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Mohamed el-Erian on global markets, Japan, and the chances of default

By Mohamed El-Erian
April 1, 2011

Below are Mohamed El-Erian’s responses to questions asked by readers during the March 31 Reuters Newsmaker interview with Global Editor at Large Chrystia Freeland.

Are the current “mixed signals” by the various markets similar to the ones you said were being transmitted before the financial crisis, and do you think that the current stock market trading activity signals caution, confidence or complacency? (from i8emallup)

The most striking aspect of the “mixed signals” is the contrast between corporate (bottom up) indicators and macro (top down) developments.

From a bottom-up perspective, the U.S. economy continues to heal after the cardiac arrest suffered during the global financial crisis. The healing process is most advanced among large multinationals as illustrated by their large profits and profit margins, as well as their significantly strengthened balance sheets. It is also being reflected in higher job creation.

At the macro level, however, the U.S. economy is facing current and future headwinds. The political system is yet to converge on a meaningful medium-term fiscal reform effort. There is uncertainty on what will happen once The Fed completes its QE2 program. And, like other countries around the world, the U.S. is dealing with the negative supply and demand shocks occasioned by the unrest in the Middle East and the tragic triple disasters in Japan.

The result is, therefore, a set of mixed signals that, so far, the markets has resolved decisively in favor of the bottom-up indicators.

In terms of historical comparisons, no this is not the same as those mixed signal that led to the abrupt 2008 market moves. The latter took place within the context of large, multi-year excesses in private sector leverage, credit creation and debt entitlement. As such, the risk and severity of the reversals were much, much higher back in 2008. Today, a meaningful part of this leverage has been shifted to the public balance sheets and, as such, the immediate vulnerability is less both in magnitude and immediate timing. If unaddressed, however, this vulnerability will grow.

Are the markets too complacent about potential risks to growth (disturbance in global production chains, fiscal tightening) and inflation (Japans expected demand for resources, continued strength in China, core EMU)? (From Michael D-R)

At this stage, the markets (and, judging from their last statement, the FOMC) are “looking through the disturbances you cite. The view is that they will be “transitory.” Put another way, the markets are signaling that their impact will essentially be “temporary and reversible.”

This view has support among some economists that draw a historical parallel with what happened after the 1995 Kobe earthquake. Due to a large reconstruction program (including fiscal outlays of some 2% of GDP), Japanese growth came back rapidly, and the economy experienced a “V” shaped recovery.

We would caution against this analytical short cut.

The recent disasters in Japan are two to three times as big as the Kobe earthquake. Their impact will linger due to the uncertainties with the nuclear reactors and the reduction in electricity generation.

Also, the Japanese economy is in a different place today compared to 1995, as is the world economy.

The country’s debt to GDP is about 205% compared to 85% in 1995. Its credit rating is AA- and not AAA. Plus it is operating in a global economy that is structurally weaker.

All this suggests that we should not rush to simply “look through” the impact of Japan’s tragic calamities. A more thorough analysis is warranted.

What percentage chance exists of default by G20 & G7 governments? (from Mark Melin)

We think that there is a meaningful chance that the most vulnerable economies in the Euro-zone (namely, Greece, Ireland and Portugal) may be forced to restructure their debt.

These countries face a large debt overhang and significant challenges to economic growth and employment promotion. Fiscal austerity on its own is unlikely to be sufficient to deal with the debt overhang and put these countries back on the path of high and sustainable growth.


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