Senior Manager | CAPTRUST Consulting Research
Questions abound across global capital markets. The health of the U.S. economy, the future of the Eurozone, a potential “fiscal cliff” late this year, plus a persistently low interest rate environment all present unique challenges and opportunities. How investors prepare for these variables will determine their investment outcomes. As a firm with over $76 billion in Client assets, CAPTRUST has direct access to some of the brightest minds in the asset management industry.
This quarter we use that leverage to share macroeconomic perspectives from a renowned thought leader. Mohamed El-Erian is chief executive officer and co-chief investment officer of PIMCO, a Newport Beach-based asset management firm currently managing $1.8 trillion in assets. PIMCO is the manager of the largest bond mutual fund and is one of the largest fixed income asset managers in the world. Mohamed recently joined me to answer a few questions and provide his thoughts on the principal issues facing investors today.
Q: Starting first in the U.S., as we’ve passed the midpoint of the year, how healthy is the U.S. economy? Is it finally healthy enough to fly on its own without the help of stimulus and achieve “escape velocity”?
Mohamed: There certainly are factors that suggest the U.S. economy is gradually healing, but the deleveraging process is still very much with us and continues to suggest weak growth ahead. Positive factors include healthy corporate balance sheets, significant cash on the sidelines, and data that indicate the housing market is in the process of forming a bottom. But it is unlikely that these factors on their own will propel the U.S. economy to escape velocity given the lack of robust demand and ongoing structural challenges, including stubbornly high long-term unemployment, government debt and deficit issues, clogged credit pipes for medium and small-scale companies, and inadequate investment in education, worker training, and infrastructure. Also, the risk of collateral damage from Europe cannot be underestimated.
Q: One of the questions we field often is the possibility of a “fiscal cliff” at year-end and its implications on investment returns. How is PIMCO positioning portfolios for this uncertain event?
Mohamed: Economists, including Federal Reserve Chairman Ben Bernanke, are rightly starting to warn that the U.S. faces a worrisome “fiscal cliff” at year’s end. If politicians take no action before the end of the year, tax stimulus and government spending worth approximately 4% of Gross Domestic Product (GDP) are scheduled to be cut. The blunt spending cuts mandated by the 2011 compromise on the debt ceiling along with across-the-board tax increases would derail the U.S. recovery and undermine the well-being of the global economy. Investors should remain defensive, possibly moving up in quality and maintaining broad portfolio diversification. PIMCO is emphasizing liquidity, both for defensive reasons and to take advantage of market dislocations should they occur. This gives us important optionality and flexibility so we can be prepared to capture opportunities should there be policy mistakes.
Q: Shifting gears now to Europe, what is PIMCO’s current view on the Eurozone? Will the European Union survive?
Mohamed: We believe the status quo is no longer an option for the Eurozone. The Eurozone will either evolve to a less imperfect union or fragment. Our baseline view is that eventually there will be a smaller, less imperfect union anchored by Germany, the owner of the strongest balance sheet in Europe, along with France, Italy, and Spain. For this union to be sustainable, it will have to be underpinned by a much stronger fiscal union as well as greater support for the banking system, adequate mutualization of debt, and greater political integration. All of these solutions are grounded in the sharing of Germany’s balance sheet, and Germany must play a leading role in several of the critical fiscal decisions. In the interim, however, the risk of a disorderly breakup of the Eurozone will remain a key tail risk for global markets for some time to come.
Q: Is there still a chance that global leaders, including in the U.S., are able to work in a synchronized fashion to promote, as you would say, a “virtuous cycle,” where growth and expansion promote regulatory reform, thereby further boosting confidence and stability?
Mohamed: In order to promote a virtuous cycle, policy makersneed a common analysis, a shared vision, and political consensus for implementation. Unfortunately, policy makers in Washington and Europehave failed over the past few years to address pressing fiscal issues and structural challenges to their economies. They are opting instead for short-term fixes and half measures instead of seriously confronting looming sovereign debt issues. Now they must pivot quickly and respond in a much more comprehensive way. Difficult decisions need to be made to restore the public’s faith in elected leaders and to ensure anorderly solution to the problems facing the global economy. If policy makers continue to opt for political posturing rather than grand bargains, legitimate concerns about growth, jobs,inequality, debt, and deficits will persist and undermine the basic functioning of markets and, in Europe, possibly lead to a disorderly outcome.
Q: Today, forecasting policy leaders’ and regulatory officials’ actions are at the center of the investment process. How do you analyze such large non-investment uncertainties, and what changes have you made to adapt to this new reality?
Mohamed: It is now almost four years since the full onset of the global financial crisis. The economic and social costs have been immense, and they continue to accumulate. Against this reality, it should come as no surprise that there have been many regulatory policy initiatives at the national, regional, and multilateral levels. Our ongoing assessment of the regulatory landscape now always includes recognition of how much is still in flux and, essentially, both what is unknowable and unquantifiable at this stage. From a PIMCO business perspective,we have increased our legal and compliance staff around the world,and doing so has enhanced our ability to monitor and react to regulatory changes in a large number of national jurisdictions.
Q: To date, much of the policy response from leaders to the crisis has come in the form of lower interest rates and quantitative easing. Central banks have used these tools to try to lower borrowing costs to encourage growth. The byproduct has been the creation of historically low interest rates. Given the current low level of rates, what role should fixed income play in a portfolio?
Mohamed: We believe fixed income will continue to play an important role in portfolios, especially given the uncertainty surrounding the global economy. Despite historically low yields, the fixed income asset class tends to provide investors with liquidity, income, and a cushion against deflation. It also provides important optionality in a world in which volatility is likely to create opportunities down the road.
Given our view that consequential risks to the global economy still remain, we suggest investors look to strategies that can take advantage of the changing global opportunity set and have the flexibility to preserve capital during bouts of market volatility. This would suggest an evolution in the way investors have traditionally deployed capital in the fixed income markets. Measures that investors might consider include “smart” benchmarks that focus on a country’s contribution to global GDP, an increased allocation to emerging market debt and currencies given favorable growth dynamics, and the use of tail risk hedging to help guard against unexpected shocks.
Q: While portfolio liquidity and optionality are important, many investors look to their fixed income allocations for yield. How would you advise a retiree to invest in this low-rate environment with a need for income?
Mohamed: We understand that generating a high level of income is often a primary goal for some investors who are looking to preserve their savings and generate reliable, steady cash streams. Given the current low-rate environment, U.S. Treasury securities may not provide investors sufficient income to meet their needs. And traditional credit-centric portfolios could expose a retiree’s principal to substantial risks. We believe that it makes sense to look more broadly at other sectors of the fixed income market and also look outside the U.S. for opportunities to generate income without taking excessive risk. These sectors could include high-quality non-U.S. government bonds as well as inflation-linked bonds and mortgage backed securities, among other options. We believe it’s important to invest in strategies that maintain flexibility, while allowing for the generation of attractive income and the diversification of risk away from a single sector.
Q: Earlier you mentioned that consequential risks to the global economy still remain and that investors may need to evolve from the ways they have traditionally deployed capital in fixed income markets to consider “smart” benchmarks that focus on a country’s contribution to global GDP. Is the Barclays Capital Aggregate Bond index still an appropriate benchmark for core fixed income managers?
Mohamed: As a starting point we can ask ourselves the following question: “Do we want to lend to the countries that have the lowest income growth and the most debt?” That’s the outcome that traditional indices can produce. Global investors need a new approach for allocating capital across regions and countries by being forward-looking and seeking attractive opportunities wherever they are. At PIMCO we have developed the Global Advantage Index (GLADI) to help investors capture investment opportunities in the “New Normal.” The index’s GDP-weighting methodology makes it more inclusive of newly developing countries with stronger underlying fundamentals and avoids an overallocation to debt-laden developed countries. This feature positions investors for future rather than past opportunities. The index also includes broad exposure across fixed income markets and sectors, including inflation-linked bonds and currencies, which can help preserve and enhance purchasing power over the long-term.
Q: And lastly, given all that we’ve discussed, have any of these largely macroeconomic issues changed the way PIMCO manages fixed income portfolios or manages risk?
Mohamed: We believe the focus on macroeconomic issues gives PIMCO a significant advantage to add value in client portfolios. The current environment reinforces our belief that an investment manager must have a well-informed top-down view, and supplement this with detailed bottomup analyses. This has been a central tenet in our investment process going back to the founding of the firm. Our investment process starts with an annual Secular Forum in which PIMCO professionals across our twelve global offices gather for a three-day discussion about the future of the global economy and financial markets. The Secular Forum has proven enormously important for PIMCO’s ability to deliver consistent value to our clients. We debate the major trends that will play out over the next three to five years and assess not what should happen but what is likely to happen. Think of the outcome as providing medium-term guardrails for where and how we invest the funds that have been entrusted to us. While we have not made any significant changes to our risk management process since the global financial crisis, we have continued to invest in human, analytical, and technological resources to continuously enhance our risk management framework. We believe in a “mosaic” approach to analyzing and managing risk that uses many different measures while not relying too heavily on any single one. As the global financial crisis highlighted, any one measure of risk can often be incomplete or even misleading. Risk management always has been as it should be, at the forefront of all that we do at PIMCO.
Dr. El-Erian is CEO and co-CIO of PIMCO and is based in the Newport Beach office. He re-joined PIMCO at the end of 2007 after serving for two years as president and CEO of Harvard Management Company, the entity that manages Harvard’s endowment and related accounts. Dr. El-Erian also served as a member of the faculty of Harvard Business School. He first joined PIMCO in 1999 and was a senior member of PIMCO's portfolio management and investment strategy group. Before coming to PIMCO, Dr. El-Erian was a managing director at Salomon Smith Barney/Citigroup in London, and before that, he spent 15 years at the International Monetary Fund in Washington, D.C. Dr. El-Erian has published widely on international economic and finance topics. His book, When Markets Collide, was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year and was named a book of the year by The Economist and one of the best business books of all time by The Independent (UK). He was named to Foreign Policy’s list of “Top 100 Global Thinkers” for 2009, 2010, and 2011. Dr. El-Erian has served on several boards and committees, including the U.S. Treasury Borrowing Advisory Committee, the International Center for Research on Women, the Peterson Institute for International Economics, and the IMF's Committee of Eminent Persons. He is currently a board member of the NBER, the Carnegie Endowment for International Peace, and Cambridge in America. He holds a master's degree and doctorate in economics from Oxford University and received his undergraduate degree from Cambridge University.