The Global Economy: What the Next Three Years Will Look Like

05/15/2012 07:34 pm ET | Updated Jul 15, 2012

Editor's note: The following post is adapted from a document originally sent to clients of PIMCO, an investment firm led by William H. Gross and Mohamed A. El-Erian. It summarizes discussions that took place at the PIMCO 2012 Secular Forum, an annual event that brings together investment professionals from PIMCO's 12 offices around the world with thought leaders from outside PIMCO to discuss and debate global financial trends. Here El-Erian relays their collective attempt to lay out for PIMCO's clients what the next three years will look like in the global economy.

This year's Secular Forum was particularly interesting and, also, very

challenging. For 2 ½ days, we debated a range of issues, with lots of time

spent on the familiar -- such as the twin problem of too much debt and too few

jobs, and the related austerity versus growth debate -- but also on the less

prominent but equally consequential -- including the game theoretics of large

debt overhangs, as well as how technology is redefining economic, political and

social interactions. In the process, we iterated to findings that, we believe, are

both consequential and actionable for investment strategies including ... but,

wait, I am trying to fast-forward a summary write-up that warrants proper

introduction and context.

The Secular Forum has proven enormously important for PIMCO's ability to

deliver consistent value to you, our clients. Indeed, if we were to pick the

handful of factors that have enabled us to serve you well for more than 40

years, this annual event would certainly be among them. It gathers investment

professionals from PIMCO's 12 offices around the world. Collectively, we

engage in a lively debate aimed at identifying the major trends that will play

out over the next three to five years (and, critically, not what should happen

but, rather, what is likely to happen). Think of the outcome as providing

medium-term guardrails for where and how we invest the funds that you

have entrusted to us.

It is never easy to take an individual -- let alone a group -- out

of the day-to-day routine and focus on issues that are not

urgent now, but will prove both urgent and important over

the next few years. To help us do so, we turn each year to

thought leaders from outside PIMCO to act as catalysts

and to challenge our views, thus also reducing the risk

of groupthink; and again this year we were privileged to

interact with terrific thinkers who brought lots of interesting

ideas to the table. We also listened to our brilliant new class

of MBAs and PhDs; and, once again, they provided us with

valuable, fresh and provocative perspectives. And all this was

mixed with quite a bit of background work and back-and-forth discussion.


To provide context for our discussions, we explicitly started with

our priors -- the conclusions of previous Forums, adjusted for

recent developments, new information and additional analysis.

A year ago, PIMCO concluded that the world would continue

to exhibit multi-speed characteristics. Specifically, advanced

countries would appear to cyclically recover. But, with lagging

policy mindsets, growth would prove insufficient to overcome

problems of unusually high (and persistent) unemployment,

large budget deficits, rising debts, and worsening income and

wealth inequality. For some countries with acute economic

and balance sheet stress, we postulated the "virtual certainty

of at least one (and probably more) sovereign debt

restructurings" during our secular horizon.1

We painted a different picture for emerging economies.

Because they are powered by higher growth, we argued that

they would continue to close the global income and wealth

gap, lifting millions more out of poverty in the process. We

recognized that this would not be linear as countries confront

inflationary concerns, disruptive surges in capital inflows and

tricky internal transitions (including what Mike Spence, Nobel

Laureate in Economics and author of the recent book on "The

Next Convergence," calls the "middle income transition").

At the global level, we anticipated that the international

monetary system would experience stress in accommodating

these historic global realignments. Remember, not only would

emerging economies grow faster, but they would also have

an increasing and ultimately defining influence on the

structural behavior of the global economy. Yet, due to deeply

entrenched entitlement mindsets in advanced economies and outdated mechanisms in multilateral organizations, global

governance would find it difficult to catch up with the

evolving new reality, let alone get ahead of it.

This, of course, is what PIMCO had labeled the "new

normal" back in early 2009 -- one that spoke to delevering

in advanced economies, structural imbalances, and global

convergence.2 It thus portrayed, as reiterated in last year's

write-up, a post-2008 global financial crisis world that "heals

only slowly and unevenly," "transitions ... in a rather messy

and uncoordinated fashion," becomes "increasingly

fragmented in terms of cognitive recognition," and in which

"social cohesion is uneven."

Our medium-term baseline was seen as being subject to

two-sided risk scenarios. It could tip into a much better

equilibrium if policymakers came up with three "grand

bargains" -- in Europe, the U.S. and China. But it could also

fall victim to a more rapid and disorderly delevering.

These two scenarios were important enough for us to argue

for a gradual morphing in the distribution of expected

outcomes that underpins many investors' behavior (and

analytical constructs): away from the traditional bell curve that

exhibits a dominant mean and thin tails (both very comforting),

to a flatter distribution with much fatter tails that, in certain

circumstances (Europe), could even go bimodal.

Much of what has transpired over the last 12 months is

consistent with these priors. Indeed, at times it has felt as if the

fast-forward button had been pressed on our secular themes.

In the run-up to the Forum, we found longer-term issues

featuring more prominently in our cyclical discussions, as well

as in the deliberations of the Investment Committee (which

meets four times a week for two to three hour sessions). And

with incrementalism dominating way too many policy reaction

functions, these developments also help explain why the

world/markets now face potential inflection points over the

next three to five years -- some probable and others possible.

Key Issues

It did not take us long last week to figure out that this would

be one of the more challenging Secular Forums. After all, we

were analyzing a global economy buffeted by complex

realignments yet lacking proper historical precedents.

Meanwhile, monetary policy is in full real-time experimentation mode, political anti-incumbency is growing,

and extreme polarization is amplifying rising social tensions.

And if this were not enough of a complex cocktail, let us not

forget what our colleague Ramin Toloui called the disparate

adherence to "alternate realities." The resulting

disagreements -- which, increasingly, cover the past, present

and future -- further undermine any convergence to a

common analysis of what ails individual countries, let alone

the vision and sense of shared responsibility to solve it.

This combination results in what Jerome Schneider described

as a self-reinforcing cycle of largely reactive partial responses,

subsequent complacency and recurrent localized crises. The

longer this persists, the greater the probability of a series of

market inflection points in the next three to five years.

Indeed, it should come as no surprise that both policymakers

and economists are struggling with what has been

oversimplified into the growth versus austerity debate.

And the resulting confusion, together with a pronounced

tendency for politicians to bicker and dither, has made the

problems more complex and the solutions more demanding.

In such a world, we believe that it is particularly important to

differentiate well between what one knows with a high degree

of both foundation and conviction (the "knowns"), and where

sufficient knowledge and confidence can only be built through

additional data and analysis ("known unknowns"). This should

be combined with enough intellectual agility to change the

composition as more information become available; and also

with the operational responsiveness required to evolve

investment strategies accordingly.


The knowns speak to the likely persistence of what has

become a familiar combination for too many advanced

economies -- too little growth, too much debt, high

joblessness (particularly among the young and long-term

unemployed), excessive political polarization and growing

calls for greater social justice.

Given current policies, none of these are likely to go away any

time soon absent a major crisis and/or a big political pivot.

Moreover, the adjustment processes in certain countries (with

Greece being the lead example) have already been

undermined by "policies that hurt but don't work," a phrase

used by British politician Ed Miliband in a different context. As such, they risk a frightening economic, financial, political

and social implosion.

This reality will continue to play out most distressingly in a

few European countries where the institutional setup is

already under strain. Indeed, politicians will find it increasingly

difficult to reconcile what Andy Bosomworth labeled as the

requirements of democracy, mutualization and conditionality

- thus robbing the region of the type of mutual assurances

that are critical to a cooperative orderly solution. With that,

allocating balance sheet losses becomes even more difficult,

both within and across countries.

Simply put, the status quo is no longer an option for Europe

over the three to five year horizon. The higher probability

outcome is that the eurozone will evolve into a smaller and

less imperfect entity -- namely, a closer political union of

countries with more similar conditions. We believe that this

smaller union would likely include the big four (France,

Germany, Italy and Spain) which, together with other

remaining members, would be underpinned by much

stronger regional coordination and financing mechanisms.

We did not come to this view easily -- especially as there is no

orderly, easy and costless way to get there. Evolving into a

smaller and less imperfect zone -- as leaders need to do in

order to save their important and historical European project,

and thus also avoid a major disruption to the global economy

- is expensive and uncertain. It requires a lot of proper

coordination, a more balanced policy mix, stronger financial

circuit breakers (well beyond the ECB's lender of last resort

facilities), less vulnerable banks, and quite a bit of luck too. It

could even take a major fragmentation scare to force political

leaders to act in a sustained manner.

All this also means that risk of a big derailment (an

"existential risk" for the European project) is far from de

minimis. Given the series of sustained negative shocks that

this would entail -- for individual nations, the region and the

world as a whole -- every political avenue should be pursued

to avoid it. But we cannot count on that.

As Thomas Kressin noted, it is not just about the willingness

of politicians to keep the eurozone intact. If it does fragment,

it will most probably be because the population loses

patience, resulting in political and social rejection that is

aggravated by a tsunami of private capital outflows.

Fortunately, politicians and policymakers still have the ability to get ahead of this, but they need to do so very seriously

and very quickly. And for that, they also need a common

analysis, a shared vision, and sufficient support.

Over the next three to five years, the U.S. will look good

relative to Europe, outperforming in terms of growth and

financial stability. That is the good news. The bad news is that

Americans live in an absolute and not a relative dimension.

Our political analysis led us to conclude, using Libby Cantrill's

notion, that political scrimmages rather than grand bargains

would dominate Washington -- a forecast that reflects not only

the reality of extreme polarization, but also the impact of

significant disagreements among "technocrats" and related

policy confusions. The fiscal cliff debate, which is certain to get

louder in the coming months, will provide insights in this regard.

In a world that is so far away from any notion of a policy first

best, look for the Federal Reserve to maintain its pursuit of

financial repression for a number of years; and look for other

regulatory bodies to pursue similar avenues in the context of

a generally more restrictive regulatory environment. The

resulting policy mix, however, will do little to alleviate

legitimate concerns about growth, jobs, inequality, debt and

deficits. In the process, the underlying structural fragilities of

the economy will grow, in both economic and financial terms.

Turning to the emerging economies, we expect them to

continue to outpace both Europe and the U.S. over our

secular horizon. But don't look to them to compensate fully

for problems elsewhere in the global economy. Also, you

should expect them to deliver a more volatile growth path,

especially as some countries undertake needed and tricky

transition in growth models (including China). Along with all

this, also look for greater differentiation among countries in

what will become an increasingly heterogeneous grouping.

Yes, we expect emerging economies will account for more

than 50% of global GDP in the next three to five years (in

purchasing power parity terms). And yes their size and

growth rate will influence even more the functioning of the

global economy. But this will not overwhelm developments in

the advanced countries anchoring the core of the

international monetary system. Moreover, with advanced

economies attempting to hold on to outdated entitlements,

the undeniable shift in economic gravity will not be

accompanied by sufficient changes in the manner the global

system is governed, wired and interconnected -- changes that are important for laying a proper foundation for more

balanced global growth and a more robust international

system in the future.

So, turning to illustrative numbers, we expect growth in

advanced economies to average some 1% annually over the

next three to five years (compared to 2'ish% at the 2011

Forum); and some 5% for emerging economies (6%

previously). Meanwhile, look for the inflation versus

disinflation debate to continue unabated as the tug of war

between stimulus and debt deflation plays out.

On balance, we believe that over the next few years,

inflationary pressures will slowly build in the global system due

to several drivers. Too many cyclical dislocations risk becoming

embedded as structural impairments to long-term growth

potential, particularly when it comes to the labor markets in

advanced economies. With other government entities doing

too little, central banks will likely maintain highly

accommodating policies for too long. And do not forget the

political appeal of resorting to inflation as a means to delever.

Known Unknowns

What about the known unknowns? There are quite a few,

including some with the potential to turn some of the slow

burn dynamics into sudden shocks, either negative or positive.

Elections and transitions could certainly be game changers.

According to calculations by our MBAs/PhDs, more than 50%

of global GDP will face a potentially defining change in 2012.

Moreover, eight out of 17 eurozone governments have been

voted out of office in the last couple of years. So the potential

for political upheavals is certainly with us.

Armed with strong new mandates, governments could deliver

the "Sputnik moment" that acts as a catalyst for a series of

beneficial grand policy bargains. And the impact would be

amplified by the crowding-in of significant private capital that

is now on the sidelines. More likely, however, is that elections

result in a further polarization that complicates economic

management. And, as illustrated recently in Greece, the

mounting loss of credibility of traditional political parties

facilitates the emergence of fringe parties that are eager to

dismantle the past but have as yet no coherent and

comprehensive plan for the future.

Over the next few years, elections will compound the

pressures that governments feel from increasingly restless populations (especially in countries with high youth

unemployment, including 51% in Greece and Spain and 36%

in Italy and Portugal). As one of our new colleagues, Min

Zhang, put it, her generation is looking for "hope and

opportunity." Instead, and also lacking control of the ballot

box, they are being saddled by an older generation's debt and

growth impediments. And demographic trends will

accentuate the challenges. Under such circumstances, we

should not dismiss the possibility of unpredictable

sociopolitical reactions that end up further complicating

long-standing social compacts and the related functioning of

an already stressed international monetary system.

What happens in advanced countries will be of more than

passing interest to the healthier part of the global economy,

namely the emerging world -- a point that Francesc Balcells,

Michael Gomez, Ramin Toloui and others stressed.

The longer it takes for the advanced countries to grapple with

their growth and debt problems, the greater the imperative

for emerging economies to transition to sources of domestic

demand to sustain growth. Nowhere is this more important

systemically than China.

History suggests that economic, political and social frictions

are inherent to such transitions, requiring careful and

responsive management. Moreover, as the emerging world

itself starts with a set of different initial conditions among

individual economies -- and a few differences are quite

pronounced -- some countries will likely be more successful

than others, with related surprises.

Have no doubts, the "concentric circle" construct

underpinning the international monetary order will be

pressured in significant ways in the next three to five years.

This is not to postulate a different system. As Rich Clarida

argued, there is no alternate system and, therefore, you

cannot replace something with nothing. Rather, it is about an

increasingly hobbled international order whose anchoring core

is weakening on a daily basis, thus undermining the standing

of global public goods over the secular horizon. Also, don't be

surprised to see countries in the outer circles (particularly some

emerging economies) increasingly establish direct links that

bypass the core. Indeed, changing clusters of global influence

are likely to be a notable feature of the next three to five

years; and the systemic impact is inevitably uncertain.

Technology also provides for meaningful two-sided tails for

our baseline hypotheses, especially given that disruptions in

this domain easily catch people by surprise.

You would have to be in North Korea to deny that the world

is in the midst of empowerment advances that fundamentally

alter the relationship between individuals, between states,

and between these sets of global actors. As discussed, it is a

changing ecosystem that results in two worlds operating

simultaneously -- but with different protocols, speeds and

legal protections: a physical world with government and

institutional control, and a virtual one with individuals

dominating the creation, dissemination and sharing of

content. Over time, the latter will have even greater

economic, political and social impact -- and do so at times

through unanticipated channels.

This provides for the exciting possibility of leapfrogging

structural impediments through what Mike Spence calls

off-sequence development. Several specific examples were

put on the table where technology could serve as a beneficial

accelerator. And if we are really lucky (and we mean really,

really lucky), perhaps this could also help in dealing with

some of the real dangers of self-limiting growth patterns,

including those associated with society's past abuse of the

environment. But, again, we should not count on that.

Yet this phenomenon has more than one potential outcome.

Some of the empowering technical revolutions can be

negatively used to undermine social cohesion and security.

Others offer the likelihood of disruptive revolutionary dynamics

that are easy to start but prove difficult to control and

complete, especially in the absence of sustained leadership.

Implications -- The "What"

Our 2012 Secular Forum discussion confirmed that the

distribution of expected outcomes for the global economy is

both flatter in its belly and fatter in its tails. This is a

potentially unstable situation, especially when compared to

the conventional bell curve. Moreover, its density has shifted

unfavorably in the past 12 months as a result of growing

uncertainty, complexity and policy risk premia. In Europe, it

has already morphed into a bimodal distribution -- a

phenomenon that colleagues in our five European offices

confront on a daily basis.

In such a world, investors need to retain a claim on the

upside while protecting against the downside, including gap

risk. They need to be highly differentiated, positioning

portfolios for the knowns (both for return generation and for

risk mitigation), while also maintaining the right level of

optionality in the face of the unknowns. And they must

ensure sufficient operational agility to evolve as more data

become available, as will inevitably be the case.

In the short run, investors are well advised (indeed, urged) to

supplement careful bottom-up security selection with macro,

and in particular a deep understanding of the implications of

the different policy approaches being used to deal with

over-indebted economies generating insufficient growth --

directly in advanced economies and indirectly in how this

impacts the behavior of others. Specifically, and in the words

of Bill Gross, they must seek to engineer a "great escape"

from a range of actual and likely realities -- be it financial

repression in the U.S., default in Greece, or other forms of de

facto confiscation elsewhere.3

This, of course, translates into a sizeable quality bias for

sovereign and company exposures, the latter both in

corporate credit and equity space. Focus on names with high

cash balances, low financial leverage, high operating margins

and exposure to growth areas. Higher quality sovereign

exposure should be concentrated in parts of the yield curve

that offer meaningful roll down and are anchored by credible

central bank policies. Exposure further out the curve should

be taken with caution, focusing on sovereigns with a lower

risk of inflation and also utilizing inflation-protected

securities. Meanwhile, higher-quality equity exposure should

be supplemented, where possible, with a dividend dimension

as a means of de facto shortening duration.

Consider real assets when thinking of the range of responses

to minimize the multi-faceted risk of financial confiscation,

especially as inflationary pressures slowly mount. Again,

differentiation will be essential, with emphasis placed on

those with low supply elasticities and offering a degree of

geopolitical protection.

Currencies are the hardest to call in the world we have

described. On the one hand, emerging market currencies will

likely be supported by continued productivity gains, strong

balance sheets and capital inflows. On the other hand,

policymakers there will be hesitant to see their currencies strengthen in a world that is so uncertain, especially if the

appreciation is turbocharged by leakages from what they

view as excessive liquidity creation in the U.S. Also, expect the

U.S. dollar to continue to be the main recipient of flight-toquality capital, at least for the first part of the secular horizon.

These considerations speak to relatively limited scaling of

currency positions pending additional information. And they

also shout for careful differentiation.

The bottom line here is a simple one: Wherever you are in the

capital structure and in geographical space, be very alert to

situations where valuations do not reflect the confiscation

risk. And remember, confiscation is not just default. It is also a

function of poor protection against inflation, nationalization

or the large preemption of company and currency earnings

by governments.


The emphasis on minimizing exposure to financial repression

will remain as long as central bankers are in control, including

a Federal Reserve that is both able and willing to compress

interest rates while underwriting the mounting collateral

damage and unintended consequences. At some point during

the secular horizon, however, investors will most likely need

to pivot. Why? Because, absent a much more comprehensive

policy response, central bank measures will prove insufficient

by themselves to ignite growth dynamics and safely delever

over-indebted segments in advanced economies.

Think of two corner solutions anchoring the range of

possibilities in this pivot. At one end, central banks end up

providing a bridge for other government entities with more

effective measures, including on the structural front. And this

serves to crowd in private capital currently on the sidelines.

At the other end, central bank policies become not just

ineffective but also counterproductive as the collateral

damage and unintended consequences eventually overwhelm

the intended benefits.4 In addition to the direct negative

impact, this would encourage the private sector to de-risk

further, thus sucking more oxygen out of the economy.

For investors, the essence of this pivot involves an

overwhelming emphasis on capturing solid and growing

value streams that reflect company and sovereign ability to

"earn" them through sound fundamentals rather than to "buy" them through financial wizardry. Its exact nature

depends on whether other policymakers, with better tools,

finally step up to their challenges.

If they do, then an across-the-board risk-on posture would

make sense; and government bonds would prove a bad place

to be. But this requires the type of political decisiveness and

effectiveness that sadly eludes most advanced economies;

and it also necessitates better global policy coordination.

Accordingly, the other pivot involves even greater emphasis on

principal protection -- or, to use Bill's recent characterization,

reinforcing the coming of age of investment defense.5 And,

together, all this speaks to the need more than ever to allow

for portfolio repositioning as new data come in and

circumstances dictate.

Implications -- The "How"

So far, we have discussed "what" investors should consider

if they agree with our secular analysis. It does not stop here

however. The analysis suggests that the "how" is equally


Given the likelihood of inflection points, investors will need to

be extra careful of traditional market capitalization indices

that underpin not just conventional benchmarks but also

many passive investment approaches. These can be

particularly counterproductive in fixed income when debt is

growing beyond safe levels (remember, they encourage the

allocation of large and rising sums to increasingly vulnerable

credits). In equity space, many of the traditional indices and

approaches risk missing out on disruptors that will thrive in

dislocated and changing markets and ecosystems.

It is also high time to revisit a whole host of backward-looking labels and dividing lines that often lurk in asset

allocation, investment guidelines and mindsets. Are

"domestic equities" really domestic when a large and

growing portion of company revenues and profits come

from other countries? Are advanced government bonds really

interest rate risk when countries continue to slip down the

credit curve? And are all emerging market sovereign bonds

as risky as the term is often seen to imply?

All this speaks not only to increasingly outdated historical

distinctions, but also to correlations among asset classes and

the flexibility to react to (and combine more optimally) different risk factors. Remember, as Josh Davis, David Fisher

and Curtis Mewbourne note, it is about how an investment

behaves rather than what it is called.

Led by our analytics and solution capabilities, PIMCO has

done a lot of work on this. This particular effort was initiated

back in 2006 and we now have encouraging results to share

with you -- from forward-looking indices (including "Global

Advantage" that just celebrated its third anniversary) to

solution methodologies and risk factor analysis.

Finally, and perhaps most disappointing for many, society will

need to lower its return expectations in general, and

particularly its risk-adjusted return expectations. Having

produced what Scott Mather called a period of "false

economic prosperity," the enormous multi-year levering of

both the public and private sectors in advanced economies

also involved the front-loading of investment returns. This can

only be maintained and enhanced now through additional

leverage (and the set of binding constraints here is set to

grow) or through the lifting of structural impediments to

growth (a much better approach but unfortunately

problematic, at least for now).

As return expectations come down, the asset side of the

balance sheet will not be sufficient on its own to meet the

objectives of many investors. An even stronger linkage to the

liabilities side will be paramount. In many cases, this requires

a concurrent evolution in portfolio construction. Moreover,

as demonstrated by Vineer Bhansali and Jim Moore, an

investment approach that places risk mitigation just on the

shoulders of asset class diversification will suffer. It will need

to be appropriately supplemented by more sophisticated

asset-liability management, cost-effective tail hedging, and a

solution (as opposed to just product) mindset.

Bottom Line

In July 2010, the Chairman of the Federal Reserve Board, Ben

Bernanke, came up with an elegant term to characterize the

United States' cyclical outlook -- he called it "unusually

uncertain." PIMCO's 2012 Secular Forum suggests that this

term could well prove as resilient as our May 2009 forecast for

a "new normal." Given our analysis, Bernanke's unusual

uncertainty applies to more than the cyclical timeframe, and to

more than just the United States. It is both secular and global.

Now uncertainty, even of the unusual variety, does not -- and should not -- translate into investor paralysis. We believe that

specific areas of the secular horizon are already clear and actionable today; others are subject to significant two-sided fat tails

that should be detailed and managed accordingly.

Over the next few weeks, we will provide you with several more detailed notes from our specialists on how the Forum's

conclusions affect their individual sectors. We will also continue to fill out the secular topology, especially as we learn more

about how the global economy is accommodating historic multi-dimensional changes -- be they in advanced countries, in

emerging economies or in the functioning of the international monetary system. And you can be assured that we will work

very hard to do so well ahead of others.


1. "Secular Outlook: Navigating the Multi-Speed World," PIMCO, May 2011.

2. "Secular Outlook: A New Normal," PIMCO, May 2009.

3. "The Great Escape: Delivering in a Delevering World," PIMCO, April 2012.

4. "Evolution, Impact and Limitations of Unusual Central Bank Activism," PIMCO, April 2012.

5. "Defense," PIMCO, March 2012.