Published June 09, 2014
As the Dow Jones Industrial Average closes in on 17000 and the S&P 500 index nears 2000, investors are cheering stronger economic data this spring after winter weather walloped the economy in the first quarter.
The latest data, including manufacturing and employment for the month of May, paint a picture of an economy that is slowly improving. Five years after the economy emerged from the Great Recession, America has finally returned to pre-crisis levels of employment. Meanwhile, many economists forecast gross domestic product will finally return to its historical average of an annual growth rate of 3% this year.
Despite reaching these milestones, the economy is still far from reaching its potential, according to Mohamed El-Erian, chief economic adviser for Allianz and former chief executive of Pacific Investment Management Company, better known as PIMCO. Perhaps most well known for coining the term “the new normal” in 2009, his prediction for sub-3% growth for the past three to five years has held true. In an interview, El-Erian weighed in on his outlook for the economy, Federal Reserve monetary policy, the bond market, his outlook for stocks and where the biggest risks to the global economy loom.
Among his predictions and insights, El-Erian said he thinks Treasury yields have likely bottomed, but that he would scoop up Treasury Inflation Protected Securities. He said U.S. stocks are fairly-to-over valued and that individuals should wait for a better entry point to invest more money in stocks. Edited excerpts from El-Erian’s interview with FOX Business follow.
Jennifer Schonberger: You coined the term the “new normal” back in 2009, calling for sluggish economic growth in the 2% range for three to five years. First-quarter GDP contracted. Most economists think growth bounced back in the second quarter to the tune of around 3%. But even when taken together, GDP in the first half of the year would still clock in at sub 3%. Are we stuck in a secular stagnation?
Mohamed El-Erian: That is a key question. We are stuck in a low-growth equilibrium where the U.S. economy grows on average 2% to 3% per year and the global economy has difficulty growing faster than 4.5%. Within that, we’ll see some interesting changes in the composition of global growth. In the case of the U.S., there is no doubt that the first-quarter contraction was related to the weather and that growth will bounce back. The good news is that for the first time in quite a few years, 3% GDP (growth) is obtainable. The bad news is that we don’t have lift off or escape velocity. So we’re still not getting back what we lost in prior years.
Schonberger: Why aren’t we getting “lift off?” Does it come back to … getting more clarity and better policies from Washington?
El-Erian: That’s absolutely correct. Unfortunately, Congress isn’t stepping up to the plate. In order for us to grow faster and to do what we’re capable of, we have to energize our growth engines. We have to support them through better infrastructure, productivity and competitiveness. That’s simply not happening because of Congress.
Schonberger: What about the Fed’s role? Do you agree with the Fed’s current policy course right now?
El-Erian: The Fed is taking a huge risk. It’s using tools to push up asset prices to artificially high levels in the hopes this will trigger the wealth effect. That is, people feel wealthier and therefore spend more. The hope is that it triggers animal spirits; the exuberance spills over into the corporate sector, pushing up investments and therefore growth, validating artificially high asset prices.
Schonberger: Is it working? It seems there’s a ceiling on that effect in that rising stock prices and home prices are disproportionately going to older Americans who are then socking that money away. They’re not spending it.
But these tools don’t directly address why growth is not more buoyant or why employment isn’t more dynamic. So it’s a blunt instrument and it has collateral damage and unintended consequences. It also leads to high income inequality, but it’s the only thing the Fed can do now.
It’s not where I’d like us to be. I’d like Congress to step up to the plate and pass policies required to produce high and inclusive growth. But Congress is not there now. So I understand why the Fed is doing this. The counterfactual is are we better off without the Fed taking these actions? It depends in large part whether financial instability ends up being risked in this process. Am I comfortable? No. Do I worry? Yes.
Schonberger: Are you worried about credit bubbles surfacing from the Fed’s low rates and encouragement of risk taking?
El-Erian: I’m worried the Fed is encouraging excessive risk taking. I see it in terms of the exuberance in the market. I see it in terms of what people are saying. I see it in terms of certain asset prices that cannot be validated by fundamentals. The Fed doesn’t target high asset prices as an end in itself. It targets asset prices as a means to a better economy. So investors shouldn’t depend excessively on the Fed. There will come a time when the Fed will no longer be there for the markets. Do I think all of this will blow up like in 2008? No. But there will be payback in future years. We’ll go through periods of financial instability where the Fed will have to intervene to ensure the smooth functioning of markets.
Schonberger: So many thought U.S. Treasury yields would climb this year. The opposite has happened. Does that surprise you? What’s the bond market telling you now?
El-Erian: The bond market is telling you that the Fed is committed to keeping interest rates low. In the short term, the Fed is worried that high interest rates would hurt housing and the economy. It’s talking the markets into maintaining lower rates than would have prevailed otherwise.
The bond market is also telling you lots of investors, particularly (on) Wall Street, were not positioned for a bond-market rally. The overwhelming view heading into this year was that rates were heading higher and that the best bet out there was to bet against the bond market. So lots of people were short, caught by surprise and are now being forced to cover their positions. That won’t last forever.
Schonberger: What’s your outlook for the yield on the 10-year Treasury?
El-Erian: Once we get through this technical adjustment, I think we’ll see a yield in 2.6% to 3.1% range. It won’t break out in a major way toward 4% like some were expecting, but I don’t think we’ll see it go down to 2% either. (Editor’s Note: The benchmark 10-year Treasury bond yielded 2.62% in morning trading Monday)
Schonberger: Would you buy Treasuries now or bet against them?
El-Erian: Depends what else I have in my portfolio... I would look at Treasury Inflation Protected Securities – inflation protected bonds. True there’s no inflation now. But the best time to buy protection is when people aren’t worried about something. Think of flood insurance. You never want to buy flood insurance after a flood. That’s when it’s most expensive. So I would look at inflation-protected bonds.
Schonberger: What’s the risk that the U.S. and the global economy will be unable to grow and generate inflation at pre-crisis levels for years to come even if rates remain at zero?
El-Erian: Every systemically important country is trying or needs to come up with a better growth model. The U.S. is having difficulty generating 3% growth. But the U.S. should generate above 3% growth given our innovation, entrepreneurship and resources. Europe is struggling to get to 2%. China is slowing down and will probably stabilize around 7%. So the big economies – the ones that make a systemic difference – are all looking for different growth drivers.
Most countries underinvested in their growth drivers. Part of it was the love affair that the world had with credit and debt entitlements. If I take you back ten years, society believed that finance was the next stage of capitalism. We stopped investing in other things. Instead we believed credit could drive our growth higher. Of course we found out painfully in 2008 that finance cannot be bigger than the underlying economy, and when it does, you get massive problems. But we are yet to come up with stronger growth drivers.
Schonberger: When you look across the U.S. and the globe what worries you most now?
El-Erian: There are four major risks that have a small probability of occurring, but with the capability of large impact. The first is geopolitics. There are lots of geopolitical hot spots. I worry that one will end up being systemic in nature. Ukraine got close. If the U.S. moved to impose sectorial sanctions and Russia countered with energy sanctions then Europe would have tipped into recession and the global economy would have looked very different.
The second major concern is China. Its economy is slowing and I expect that it will soft land at around 6.5% or 7% growth. But China also has credit issues that could create problems. I don’t think that is the baseline, but it merits watching.
The third issue is that we’ve gone through six years of extensive global central bank experimentation. No one knows for sure what the collateral damage is for experimenting with so much money and credit. The hope is that the damage isn’t too bad, but there’s a risk that it could be. We simply do not know.
The final risk is the big difference between what’s happening in financial markets and on Main Street. You see this in terms of Europe where high youth unemployment and inequality is having an impact on citizens’ trust in governance. In this country worsening inequality means it will be harder to govern the United States.
Schonberger: The European Central Bank unveiled a large stimulus package last week to combat falling inflation. But was it enough?
El-Erian: It was a historic and impressive move by the ECB. They implemented a number of measures – some that were unthinkable -- and did it as a big package. ECB head Mario Draghi said we aren’t finished yet. Yields on peripheral government bonds in Europe sunk to record lows. The currency market didn’t respond as much because the currency market is more sensitive to outcomes and realizes that what the ECB did is not sufficient. So there is a transmission problem because a lot of Europe’s issues are structural in nature.
Schonberger: What is the risk that Europe turns into a larger version of Japan?
El-Erian: The risk is high. Inflation is already down to 0.5%. Growth has picked up, but isn’t anywhere near the level that’s needed. Politicians aren’t moving on structural reforms. Most of what Europe faces is structural in nature and there’s only so much the ECB can do right now to bring the continent back from the brink. What the ECB can do is buy time. Keep the motor warm until the politicians get their act together. But the ECB itself cannot deliver outcomes. It’s building a bridge but it cannot deliver the destination.
Schonberger: What’s your outlook for the U.S. stock market? Nearly every day the market seems to be hitting a new record, granted it’s on low volume. How are valuations? Will we get a correction this year?
El-Erian: It’s difficult to specify when a correction will happen. The economy isn’t poised to strengthen so much that it would force the Fed to tighten policy. But you won’t have a collapse that would undermine corporate earnings either. So the market is comfortable with a gradually improving economy and a transparent Fed. Most investors attach a high probability to the Fed’s actions over the next two to three years. [This is] a Goldilocks scenario. So the market will continue to trade well until you get some sort of disruption.
Schonberger: Would you buy into U.S. stocks here?
El-Erian: I would wait. I think there will be better entry points. It may not come tomorrow or next week, but it’s hard to see the fundamentals improving to the extent that would validate these prices quickly. The market is fairly-to-over valued now.
Schonberger: You were the CEO of PIMCO. You’re still with Allianz. What are your thoughts on regulators deeming asset managers as systemically important financial institutions (i.e. firms that are too big to fail)?
El-Erian: That’s a complicated issue because unlike banks, asset managers don’t take risk with their own capital. They don’t take on leverage with their own capital. So if you don’t leverage with your own capital, you don’t get that source of instability that you’ve had with the banks.
At the same time, asset managers allocate a lot of capital around the world. In many cases this is not levered and it’s against good collateral. So how do you balance major capital allocators with the fact that they are not allocating their own capital and that they aren’t levered like Wall Street was? I think you’ll see is a lot more differentiation. What started out as treating asset managers like banks is now evolving to better understanding the industry. The key issue is to get cross-border coordination on the non-bank side, otherwise the regulation won’t be effective enough.