El-Erian: Worst-case scenario may spark correction

Mohamed El-Erian, chief economic adviser at Germany-based Allianz, told CNBC on Tuesday that his worst-case scenario could spark a correction in the stock market.

In a "Squawk Box" interview, El-Erian stressed he's not predicting a correction—calling it a "risk scenario, not the baseline."

The former Pimco co-CEO warned it all comes down to whether there's a paradigm shift away from investors believing in a low volatility environment, against a backdrop of an improving U.S. economy and manageable European problems. "If all that changes, then you a looking at at least a 10 percent correction," he said.

El-Erian also predicted a Greek exit from the euro would cause "short-term chaos," but it would not bring the global economy to its knees. He expects short-term losses and a lot of volatility. "The reason it would not be a major catastrophe is because Europe has done a lot to navigate a Grexit [Greek exit]."

Debt talks between Greece and its euro zone creditors broke down late Monday, raising concern ahead of the expiration of Greece's current bailout loan later this month.

Read MoreGreece: The final countdown

On one side of the standoff, Greece sees the euro zone as a house of cards, in which a Greek exit would bring down the rest. Germany, on the other, considers the 19 single currency nations as climbers held together by a rope, with Greece as a weak link that may need to be cut loose.

El-Erian said the truth lies somewhere in the middle if not "more to the 'climbers' characterization than the 'house of cards,' ... [but] not decisive enough to make one side feel that strong."

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