Felix Salmon

Pimco’s risk-filled global outlook

By Felix Salmon
May 13, 2010

Mohamed El-Erian has released his 8-page summary of the medium- and long-term outlook for the global economy, and while there are few surprises, it makes for a most worthwhile read.

The big picture is of a world which (a) can’t afford to make more mistakes, and (b) is certain to make more mistakes, thanks in part to the increasingly important role of politics in national economies. The world seems to be converging on a model of “state capitalism”, but no one really knows what that model looks like, and with national and international politics becoming increasingly fractious, tail risks are increasing even as the base-case outlook remains underwhelming.

We seem to be leaving the era of independent central banks behind us, as they are now the only institutions capable of taking on the debt which moved during the most recent crisis from banks to now-overburdened sovereigns. The last major holdout, Jean-Claude Trichet, threw in the towel last weekend, and we’re now in a world where the only real guarantee of central bank independence is a small government debt. (Think Australia, which, alongside Canada, is one of the few relatively bright spots in the non-EM Pimco universe.) El-Erian is not happy about this development:

I am inclined [to warn] against the long-term implications of additional steps to turn monetary authorities (with revolving balance sheets) into fiscal agencies (with more permanent exposure to dubious assets). An even larger-scale use of central bank balance sheets, if it were to materialize, would provide only a temporary respite, and the collateral damage and unintended consequences would be serious, including the impact on inflationary expectations.

But in an overleveraged world, inflation is maybe preferable to default as a means of getting rid of the massive debt burden which Pimco sees weighing down all of the G3 economies for the foreseeable future. In any case, Pimco is looking at what it thinks will happen, rather than what it thinks should happen, and it sees inflation coming back first in some emerging economies, and then, looking out a few years, in the U.S., then Europe, and finally in Japan.

As far as the U.S. is concerned, El-Erian sees a vicious cycle playing out in the high unemployment figures:

Unemployment is high and will likely remain so for the foreseeable future, accentuating concerns about skill erosion and loss of labor market flexibility.

I’m hopeful this isn’t the case. It’s true that most important skills are learned and honed on the job rather than at schools and colleges, and it’s also true that a labor market where professionals are jumping from one great opportunity to the next has more inherent flexibility than one where they care mostly about holding on to their present position. But on the other hand, I suspect that geographical labor-market flexibility is increasing, as the unemployed become more willing to move to where the jobs are, and also to simply walk away from their underwater mortgages. Meanwhile, all those people going back to school while they wait for the labor market to pick back up have to be learning something useful.

There’s not a lot of what you might call investment advice in this paper, beyond a general idea that it’s important to stay alert and that a set-it-and-forget-it buy-and-hold strategy of any description is prone to failure. But there are two interesting long-term ideas at the end of the piece:

- It is a world where the currencies of the emerging (as opposed to submerging) economies will continue to warrant a greater allocation over time; and

- It is a world where the safest of carry will come from duration and curve in sovereigns that, due to their economic and financial fundamentals, are truly core countries in the midst of this global paradigm shift.

If a retail investor was interested in playing these trends, the first one is relatively easy: you buy a emerging-market local-currency bond fund. The second one, however, is harder: how do you put on a trade where you basically borrow short and lend long in the biggest global economies, without inadvertently becoming a bank and taking on all the credit risk that entails, especially in a world where it’s becoming increasingly difficult to differentiate credit and rates?  I daresay that El-Erian is right when he implies that the U.S. yield curve is going to remain pretty steep for the next few years. But I suspect you need to be a big company like Pimco to make money from that trade.

3 comments so far | RSS Comments RSS


I wouldn’t be so sanguine about the geographical flexibility issue. A story in the Journal Tuesday (“Americans Moved in ’09, but Not Far”) indicated that people were moving at the lowest rate since 1948 (the lowest on record) last year and — when they did — it was within their home counties, presumably in with friends, family members, etc.

I think that skill erosion would be a less trivial risk had the lower end of the workforce not been so effectively deskilled and deracinated already.


Posted by ClarkTroy | Report as abusive

I am thinking that the real problems are skill erosion as we have a lot of people who have been out of work for a long time, and we have gotten rid of so much work and never ever replaced it. the geographical problem was more tactical, yes some were stuck because of their houses, but jingle mail solved that, the bigger problem is the recession was almost nationwide, so there really was no place to go

Posted by willid3 | Report as abusive

There’s a lot of discussion of the role of government regulation in the PIMCO Outlook. After Enron went bankrupt, the Sarbanes-Oxley rules were put in place to prevent another Enron. I suspect that a number of CEO’s on Wall Street were probably in violation of those rules. There has been no mention of Sarbanes-Oxley by regulators, by government officials, or by the news media.

Which brings us to the idea that there can be a lot of rules and regulations in place, but they can be ineffective, or be ineffectively administered. In fact, the PIMCO document describes the future as: “a world with a flatter distribution of potential outcomes, fatter tails” – this implies more risk and widely variable outcomes – the exact opposite of what you would expect if government regulation were effective.

PIMCO thinks that “emerging economies will maintain their development breakout phase” even though PIMCO thinks that “concerns about the dark side of globalization tempers enthusiasm for its benefits”. So what happens if voters say: “we’ve had enough of this globalization thing”?

PIMCO thinks that Australia and Canada will be special beneficiaries of globalization (That means that Australia and Canada export raw materials to China). It’s probably worth remembering that the PIMCO guys are not infallible. There were a few times that they told us that they favored German bonds. Unless they hedged their currency exposure to the euro, that wouldn’t have worked out for them. Likewise they favored Canadian bonds in keeping with the globalization theme. The Canadian dollar is really a petro-dollar. It moves up and down with the price of oil. Again, with oil moving down, that wouldn’t have worked out unless PIMCO hedged the currency.

Posted by nose2066 | Report as abusive

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