There’s no doubt that 2009 was a tough year. Luckily, however, the doomsday scenarios that many were predicting did not end up playing out. Financial Armageddon was taken off the table after the government acted to shore up major banks -- Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) et al. -- and the economy started to stabilize.
In the second half of 2009, economic data have turned positive, signaling the worst is behind us. Global package deliverer FedEx’s (NYSE:FDX) CEO Fred Smith said this month that the economy has reached a “turning point.” Higher-end retail stocks like J. Crew (NYSE:JCG) and Coach (NYSE:COH) have risen in anticipation of a recovering economy and consumer.
But even if we’ve turned the corner, 2010 may not be a banner year for the economy. Indeed, next year will be a bumpy year, according to Mohamed El-Erian, CEO and co-CIO of PIMCO (the world's largest bond investor). In an interview, El-Erian said he expects a difficult transition from government stimulus-led growth to real growth. Underlying that opinion is that unemployment is expected to remain high, which worries him because of the potential long-lasting effects on the labor market. These assumptions serve to confirm his standing thesis that we are living in a “new normal,” a period of tempered economic growth.
Here is an edited transcript of our conversation:
Jennifer Schonberger: You’re well-known for coining the term “the new normal.” What does 2010 look like to you?
Mohamed El-Erian: It looks like it’s going to be a bumpy year where we’re going to continue to see unusual developments. I would note the following in particular:
1. We’re going to have a bumpy transition from our temporary sources of growth to more permanent sources of growth. So at the beginning of the year, the first quarter in particular, things will look OK because of the inventory cycle and because of the stimulus. But as we get further into the year, it will become harder to sustain growth, because consumption will be facing headwinds.
2. We’re going to see a lag reaction [to] the crisis from the political side. The political process will be responding to high unemployment and will be looking to take steps to change the unemployment picture.
3. We should expect high regulation. We should expect higher capital requirements on financial institutions. We should expect the passage of more rules on “too big to fail” -- on resolution mechanisms.
4. Finally, we’re going to see a multispeed global economy. We’re likely to see certain parts of the world continue to recover strongly, including the major emerging economies such as Brazil, India, and China. There will be other parts, such as the U.S. and the UK, having to deal with what are structural issues, and therefore they will need more time to ensure a sustainable recovery.
Schonberger: What concerns you the most now?
El-Erian: The unemployment picture in the United States. That concerns me on three counts. First, unemployment is high. At 17%, the U6 measure of the under- and unemployed is very high. We haven’t had such high levels for a long time, and it looks like it’s going to be persistently high. Secondly, the composition of the unemployed worries me. The average period of unemployment is going up, and unemployment is disproportionately hitting younger people. Both of these elements tend to erode human skills over time. So you tend to have a long-term impact.
The third thing that worries me is that the benefit system is built on the assumption that the unemployment rate cannot remain consistently high. So there’s going to be a lot of pressure just from the fact that the unemployment benefit system does not correspond to the reality of today’s unemployment.
Schonberger: Given that, what are your thoughts on the second stimulus package the House just passed? Will it help create jobs as intended, or simply be more of a sugar high and create short-term jobs versus sustainable jobs?
El-Erian: It’s going to create short-term jobs versus sustainable jobs. It speaks to a simple notion that stimulus packages may be necessary, but are not sufficient. So we need more structural measures that deal with things like labor mobility -- the flexibility of the labor market -- things that you cannot overcome easily through just stimulus. So I think what you’re going to see during the year is a focus toward structural policies as well as cyclical policies.
Schonberger: What’s the bond market telling you now?
El-Erian: The bond market is telling you a couple of things. First, it is telling you that it is worried about the amount of issuance that is on the horizon. I think that the bond market is internalizing the change in the budgetary outcome for the U.S., and the fact that we’re looking at another $1.2 [billion] to $1.4 trillion deficit this coming fiscal year. So, the first thing it’s telling you is that we understand there’s going to be a lot of government issuance, and therefore it is repricing the price at which it is willing to take down this increased issuance.
The second is that it has heard clearly that the intention of Washington is to increase the average maturity of the debt stock. So it’s not just a matter of more debt being issued. It’s also about more long-term debt being issued. That’s why the [yield] curve is steepening so much. The third element it’s telling you is that it’s giving the benefit of the doubt right now to the strong economic numbers.
Schonberger: Do you think it’s right?
El-Erian: I think it’s right to price in the first two factors. I think on the third factor it is pricing in too strong a recovery in 2010.
Schonberger: Given that, are your expectations for yields to rise in 2010? Specifically, can you pin down the 10-year and the two-year as we look at the yield curve?
El-Erian: I think what you’re going to see is a very big tug of war throughout the year. That is, on the one hand, [it] is going to reflect concern about issuance, but on the other hand is going to reflect the reality that growth will not be as strong. So if you take today’s 10-year [yield] at about 3.75%, I suspect that we’re looking at a range of plus or minus 50 basis points from where we are today.
Schonberger: Is that risk holding back an already muted recovery? Or is the increase minimal enough where it won’t create such a severe impact?
El-Erian: Let’s start with the fact that the average person is facing three distinctive headwinds. One, credit is less available and is more expensive. The second is unemployment, which is that incomes are not growing as rapidly as before. Thirdly, as long as the housing market does not stabilize and house prices do not start going up again, then the ability to use your home as an ATM is no longer there. So the average person faces a combination of headwinds, of which credit is one of them.
How bad that impact is has to do with what the Federal Reserve decides to do going forward ... I think the most likely outcome is that they stop buying [assets], but they don’t sell. At that point the market reprices and you take off about 50 basis points of subsidy because of central bank buying.
Schonberger: What is your take on when the Fed will raise rates, versus when you think they should raise rates?
El-Erian: I think they are unlikely to raise rates for most if not all of 2010. When should they raise rates has to do with the balance between type 1 mistake and type 2 mistake. Type 1 mistake is to keep rates too low for too long, and you end up creating mispricing and bubbles. Type 2 is, you raise rates too early, and you end up slowing the economy. I think they are more likely to tolerate type 1 error -- meaning that they may overstay at zero, rather than understay at zero.
Schonberger: Where will the best opportunities in bonds be for 2010?
El-Erian: You should be a global investor, because that’s a reflection that we live in a multispeed world. The best will be in what we call “high-quality carry.” You want to find where you get paid, but where you get paid up in the quality structure. If you ask me where that is, I would tell you that’s in a certain part of the corporate markets. It is the strong emerging economies. There are opportunities in volatility where you can get paid for underwriting high-quality volatility.
Schonberger: So you think corporate bonds are still going to outperform in the high-quality space?
El-Erian: Yes. If you go to the low-quality, there is a risk of repricing ... If you look at a high-quality company today, it can refinance itself with relative ease, whereas low-quality companies still face a credit crunch. Also, a high-quality company can normally adjust its balance sheet much more quickly than a low-quality company. But the market has now priced in that the low-quality companies will be able to have as much flexibility as the high-quality companies, and we think that that is going to be challenged in 2010.
Schonberger: Are you still a fan of Treasury Inflation Protected Securities? I remember last we spoke, you were keen on making sure investors had TIPS as part of their portfolios.
El-Erian: Right, so TIPS reprice ... if you didn’t add to TIPS at the more attractive level, I would hold off at this point.
Stay tuned for the second part of my interview with El-Erian, in which he shares his outlook for the stock market in 2010.
For El-Erian’s take on how to invest using “the new buy-and-hold,” click here.
How do you think the economy will shake out in 2010? Weigh in below!
