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.
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.
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
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
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
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.
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.
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