A New Normal

Mohamed El-Erian

Risk Scenarios

These factors pose interesting questions for long-term investments: Over the secular horizon, will global low growth transition into even more unpleasant stagflation? Will some central banks’ current efforts to repress real interest rates throughout unusually large segments of the yield curve succumb in a disruptive fashion to the dark forces of higher inflationary expectations and sovereign risk spreads?

At present, such transitions constitute important risks to our secular baseline. They are not the only ones in what, unfortunately, is a “balance of risk” picture that is tilted to the downside.

John Maynard Keynes, whose thinking dominated the inter-war economic debate and whose influence is obvious today in many policy circles, is said to have stated: “When the facts change, I change my mind. What do you do, sir?” In this spirit, let me share with you other risk factors that we will be following closely in the months ahead.

First, politics matter a great deal. Over the next few months, political feasibility (rather than economic desirability) will dictate most economic policy responses. Given the fragility of the global system, the world can ill afford a new round of policy mistakes and political unpredictability. Protectionist measures would be particularly harmful, as would steps that undermine the image of the U.S. as a responsible shepherd of other countries’ savings.

The political dimension is not limited to the next few months. Farther down the road, political commitment will be needed to drain the system of emergency liquidity – a task complicated by the strong possibility that the U.S. and U.K., in particular, will face a reduction in trend growth rates at a time of increasing pressure to lower unemployment. Remember, the evidence of recent years is that governments are reluctant to impose short-term pain for long-term gain.

Second, the healthy functioning of markets (and societies at large) depends on a set of implicit contracts – what our MBAs labeled social contracts. As is often the case in emergency situations, these contracts are being subjected to major shocks. For many, 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.

Third, the management of public debt in industrial countries will be a delicate process. For sure, the numbers going forward are very, very large – in terms of both stocks and flows. The starting point, including the fact that the average maturity of outstanding U.S. debt is at the lowest (i.e., most vulnerable) seen for some 25 years, is far from reassuring. Also, let’s not forget that, in a few years’ time, very large unfunded entitlements (Social Security and Medicare) will start to significantly hit the budget.

Fourth, any further erosion in the autonomy and mission of key economic institutions, including the Federal Reserve and to a lesser extent the FDIC, would be terrible news. Governments must resist the temptation to co-opt further such institutions, saddling them with fiscal activities that lack sufficient transparency and belong with the budgetary process. The lessons of history are unambiguous on this: the weakening of key institutions serves to adversely impact risk premiums across many markets.

Fifth, even our muted projections for global growth assume some important handoffs that are inherently difficult and face large time-inconsistency challenges. Remember, we are postulating that continued robust growth by some major emerging countries (particularly Brazil, China and India) will serve to partially offset the lower growth in the G-3 and the U.K. We are also postulating that growth in these countries will be driven by a significant pickup in the consumption of an expanding middle class.

Investment Implications

While the Forum process was intellectually exhausting, it yielded a rich menu of strategic insights – starting with secular investment positioning and extending into product design, client servicing and business management.

With regard to our secular investment guardrails, our baseline favors the front end of yield curves in many countries (as the authorities overstay with negative real policy rates), income-generating instruments (which will dominate the pure equity premium), and an international orientation (as the U.S. faces the prospects of a plateau shift in sovereign risk and the return of higher inflationary expectations).

It specifically argues for

• Exploiting periodic anomalies associated with clumsy internal and external handoffs


• Favoring credit spreads higher up in the economic and capital structure and, increasingly, on an even more international basis


• Remembering that premiums across risk factors and markets will reflect in a seemingly permanent fashion the bout of disruptions to the sanctity of contracts and the capital structure, as well to the autonomy of key economic institutions


• Positioning for the eventuality of renewed depreciation of the dollar, keeping in mind that the magnitude of depreciation against other currencies could potentially be outpaced by that vis-à-vis real assets


• Recognizing that the equity risk premium will now reflect a permanently higher threat of subordination.

Over the next weeks, our specialist desks around the world will be working on assessing the implications of these factors for specific strategies, asset classes and products.

In Sum

Markets will revert to a mean, but it will not look anything like that of recent years. Relative to where it is coming from, the financial system will be de-levered, de-globalized, and re-regulated. Global growth will be lower and unemployment higher, notwithstanding the continued rotation of dynamism away from industrial countries and toward emerging economies. Price formation in many markets will be influenced by the legacy and, in some cases, continuation of direct government involvement. Burden sharing will feature more prominently, being one feature of the heavier hand of government in economic life.

For a financial industry known for its famously short memory (and related infrastructures and behavior), this will feel like a new normal. Adaptations will be needed as the configuration of risks and returns shift, government debt balloons, and capital structures potentially migrate toward a simplified structure consisting just of equity and senior debt instruments. Business models will need to be retooled, and investment management vehicles made more responsive and robust.

These issues will be front and center on our radar screens as we navigate the resources that you have entrusted to us. Indeed, in closing, allow me to quote from Bob Dylan’s song, “Forever Young,” which (italics added) expresses a simple notion that will influence how PIMCO navigates with you the bumpy journey to this new normal:

May your hands always be busy
May your feet always be swift
May you have a strong foundation
when the winds of change shift

Thank you.

Mohamed A. El-Erian
CEO and Co-CIO

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