‘If the US defaults, there will be simultaneous selloff in equities, bonds and currency’

‘If the US defaults, there will be simultaneous selloff in equities, bonds and currency’
Published: Friday, Jul 8, 2011, 7:00 IST
Place: California | Agency: Reuters

Mohamed El-Erian, the CEO of Pimco, the world’s largest bond fund based in California, says the US Congress will have to raise the country’s debt ceiling if cataclysmic global dislocations are to be averted. In a live chat late on Thursday evening (India time) organised by Reuters, El-Erian answered questions from a global audience on issues including the Eurozone crisis. Excerpts:
What would happen if the US Congress does not allow an increase in the debt limit? What would happen to the average American?
Here is the likely sequence if you assume that we do not get political agreement (and note that US President Barack Obama is working very hard to reach a compromise that is acceptable to both parties). If the Congress does not increase the debt limit, the government will be forced to prioritise payments. It would most probably start by reducing program transfers (including to the elderly) and all sorts of federal outlays (including to federal employees). States would also be impacted. And concern would mount about the ability of the government to keep up its debt service payments. For the average American, this would translate into another headwind to employment creation, higher market interest rates, and even less enthusiasm on the part of cash-rich companies to invest. And to make things even more complicated, there is also an important element of unpredictability.
The national and global system is built on the (reasonable) assumption that the US, THE AAA country at the very core of the international system, does not toy with default - technical or otherwise. If this assumption proves incorrect due to political posturing and bickering, there could well be major global dislocations. The hope is that Congress will agree on a package that combines a higher debt ceiling with meaningful progress towards medium-term fiscal reform. There is a lot at stake here.
If there is a failure to reach a deal on the US debt ceiling, what impact could we expect on the markets? Where would the new flight to safety be? For example, to hard assets or foreign bonds?
First, we will see much greater price differentiation. This will favour commodities with slow supply responses (for example, oil) and those that act as a store of value (gold). Second, there will be considerable price volatility as higher demand competes with bouts of general uncertainties about the overall health of the global economy and possible administrative actions (for example, higher margin requirements).
If agreement is not reached, the likely consequences for markets would include a simultaneous selloff in equities, bonds and the currency. Gold would most likely benefit from the flight to quality.
How will the US credit rating affect the world bond market, if Washington doesn’t reconcile to raise the debt ceiling?
A downgrade to the US AAA rating would be disruptive to a global economy that is constructed with the US at its core. Or, to be even more blunt, the US is the core of the core. For example, it would make global financial markets more volatile and unpredictable. It would risk major re-allocations of capital both within, and across border. And it would severely weaken the standing of the global public goods provided by the US, encouraging greater economic and financial fragmentation. In sum, it is best for all if we avoid a downgrade of the world’s AAA.
Could we have avoided financial tsunami by bailing out Lehman Brothers? What’s the equivalent today — Spain & Italy?
A great question. And one that we will never know the answer for sure as, by their nature, counterfactuals are hard. Having said that, what was most surprising about the Lehman failure was not the choice between bailout and failure, but between an orderly and a disorderly failure. Judging from the books and articles that have been written about Lehman (as well as comments), it appears that this latter trade-off was not sufficiently explored due timing and other aspects.
On the debt crisis in Europe, you have said one country would leave the euro. Which is that and has that day drawn closer?
Europe’s peripheral situation is worrisome — call it a bad situation that, unfortunately, will get even worse before it gets better. Indeed, in a recent piece for Reuters a few weeks ago, I noted that Europe unfortunately faces a set of bad choices. And this is playing out in Greece, which is the most vulnerable country for both a debt restructuring and a Eurozone sabbatical.
The euro took a big slide this morning..
For the last 36 hours, markets have been adjusting to Portugal’s downgrade to junk by rating agencies. This has had quite an impact on the country’s credit spreads, those of other peripherals and the euro.
What do you think about the Eurozone situation right now and the future of the euro?
Here is one way to sequentially think about this: The Eurozone is truly a multi-speed economy. Countries such as Greece are struggling mightily due to excessive debt and an inability to grow; and the current policy approach does little to deal with these issues. And who would have thought that a Eurozone country would have a rating (CCC) that is worse that a country such as Pakistan? Portugal and Ireland face similar issues, though the magnitudes are different. These two peripheral countries are already in the Eurozone’s financial ICU, having both had to resort to bailout packages. And just this week, a rating agency downgraded Portugal to junk status. Again, this was unthinkable just a year ago. At the other extreme, Germany is doing well. In fact, it has surprised many. It is reaping the benefits of years of economic restructuring and sound liability management. Yet its well-being risks being negatively impacted by repeated demands to bail out weaker members of the Eurozone.
The question for the Eurozone is how to reconcile these multiple realities; how to deal with multi-speeds in growth and balance sheet dynamics. And it is a question that assumes added urgency given that the political decision to address the peripheral economies’ solvency problem using a liquidity approach has contaminated other important parts of the Eurozone - most importantly, the balance sheet of the European Central Bank. Therefore, the concern about the integrity of the Eurozone, including the robustness of the euro.
The current approach of ‘kicking the can down the road’ (I prefer ‘rolling a snowball down a hill’ as it captures the growing size of the problem and its accelerating nature) will not last for much longer in my opinion. If it wishes to avoid a really disorderly outcome, Europe will be forced to opt for one of two corner solutions: fiscal union, or debt restructuring and, possibly, a Eurozone sabbatical for at least one (and possibly up to three) of the 17 members of the Eurozone. The more Europe delays this choice — and it is a difficult one — the greater the risk that policy makers may lose control of the situation.
QE2 seemed to succeed only in driving up input costs for companies and consumers and incentivised misallocated capital. Meanwhile, trillions in monetary base remain idle, velocity (of money) continues to fall and duration of unemployment continues to climb. What adaptive thinking is required to depart from the Fed’s 1931 blindspot solution, which seems benign to market feedback, in order to target solutions where they are most effective for a debt liquidation cycle?
Wow, there is a lot to this question. Let me try to answer them all. First, the context. QE1 was aimed at restoring the normal functioning of markets that had either frozen or where severely dislocated. QE2 targeted an asset price inflation as a means to stimulate economic activity. The outcome was a more general inflation — what at Pimco we called a mix of good and bad inflation. The good inflation was the rise in equity valuations that made people feel wealthier. The bad inflation drove up input costs as you mention, thereby countering the desired impact on economic activity (and, by the way, turning the Fed into portfolio managers in the process!). While asset prices did go up, companies and individuals did not ‘bite’ to the extent that the Fed had hoped. Thus the idle cash balances you mention. This issue of cash on the sideline speaks to the need for structural reforms and for lowering the uncertainties that dampen the ‘animal spirits’.
I do not have the numbers at my finger tips, apologies. Having said that, thank you for raising the issue of unemployment. It is something that I worry about a tonne. And not only because of the level of joblessness, but also due to the worrisome compositional aspects. Just think, 24% of the 16-19 year olds in the labour force are unemployed (this number is 40% among African-Americans).
These are hugely worrisome numbers - especially as being unemployed at that age can turn into being unemployable. And this is just one example of how US’ dreadful unemployment problem can become increasingly structural in nature and, therefore, harder to solve. The other, of course, is the duration of unemployment.
As regards to the recession dimension, this is not our baseline scenario — it is in the risk scenarios. Factors that would increase this risk include a breakdown in the debt ceiling discussions, a more disorderly European debt crisis, and an exogenous shock (include a geopolitically driven surge in oil prices). Remember, with its over-stretched balance sheets and structural economic headwinds, the US has fewer effective policy instruments at its disposal.

Do you assign any probability to the Fed engaging in some sort of QE3? What form would it take?
We would assign a low probability at this stage to QE3 given the general recognition that the forward-looking cost-benefit analysis has shifted - away from the potential benefits and towards greater costs and risk. Indeed, this was again acknowledged by Fed chairman Ben Bernanke at his recent press conference. Therefore, it would take a major further deterioration in the economic outlook, combined with a willingness by the Fed to take greater reputational and political risks. If this were to materialise, QE3 could take the form of renewed asset purchases combined, possibly, with various forms of partial interest rate ceilings.
What do you expect the behaviour of the bond market to be after the end of QE2?
The bond market is in the midst of a tug of war. On the one hand, yields face downward pressures because of the weak economy and the disruptions in Europe. On the other hand, they face upward pressure due to the end of QE 2, continued high issuance by the US Treasury, and a slow and gradual increase in credit risk. Investors must navigate well this tug of war. And they benefit from finding alternatives that, in a proper mix, perform the portfolio role (‘hard duration’) of Treasuries in most states of the world, while minimising the specific risks.
Central banks are extremely reluctant to talk about gold. What role should gold play in the world monetary system?
No doubt you know that we have witnessed quite a change in the attitude of central banks vis-a-vis gold. It’s not so long ago that gold was regarded as too much of an idle asset in central banks’ reserves. Why? Because it earned no interest. This has changed. In recent months, a number of central banks have announced that they have been buying gold. And I suspect that they are not the only ones. Why this change? Because of a growing fear that the issuers of the major currencies - including the US, as the issuer of the world’s reserve currency - risk de facto debasing gradually their currencies. So some central banks are incrementally and gradually diversifying away from the dollar through purchases of gold. Individuals are doing the same thing.
The media has our attention focused on the US debt ceiling and the Greek bailout. What other world events are you paying particularly close attention to? Are they only financial or do you have geopolitical concerns as well.
I would suggest that there are two other regions deserve our attention: the Middle East/North Africa and China. In the former, the situation is very fluid. Egypt and Tunisia are completing their revolutions. Libya and Yemen risk becoming failed states.
Repression has increased in some other countries (for example, Syria). And others are trying to get ahead of the process by pre-emptively meeting the legitimate aspirations of their populations. How all this plays out will have a huge impact on the price of oil, migration patterns and, more generally, the extent of geopolitical risk that markets should reflect. Because of its size and complexity, China is navigating a complete middle-income transition - an inherently challenging development phase judging from the experience of other countries. So far, China has done very well, pulling millions of people out of poverty. Looking forward, they need to continue to manage well their success. And the world needs to accomodate their success.
Given what appears to be a great ‘readjustment’ of balance sheets to ‘mark down’ excessive and unpayable debt, what assets would you own to either profit from or protect one’s net worth?
There are a few principles that you may wish to consider: avoid exposure to balance sheets that may well experience large haircuts. Sovereign debt issued by the weak peripheral European governments is a case in point, as is some of the debt of very weak municipal issuers. Look for opportunities where good issuers are being excessively impacted by defaults elsewhere.
“Technical contagion,” as it is called, is a common phenomenon. It provides good entry points for investors as the price decline tends to be both temporary and reversible. Finally, look for situations where brand-new contracts are being established and, in the process, healthy balance sheets are being linked. An example of this is the growing residential mortgage market in emerging economies with an increasingly prosperous middle class, a solid housing stock, and improving rule of law.
Great question, one that speaks to the cross-currents presently in play. Deleveraging, such as what the US will experience for a number of years, has dis-inflationary tendencies. At the extreme, it can result in outright deflation and even an economic depression. This is why the Fed has been so focused on minimising that risk. And it explains why chairman Bernanke has repeated the point several times (most recently at his press conference).
Yet, in an open economy — and the US is increasingly open in an economic and financial sense — policy actions to counter this risk, such as QE2, can also be inflationary. (QE1, which you also mention, was aimed at restoring the normal functioning of markets that had either frozen or where severely dislocated. By contrast, QE2 targeted an asset price inflation as a means to stimulating economic activity.) We should expect higher imported inflation, partly a result of a weaker dollar and partly because the last thing the rest of the world needs is more liquidity injection by the US. Indeed emerging economies are now tapping the policy brakes in order to offset a domestic overheating that has been turbocharged by surges in capital flows from the US.
What and where are you investing in now? And where in the world do you see the most potential for the coming two years?
We are focusing on countries and companies with strong balance sheets and favourable debt dynamics. We are retaining ‘dry powder’ to invest during what we expect will be an increasingly volatile market environment (where strong names can be temporarily contaminated and offer good value). And we are ensuring that we are not hostage to old labels and conventional wisdoms that no longer apply in today’s re-aligning global economy.
What’s your view on the two horsemen of the micro-apocalypse, the Bond Vigilantes and the Confidence Fairy? Do they exist? Are they likely to show their faces anytime soon? And why are people so worried about them?
They both exist but their impact has been much reduced by a number of factors. The impact of bond vigilantes has been dampened by the importance of central banks and other “non commercial” players in the bond markets. Just consider the size of purchases by China and the Fed as an illustration. The confidence fairy has to counter the reality of an economy that still has to de-lever, structural headwinds, concerns about Europe, etc.
Do you think commodity prices will rise through the second half of this year, into next year, and for some time next year?
I suspect that, over the longer term (next 5 years), we are looking at higher commodity prices. The main driver is the increasing demand from emerging economies. Remember, emerging economies consume a lot more commodities per unit of output than advanced countries. Because of this higher commodity intensity, their faster growth rate has a significant impact on demand. I would add that this secular view is subject to two important qualifiers that also address your shorter time horizon.
What’s a better investment long term in the year 2011 - investing in the US or in China?
I would combine both in a well-balanced portfolio. Recall that the two play very different roles in global asset allocation. China is a growth play. The key is to be able to tap the high growth areas and benefit from the incremental value. Increasingly, this emphasis will shift from export-oriented companies to those supplying growing domestic consumption. The currency also looks attractive.
In the case of the US, look primarily for consolidation, emerging market exposure and dividend plays. Stay high up in the capital structure for unsecured debt exposures, including in the area of municipals. And guard against dollar weakness.
What would you recommend to a young person who would like to preserve and grow investment when all nations appear to be operating on fiat currencies that will all default in the long run?
Emphasise opportunities in countries with strong balance sheets (low debt and large reserves) and healthy economic growth dynamics. These countries are less likely to devalue their currencies. And they will avoid defaults.