Much to everyone's pleasant surprise, 2009 turned out to be an exceptional year for the stock market. Stocks like Freeport-McMoRan
Thus, investors should be cautious in 2010. This is according to Mohamed El-Erian, CEO and co-CIO of Pacific Investment Management Co. (the world's largest bond investor). In an interview, El-Erian said he thinks there is a good probability that equity markets will move lower next year, while the dollar remains weak. This is a departure from this year's pattern, which was propelled by the logic that stocks that gain a substantial portion of their revenue overseas (such as Coke
El-Erian says that 2010 will be a stock picker's market, with a shift toward higher-quality companies. The themes he predicts to dominate the year are the continuation of a larger role of regulation in the pricing of markets and a continued realignment of the global economy. He also warns of the risk of muted returns in the upcoming decade.
What follows is an edited transcript of our conversation.
Jennifer Schonberger: The dollar has been central to the movement in asset prices this year, moving inversely to equities and commodities. Do you expect the linkage between equities and the dollar to continue into next year?
Mohamed El-Erian: That relationship was almost by its very nature an unstable relationship, because the relationship ran as follows: Interest rates on the dollar were very, very low. Therefore, people borrow dollars in order to invest in higher-risk assets, and they have the big carry trade.
The problem with that is twofold. One is that the dollar is a reserve currency. At some point, the weakening of the dollar starts to threaten its role as a reserve currency, so that trade cannot go on forever. The second issue is that while S&P companies benefit from dollar weakness because half their profits come from outside the U.S., most of their business is still inside the U.S. That was a relationship that made sense from a short-term perspective, but ultimately was increasingly unstable.
... Notice the correlation becomes weak and weak, not strong. The correlation has been weak currency, strong equity market, which it cannot sustain. What the U.S. should aspire to is a strong equity market and a strong dollar, but the risk is that we're going to end up with a weak equity market with a weak dollar in 2010.
Schonberger: So you think equities will move lower in 2010?
El-Erian: I suspect there's a higher probability they go lower from here. We have priced in not only a recovery from the Armageddon scenario, which was correct, but we have priced in very strong top-line revenue growth, which depends on strong economic growth. And because we worry about the handoff to consumption, these valuations look stretched at this point.
Schonberger: PIMCO recently raised its cash levels to the highest level since Lehman Brothers' default. Given those actions, are you more risk-averse?
El-Erian: What you see is, we're saying at this point: Lots of markets look pretty rich in terms of valuations, and we would like to have powder dry for 2010, when we believe there will be a repricing of markets.
Schonberger: How are you positioning yourself for 2010? Are you still very keen on asset allocation and active management in the context of the new normal, as you noted last we spoke?
El-Erian: Yes. First, we think that there are lots of bottom-up opportunities. So I spoke to you about high-quality carry, about opportunities in the volatility space. At the same time, we feel markets have gone too far too quickly ... It's going to be a stock picker's market, with the balance being on the defensive in order to have powder dry for what is likely to be a repricing.
Schonberger: So, then, you think there will be a shift to quality and a retreat from risk, especially as the Fed winds down its temporary liquidity facilities. Right?
El-Erian: We had a tremendous amount of liquidity injected into the system, which has raised all boats. With interest rates basically at zero, a lot of people have been pushed into taking more equity exposure. They're doing it because zero-percent money market rates to them are unacceptable. So that turbo-charged the rally.
We're going to see less injection of liquidity in the new year.
Schonberger: Are there other themes that might dominate the market in 2010?
El-Erian: When you look at 2010 and beyond, we expect a continuing evolution in line with our "new normal" hypothesis. So, first, we're going to continue to see a larger role of regulation in the pricing of markets. The second thing we're going to see is a continued realignment of the global economy. In particular, we're going to see this multispeed global economy evolve. So these are themes that are going to play out in 2010 and 2011, and they are not fully priced into the market as yet.
Schonberger: Given the trajectory of the dollar, what are the implications in terms of rebalancing the global economy?
El-Erian: There are two elements. The hardest thing to get your arm around is the following. Our global system is built with something in the core system and the periphery. The core is the United States. It is the strongest economy. It provides a reserve currency. So it provides a currency that other people are willing to use and hold their savings in. It provides the deepest financial markets in the world. It provided the consumer of last resort -- the U.S. consumer. That was the core of the system. It still is the core of the system today.
Then you have the periphery, where you put emerging economies, Europe and Japan. Now, when you have a system built on the core and the periphery, the circuit breakers are meant to protect the core from the periphery. So the assumption is the core is strong, the periphery is crisis-prone, and the circuit breaker snaps when you have a crisis at the periphery that contaminates the core. That's how the system is supposed to work.
The financial crisis that originated in our country has weakened the core. And once you weaken the core, you start changing behavior on the periphery. So you start hearing about central banks diversifying away from the dollar. You start hearing about Asia wanting to increase financial intermediations at the regional level. The risk that we have for 2010, 2011, and 2012 is that the system itself becomes unstable because the core is weaker. This is sort of the big issue right now that a lot of us are trying to figure out and put our arms around as to what does that mean for markets. If the deficit continues to go up, then we should worry about this more and more.
Schonberger: Are you biased toward international stocks or domestic stocks?
El-Erian: I think at this point you need to have a mix of both, because the international stocks -- especially the ones in emerging economies -- have higher growth going for them. So the multiple expansion is there for you to capture as these countries continue to mature. Against that, when the core of the system is weakened, as I mentioned to you, the periphery suddenly has a number of additional challenges that it hasn’t had before. This is going to be one of the most interesting markets to navigate that I can remember.
Schonberger: Translation: "Interesting" means difficult, does it not?
El-Erian: Yes. It means it's critical for the individual investor to be very explicit about what mistake can they afford to make. This is a world in which there are a lot of moving pieces. So one has to recognize, when you have a lot of moving pieces, a lot of unanticipated things happen. It's very important to manage your downside. This is not a world in which you only want to look at your upside. You also have to be aware of your possible downside.
Schonberger: Would you be a buyer of gold at these levels?
El-Erian: I would be a buyer of gold whenever it goes below $1,000. But I wouldn't build on the momentum all the way up.
Schonberger: There's all this talk about a lost decade -- a Japan-like scenario. We had George Mason University economist Tyler Cowen in to visit the Fool not too long ago, and he said he thinks the lost decade is behind us, based on the idea that wealth creation was built on credit and therefore wasn't real. Do you think the lost decade is behind us or in front of us?
El-Erian: I think that we are well advanced, but we haven't yet completed the process of deleveraging. So we're not going to get another lost decade on account of credit-induced valuations that cannot be sustained. What we are risking, however, is that we get a disappointing decade in terms of growth -- that the potential growth of the U.S. goes down from around 3% a year to 2% a year -- and that as a result of that, you get muted returns. You don't get negative returns, but you get 4% to 5% returns versus 10%.
For El-Erian's take on the economy and the bond market, click here.
