with a weaker core?
In the past, Pimco stuck its neck out forecasting higher bond yields. They haven't materialized. What did you get wrong?
It is inadvisable to look at just one position in the portfolio. When we sold our U.S. Treasuries, we found substitutes elsewhere. Bill [Gross] wrote about Australia and Germany, and they've actually outperformed Treasuries.
So why did Treasuries do so well despite the end of QE2 and mounting noise on the debt ceiling? Three factors. One, we saw a massive downward revision in GDP expectations for the second quarter, from about 4% to below 2%. That tends to support yields because it means the economy is weaker and the Fed keeps policy rates lower for longer. Two, uncertainty in Europe and the flight to quality in U.S. Treasuries. We've called the U.S. the 'cleanest dirty shirt' in the laundry. And three, the triple tragedy in Japan and uncertainty in the Middle East. The impact of all these overwhelmed QE2 and the noise on the debt ceiling.
Will the Federal Reserve raise interest rates or embark on QE3?
For the next year, the Fed will continue to pull certain rates down, up to the three- to five-year segment of the Treasury curve. Beyond that, it's also a function of the weakness of the economy and the extent to which the Treasury curve starts reflecting credit risk, interest-rate risk, and how the world feels about our instruments. The yield curve will also be influenced by the issue of whether we get QE3 or not.
The Fed would need to see a significant worsening in the economic outlook in order to seriously consider QE3. In doing so, it would also need to recognize that, relative to QE2, the expected benefits are lower while the expected costs and risks are higher. The safety will be at the front end, and the back end will be volatile with a tendency to sell off. It's likely the U.S. avoids a recession, but that outlook needs to be reassessed on a high-frequency basis.
How does all this color our creditors' thinking?
They are torn. There was a desire to diversify, but the ability is limited: This is true for China, for India. Commodities are the best hedge in a world where [the U.S., Japan and the EU] are debasing their currencies. Central banks and other monetary authorities are a lot more interested in buying commodities, including gold. I was brought up in a world in which the conventional wisdom for central banks was to sell gold. But it is difficult to diversify away from the dollar significantly. That's why the U.S. has time to get its act together, but should not delay.
What are you thinking about the emerging markets and their struggles with inflation?
When you look at any emerging economy, and I'm talking about the strong ones, you have to ask if they can manage success, then if the world can accommodate their success. With China, these questions are absolutely critical, since it's the world's second-largest economy. With Brazil and Indonesia, you ask the first question more than the second. With Saudi Arabia, you ask the second question more than the first, because oil prices are really important. Left to their own devices, most emerging economies will manage their success well.
Where the story gets complicated is twofold. One is the West and its resistance to deleveraging, including QE2, which complicates the outlook. Emerging markets now have to deal with big surges in capital inflows. Secondly, the longer the West resists global realignment, the bigger the challenge for the emerging world. The time has come to change some feudal modalities. Belgium has a bigger vote at the IMF board than Brazil. China is No. 6 or No. 7 even if it's the second-largest global economy. The emerging economies see themselves operating in a system that's still dominated by the colonial past, and that is why they are not willing to step up.
Which ones do you like, and not like?
We screen according to fundamental criteria, then look at market valuations. We look for countries with strong balance sheets and strong growth outlooks, maturing institutions and increased reliance on domestic demand. Brazil, China, Indonesia, Singapore, Korea, Peru all score well. At the bottom are the Central European economies and the basket cases. Valuations are pretty frothy, not surprisingly, because there's been a tremendous allocation of capital to these markets. So we are very selective. We prefer local markets to the external debt markets. But generally, we use equities, local-currency bonds, external bonds, currencies and infrastructure.
How are you positioned?
There are some key principles investors should think about. First, they should be able to navigate volatility, because the danger of volatility is it forces you to do the wrong thing at the wrong time. Second, I'd be careful about return expectations. Governments have borrowed returns from the future. [Fed chief] Ben Bernanke said the objective of QE2 was to push asset values up to make people feel richer. The Fed succeeded in asset-price inflation but the transmission mechanism to higher spending hasn't materialized. Third, the tail risks are much bigger: The loss of triple-A status, the possibility of a disorderly default in Europe, of China not being able to manage its success. An investor has to ask, 'Can I afford such a tail?' If the answer is 'No,' they should hedge the tail or look again at asset allocation. And don't underestimate the value of cash; in a volatile world both good and bad assets are impacted, and the higher the probability of being able to buy good assets at really cheap levels. You don't want to be fully invested today.
In the Pimco Global Multi-Asset Fund [ticker: PGAIX], which I manage with Vineer Bhansali and Curtis Mewbourne, we have 10% cash, which is very significant, because we also have a mix of equities, bonds, commodities. We have under 4% in commodities, down from over 20%. The fund invests in other funds, so it relies on the alpha engine of Pimco portfolio managers [the fund's largest holdings, as of March, are listed nearby]. The benchmark is 60% global equities, 40% global fixed income. Recently, we have been underweight equities, have no exposure to small, peripheral European economies, and overweight local currency bonds in emerging markets. All this is combined with a tail hedge to minimize volatility.
Thanks, Mohamed.
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