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 ? 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.
Context
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.
Knowns
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.
And…
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 consequential.
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.
References:
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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