David Gaffen

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El-Erian’s Push-Pull Question

August 18, 2009

Investors have been forced to contend with a severe pullback in consumer demand and the panic that overtook the banking sector in late 2008.

Since March, stocks are up by nearly 50 percent and investors have shifted into riskier fixed-income assets as well, but whether these rallies continue will hinge on whether investors are drawn to those purchases, not whether they’re forced into it because nothing else looks attractive.

That’s how Mohamed El-Erian, chief executive at bond fund manager Pacific Investment Management Co., put it when speaking with Reuters Television earlier today. He noted that investors in longer-dated Treasuries were moving in that direction, in part because of the desire by authorities to move them away from short-dated risk.

“The question is not whether you can be pushed, but whether you can be pulled,” he said. “What makes a rally sustainable is whether you can be pulled into more risk.”

That may seem like a distinction without a difference, but the motivating factor is important to consider: When investors feel flush with liquidity and perceive opportunities for growth to be strong, they’re more likely to hold investments in riskier assets, rather than fleeing swiftly to short-dated debt that poses little risk. The push-pull argument seems to allude to the phrase, “pushing on a string,” in that there are certain things that cannot be pushed on.

With the prospects for growth muddy, many believe the stock market is due for a course correction after the post-panic run-up – and why Treasury auctions continue to draw strong demand.

El-Erian’s colleague, Bill Gross, pointed out the knotty problem facing U.S. markets in his most recent commentary, saying that “but a modern capitalistic economy based on levered financing and asset appreciation cannot thrive if its ‘return on capital’ or nominal GDP suffers such a significant shock.”

And a shock it has suffered. Look no further than the news from Lowe’s Monday, as the company cut back expansion plans due to weak demand.

The middle part of this decade made desire for investment – being pulled into growth opportunities – easy. Cash was flush, prices were going up, and few worried about leverage.

But the economy is in the midst of the painful, ongoing process of deleveraging, one that does not happen quickly. Economists at Goldman Sachs expect second-half growth to rise to about 3%, but then project early 2010 growth to decline to about 2%, and the square-root recovery (a long, drawn-out period of stagnation) appears likely.

With that in mind, there may be more pushing than pulling in coming months.

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