SmartMoney: The new normal is now part of the financial vernacular. What other realities do you think investors need to come to terms with?
Mohamed El-Erian: We all need to come to terms with the series of important structural realignments occurring at both the national and global levels.
At the national level, we are leaving behind what will be seen as the great age of leverage, debt and credit entitlement, and moving toward a more de-leveraged and re-regulated world that has to overcome structural and debt headwinds.
At the global level, we are witnessing a historic development breakout phase in countries such as China and Brazil, along with an accelerated migration of global wealth and growth dynamics toward these economies and away from the industrial countries.
SM: Instead of just more stimulus, you recommend a multiyear policy initiative, to give a boost to human capital, infrastructure and R&D. If policy makers don t address these issues, how can investors brace for the effects? What should investors do at a time when the global economy has no spare tire?
ME: The U.S., as well as other industrial countries, needs to achieve medium-term budgetary adjustment, together with higher growth and lower unemployment. Just one will not suffice.
Accordingly, rather than just obsessing over the debate about austerity now versus growth now, the policy discussion should go beyond and ask how to achieve both over the medium term. This requires the urgent design and implementation of multiyear measures aimed at enhancing human capital, technology and infrastructure investment.
If the policy debate does not evolve quickly and most likely it won t investors need to be ready for a world of protracted low growth, persistently high unemployment, recurrent concerns about budgetary trends, a gradual erosion in sovereign creditworthiness and a higher risk of protectionism.
SM: Pimco raised its weighting for U.S. Treasurys, and then lowered it. Why?
ME: Two reasons, reflecting national and global considerations:
We raised our holdings of Treasurys before the market s view shifted away from romancing a V-shaped recovery and moved toward what we call the new normal.
In addition, given what we regarded as an increasingly uncertain outlook for some European countries, we expected that the Treasury market would also become a bigger recipient of funds that would flee Europe and look to the U.S. market for its deep liquidity and relative safety.
These two themes played out as reflected in the strong rally in Treasurys. Accordingly, we reduced our holdings to reflect the sharp move in market valuations.
SM: What should investors make of all the talk about a bond bubble and Pimco s recent foray into stocks? What does it all signal?
ME: It is not surprising to hear talk about a bond bubble. After all, the yield on the two-year Treasury reached a record low (below 0.4%), and yields on 10- and 30-year bonds broke through historically notable levels (of 4%, then 3.5%, 3% and 2.5%).
Today, Treasurys reflect a combination of things that include the weaker economic data and outlook, additional purchases of securities by the Fed, and the general tendency of households and companies to de-risk their balance sheets.
The steps that Pimco is taking to expand its equity lineup are not a result of the short-term moves in the bond markets. Instead, they reflect three longer-term considerations that relate to our clients needs and to our ability to deliver superior global investment management services to them.
First is the anticipation that, over the next few years, many more of our clients will be supplementing their traditional product focus with a holistic solution focus; it is therefore important that Pimco be able to offer them a complete range of global investment solutions. Second is the belief that our time-tested investment philosophy and process should continue to provide value to clients by being applied to a wider universe of asset classes. And third is our success in continuing to attract top investment talent to Pimco.
SM: What is your view now on the European sovereign-debt crisis? Has it run its course, or do you think it can still do more damage globally?
ME: Unfortunately, the European sovereign-debt crisis has not yet run its course. A number of European countries still have excessive debt levels, high deficits and a limited ability to grow out of their problems.
Moreover, the policy steps taken so far only kick the can down the road. They do not constitute a sustainable solution.
Absent some proper responses in Europe, the situation there will lower global growth, retain a cloud of uncertainty over the banking system, and fuel occasional bouts of market risk aversion.
SM: You ve talked about the ripples created by persistent high unemployment? What should be done to blunt the impact?
ME: I worry a lot about this issue, as I believe it is the key economic, political and social challenge facing us today; and it is a big challenge.
Looking at the economic dimension, the U.S. labor market faces three serious problems: only a muted ability to generate new jobs; lower labor mobility, due to the amount of mortgages that are under water; and high and rapidly increasing levels of youth unemployment and long-term unemployment, which lead to skill erosion and structural rigidities.
If left to fester, this will result in lower future productivity, a higher burden on budgetary resources, and further pressures on already stretched social safety nets.
This is another area where the policy response needs to go beyond cyclical considerations and also incorporate structural ones. Urgent steps are needed in such areas as providing job retraining, enhancing labor mobility and improving social safety nets.
SM: It s hard to argue with the view that the emerging world will be the engine of long-term growth in the coming decades, but are people putting too much on the developing economies in the 3-to-5-year time frame, given the challenges China, for example, faces in slowing its economy by just the right degree? Could investors be setting themselves up for a disappointment?
ME: Think of a running back that has managed to break loose and is now running toward the goal line, chased by a defensive safety. He has the ability to score a touchdown, yet he could also stumble, fumble the ball, or relax and celebrate too early.
This is the position of China today. The country has broken free, in terms of the development process, achieving remarkable rates of economic growth, employment, reserve accumulation and wealth creation. Yet it could also stumble, especially in the event of a policy mistake, social unrest or trade protectionism.
Investors should therefore maintain a high frequency assessment of fundamentals. They should scale their investments remembering three key realities: first, that economic development is an inherently nonlinear process, with lots of bumps along the way; second, that managing success well is not automatic; and third, that valuations in emerging markets will overshoot on the way up and on the way down, given that the size of the markets is still small relative to the flow of capital in and out.
SM: What do you tell your closest friends to do with their money?
ME: In today s fluid and uncertain times for the global economy and markets, I tell them to be particularly thoughtful and careful about their investments, and to think both about the return on their money and about the return of their money.