Investors Position for a Synchronized Global Slowdown: El-Erian

The insufficient job creation, stagnant earnings and alarming long-term unemployment highlighted by May’s disheartening jobs reportunderscore America’s persistent unemployment crisis. The numbers also speak to a synchronized slowdown that is now taking hold of the global economy — a phenomenon that is being signaled by virtually every other data release out of Europe, the U.S. and emerging countries.

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The realization of lower global growth, together with increasing financial instability in some parts of the world (particularly Europe), is an important driver of the recent sharp selloffin equities and other risk assets. It has also turbocharged the collapse in yields on higher quality government bonds, with the 10-year U.S. bondat a record close of 1.46% on Friday (and Germany even lower).

To state the blatantly obvious, the best investor positioning for the last few weeks was an across-the-board defensive, “up in quality” one. The much more difficult (and urgently relevant) question on many people’s mind today is whether this still makes sense — particularly in view of the dramatic valuation moves.

Already, several analysts have come out recommending that investors react to the recent selloff by significantly adding risk assets to their portfolios now. And those who favor this "mean reversion" approach, a theory that assumes highs and lows are temporary and that prices will eventually move back toward the mean or average, cite historical levels to support their recommendation. They see enticingly cheap price-to-earnings ratios for stocks to unsustainable low yields for government bonds.

They would be right if history does indeed provide a good guide to what constitutes “fair value” at this moment in time. And in extrapolating from what has been to what is and will be, investors are advised to consider four issues as they confront one unthinkable scenario after another.

Europe, the world’s largest economic zone and a highly interconnected one, is stumbling from bad to worse. The fundamental issue here goes well beyond the usual questioning of whether the euro zone will have an ugly recession (it will) and policy makers will intervene again (they will).

The construct of Europe is in play. This adds meaningful risk by supplementing the usual credit, intertemporal and policy components with convertibility, settlement and complexity risk premiums.

The second factor involves the unusual level of political dithering and bickering which, in some countries (e.g., Greece), has led to heightened disillusionment and rejection on the part of citizens. This serves to undermine responsive policy making and exposes economies to new threats.

While Europe is again the most obvious example, it is far from the only one. America’s unusual level of political dysfunction/polarization has resulted in policy paralysis; it will also expose the country to the possible disruption of a “fiscal cliff.”

Third, with some segments in the global economy still highly indebted and not growing properly, ugly deleveraging dynamics are re-imposing themselves. The longer this persists, the lower the probability of a much-needed “safe delevering.”

Central banks could once again intervene through their experimental combination of exceptionally low policy rates, unusual policy communication and additional balance-sheet purchases. But there is growing recognition that this policy bridge is only effective if other policy-making entities are both able and willing to get off the sidelines. Regrettably, there is little evidence that this will happen any time soon.

Finally, the risk of a synchronized global slowdown requires a coordinated global response. Yet there is no conductor to speak of. The U.S. has lost an important part of its global leadership role. The G7 and IMF lack legitimacy and credibility. And the G20 is still working on its operational effectiveness.

All this speaks to continued uncertainty and volatility — economic, financial, political and social. Since the world starts naturally long risk assets, we could well see more investors seeking less risky asset allocations, including cash in what they deem as “safe jurisdictions.” In the process, valuations — for bonds, commodities, currencies, and equities — could well diverge for a while from what many deem to be historically fair valuations.

As Will Rogers is said to have observed decades ago, investors should be concerned with the return of their money and not just the return on their money.

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Dr. Mohamed El-Erian is CEO and Co-CIO of PIMCO, the global investment manager.