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Mohamed A. El-Erian
Risk ScenariosThis hobble through world is a reaffirmation of the concept of a bumpy journey to a new normal. Be it China, Europe, or the U.S., it presumes that policymakers and politicians can continue to dominate economic and market fundamentals. It is also a baseline that is subject to two-sided tails that should be kept front and center on our secular radar screens; and these tails could well get fatter as the years pass.The baseline can tip into a better global equilibrium (“the right tail”) through a series of “grand bargains.” Think of three in particular. First, the U.S. having a “sputnik moment” where serious structural reforms – focused on re-aligning balance sheets over the medium term, enhancing employment creation, and improving international economic competitiveness – result from a sense of national unity, common purpose, and shared sacrifice. Second, Europe confronts its “moment of truth” and course-corrects the setup of the Euro-zone to enable both debt sustainability and high economic growth. Third, emerging economies actively unleash their consumers, thus ensuring that their systemic impact is felt through both production and consumption.While the probabilities for these grand bargains have increased in recent months, they are still far from dominant. Accordingly, rather than drive at this stage the baseline for the next three to five years, the best that they can do is offset pressures for a less favorable global outlook.These pressures, which are multifaceted, speak to the unfavorable risk scenario (or “left tail”). There are limits to how long excessive liabilities can simply be shifted around the system. You cannot address solvency concerns by piling new debt on top of old debt. Excessive income and wealth inequalities eat away at the fabric of societies. Persistent joblessness undermines productivity and skills, and can also turn part of the youth from being unemployed to being unemployable. Finally, policymakers cannot kick the can down the road forever, especially as both policy effectiveness and flexibility are eroding and the risks/reality of collateral damage and unintended consequences grow day in and day out. Remember, the world is interconnected as a system but is increasingly fragmented in terms of cognitive recognition and policy coordination. Importantly, social cohesion is uneven across countries at a time when difficult decisions have to be made about entitlements and a related need to allocate and tolerate the disappointments associated with broken contracts. Investment ImplicationsOur discussions point to five important considerations for the three- to-five-year guard rails for investment strategies.First, there is a limit to the amount of investment returns that can be brought forward from the future, especially in advanced economies. Yes, the authorities have succeeded in driving a wedge between sluggish and uneven fundamentals and high investment returns. In the process, investors as a group have essentially borrowed returns from the future. But the thickness of this wedge is limited by the extent to which real rates have already been compressed.Second, secular baseline portfolio positioning should incorporate some key principles impacting both risks and returns: e.g., minimize exposure to the negative impact of financial repression; hedge against higher inflation and currency depreciation; and exploit the heightened differentiation in balance sheets and growth potentials.Third, differentiation within asset classes, including careful security selections, will remain key. Global yield curves will be steeper than historicals, with duration/roll down at the front end dominating. Government bonds should be influenced by the exact country mix of budgetary austerity, creditworthiness, financial repression and monetization. Corporate exposures, through both stocks and bonds, should be heavily impacted by top line growth, cash holdings and pristine balance sheets. Most tradeable sectors are likely to dominate non-tradables and, within the latter, high dividend stocks will lead growth in advanced economies (and vice versa in developing). Foreign exchange positioning will be key, favoring undervalued/fair valued emerging currencies supported by strong balance sheets and where capital controls tend to be ineffective. Supply-constrained/store of value commodities will likely do well, but in the process also demonstrate large volatility on account of regulatory reactions (real and perceived).Fourth, investors will need to show significant agility given the fatness of the two-sided tails just discussed. This relates to the scaling of positions and the assessment of correlated risk factors. It also speaks to cost effective tail hedging given the investment implications of the tails.Finally, the next few years will require investors to upgrade and retool a whole set of conceptual and operational approaches that have served us well in the past but are less relevant going forward and, in some cases, could even be dangerous. It is not just about the country distinctions mentioned earlier. Ongoing changes in the global economy are still inadequately captured in the construction of traditional indices, asset allocation methodologies and investment guidelines. As an illustration, conceptual constructs, including market cap approaches, will likely prove less useful; and a sustained effort will be needed to counter well-entrenched home biases (e.g., Figure 6) that result in asset allocations that are increasingly inconsistent with domestic and global re-alignments.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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