The Guest Blog

El-Erian: Markets Balance Solvency, Growth and Liquidity

Mohamed El-Erian |CEO, PIMCO
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The health of the global economy, and that of markets, depends on the success of a series of medium-term handoffs between the public and private sectors – in growth, balance sheets and credit flows. This week’s data highlighted their complexity. Fortunately for investors, the valuation impact is being compensated by central banks' wide open liquidity spigots.

To counter disorderly private sector de-levering and avoid an economic depression, governments and central banks around the world have aggressively ballooned their balance sheets. This has helped heal some private balance sheets but job creation has remained very anemic, income inequality has increased, and growth has been too weak to allow for the de-levering of the public sector (including fiscal deficits and central balance sheets which now vary in size from from 20% of GDP in the US to 30% in Europe).

In the US, Friday’s disappointing GDP print for the fourth quarter was a reminder of the challenge, especially in view of a less-than-reassuring composition. Consumer growth was limited to just 2% notwithstanding yet another decline in the savings rate to 3.7%, a level last seen at the end of 2007. Export growth also decelerated. Indeed, were it not for a surge in inventory, the economy would have probably succumbed to the drag from government components.

The extent of the growth challenge in Europe was highlighted by Friday's higher than expected increase in Spanish unemployment (to an agonizing 22.9%). Meanwhile several of the region's governments, ECB, IMF and private creditors continued to squabble about how to allocate the inevitable losses on Greek debt. In Portugal, another highly vulnerable economy, market measures of default risk reached record highs this week.

The longer such solvency and growth indicators continue to flash red in Europe, the more likely that capital will continue to flee; and the harder it will be to overcome the region's debt crisis.

With the US still too weak to act as the global growth locomotive and Europe being more of a caboose, attention naturally shifts to the emerging economies. Are they robust enough to tip the global balance in favor of high growth?

The IMF was less than fully re-assuring on this a few days ago. Yes, several emerging economies still benefit from strong balance sheets and productivity gains. Unfortunately, they too are slowing and, in the process, will act as less of a global locomotive.

Today's markets are not pricing in fully the growth and solvency disappointments, and for good reason. Central banks continue to pump a massive amount of liquidity into the system. And, this week, they again left little doubt about their commitment to this course of action notwithstanding it's failure to deliver the desired economic outcomes.

In Wednesday's statement, the American Federal Reserve extended by another 18 months the expected period for exceptionally low interest rates (through at least the end of 2014). Chairman Bernanke went further in his press conference, confirming that the Fed stands ready to consider additional quantitative easing should economic data remain weak.

Across the Atlantic, Meryvn King, the governor of the Bank of England, also signaled his willingness to do more. Meanwhile the ECB did nothing to counter market expectations that it's second 3-year LTRO operation next month will be sizeable, especially given the lowering of collateral requirements.

Wherever you look, markets are balancing liquidity versus solvency and growth. The hope is that ample central bank liquidity will serve as a bridge to help the west overcome too much debt and too little growth; the risk is that the liquidity will prove a bridge to nowhere.

Dr. Mohamed El-Erian is CEO and co-CIO of PIMCO, the bond investment house.