Monthly Investment Commentary | May 2008

Stocks rebounded strongly in April, making up some ground after a very rough first quarter. The large-cap Vanguard 500 (based on the S&P 500) gained 4.9% for the month, cutting its year-to-date loss to just over 5%, while the small-cap Russell 2000 iShares gained 4.2% and is now down 6.1% for the year. Growth outperformed value, and the margin of outperformance was greater for smaller companies. Foreign stocks did even better than domestic, with the Vanguard Total International Stock Index Fund gaining 5.9% in April—trimming its year-to-date loss to 3.6%. REITs continued their strong run, also gaining 5.9% for the month, and are up over 8% so far in 2008. High-quality intermediate-term bonds saw a slight loss in April, while short-term emerging-market local-currency bonds gained 1.9%. Both our equity and fixed-income managers generally did well in April.

Q&A with Mohamed El-Erian of PIMCO

Editor’s Note: On January 1, Mohamed El-Erian rejoined PIMCO in a new position as co-CEO (with Bill Thompson) and co-CIO (with Bill Gross). El-Erian previously headed PIMCO’s emerging markets team from 1999 to September 2005 before leaving to become president and CEO of Harvard Management Company, the firm that manages Harvard University’s $35 billion endowment. El-Erian is an economist by background. He has master’s and doctorate degrees from Oxford University and he spent 15 years at the International Monetary Fund. In order to become better acquainted with El-Erian and to get the latest on PIMCO’s outlook amid this very interesting and challenging economic environment, the following interview was conducted with El-Erian on April 21, 2008.

Let’s start with the current cycle. Have we averted disaster or is there still worse to come?

Let’s define “the cycle.” We think that the story since February of last year has been a morphing of disruptions or dislocations. It’s a very live, dynamic concept. We think that we’re on the verge of a new evolution of the dislocations.

If you were to run the tape back, what started out as a contained subprime disruption started infecting structured products. It then migrated all the way up the capital structure to the high-quality instruments, which involved swaps, bank capital, and high-quality mortgages. That then triggered a policy response.

Now we’re seeing this morph into something else—which is what we’re going to be talking about in the next six to 12 months. It’s no longer just how the financial sector impacts the real economy. Now the economy is disrupted to such an extent that it will become the driver of the next dislocation. One good thing is that it will be less esoteric than what we’ve seen over the last 14 months. It’s going to be a significant slowdown in the U.S. economy that will be characterized by higher unemployment. That, in itself, will start undermining things like consumer credit and the retail sector.

You’re going to see a U.S. economic slowdown that has the characteristics we’ve been used to in the past. What’s interesting is that it’s come at the back end of the cycle as opposed to the front end of the cycle.

The good thing is that it’s not as esoteric as what we’ve seen. The bad thing is that higher unemployment is a lot more real to everyday Americans.

That’s absolutely correct. The silver lining is we believe that unlike the past, the rest of the world—and especially the further east you go from New York—will be able to economically decouple. Notice that I’m stressing, economic decoupling as opposed to market decoupling. We think it will be able to economically decouple. That means that U.S. exports will continue to do well. But that’s simply not big enough to offset the slowdown in domestic demand.

What are the causes of this particular “dislocation”? What is driving the expansion of problems from the confines of the financial sector to the whole U.S. economy?

I think a few things happened. First, the transmission mechanism is broken. While the authorities are successful in getting liquidity to the banking system, each individual bank is still not engaging with the rest of the world. So the interbank market remains disrupted. You see this in LIBOR [London Interbank Offered Rate]. We continue to see a contraction of credit lines.

I often say the banking system is like the oil in your car. You don’t spend much time worrying about it. But if it breaks down, it doesn’t matter how good your engine is. It doesn’t matter how good your safety elements are and how good your brakes are. If the oil breaks down, everything else stops functioning.

The second thing is that—unlike the past—we are starting this economic cycle from a situation where the consumer is highly leveraged. The minute house prices start to come down, you take away the use of houses as an ATM. So there isn’t much savings in the system to act as a shock absorber. Consumers are much more vulnerable than they have been in past cycles. So that is why this has morphed from a financial-sector problem to the whole economy. You’ve disrupted the banking system, the housing sector, and the credit mechanism. The next shoe to drop will be employment.

We are seeing this through two indicators that worry us tremendously. One is a very broad-based inventory buildup. It’s virtually in every sector of the U.S. economy. This is not people stocking up in order to meet future demand. Demand is declining so quickly that people haven’t adjusted inventories yet. The second element we’re seeing is profitability starting to come down very sharply. Historically, both these elements have led to higher unemployment. Our concern is that you’re going to see unemployment pick up, which means real incomes will fall.

That means the average consumer is going to face four factors—if you talk about a perfect storm, this is it: a negative wealth effect because of housing, a negative credit effect because the banking system is retrenching, a negative terms-of-trade effect because food and energy prices are higher, and a negative income effect because unemployment is going up. That is a very large burden on the U.S. consumer.

How effective do you feel the Fed has been in the actions it has taken so far and how effective do you think they can be in helping to improve some of the problems you just mentioned?

That’s absolutely a key issue. Where you come out depends on how you pose the question. If you pose the question, “How do you feel the Fed has done, given the instruments that it has?” then we’d say, “The Fed has done very well, given the instrument that it has.” In fact, it has taken a series of unthinkable policy actions. Creating a new window for the investment banks is one of those actions. Bear Stearns was another one. Creating all of these temporary windows was a third one.

If you ask the question, “Are they trying really hard to do the best that they can do with what they have?” the answer is, “Yes, they’re doing fine.” But if you ask “how effective have they been?” then you end up with this dilemma.

On the one hand, you have policymakers taking unthinkable policy measures. And yet, it ends up looking like they’re doing too little too late. The reason that’s happening, we think, is due to a broader phenomenon. We use the analogy of trying to put new flows through an old system of pipes. The pipe at some point breaks, and then you have to clean up—and it’s an unpleasant cleaning up.

Think of what the world embarked on at the level of the individual firm. If you look at the Wall Street banks, their risk-management systems weren’t up to the task of what they were being allowed to do because of structured finance. There was a similar problem with the rating agencies and the bond insurers. The private sector clearly was behind, in terms of retooling its infrastructure, for the reality of what people were doing in the marketplace day in and day out.

Similarly, the policy mechanism was lagging. So you did not have instruments that allowed you to get to the root of the problem quickly enough. Not because there wasn’t a willingness to react, but there wasn’t an ability to be effective. That’s the big distinction that we’re living through right now.

Of course, once you go to the multilateral level—once you go to the international level—it’s even more apparent where you don’t get the sorts of coordination that you require for the extent of the dislocation that has faced the banking system. So the Fed—just like banks on Wall Street; just like the consumer—is simply facing a very different world, with instruments that were better suited for the world of yesterday than they are for the world of today.

You mentioned the next dislocation playing out over the next six to 12 months. Do you expect the recession to end after that period?

Yes. Where we differ significantly from the Federal Reserve is in ’09. In the Fed’s minutes that were published two weeks ago, they talk about getting back to “above-trend growth,” in ’09. We simply don’t see that happening. When we look at the different constituencies of aggregate demand, we simply don’t see how you get above-trend growth. We think that the U.S. will continue to grow below potential in ’09 as well. We think that means 0.5% to 1% growth rate in 2009. That’s significantly below what the Fed is predicting. That’s a big difference of view.

What will get consumers spending again in 2010?

It’s going to be a recapitalization process. In 2002 and 2003, the U.S. economy went through a process of recapitalizing its corporate sector. That was post-Enron, post-WorldCom. Today, we are in the process of recapitalizing the financial system. Every day, there’s somebody new coming to market to raise capital.

The story right now is recapitalizing the banking system. The next step is going to be recapitalizing the consumer. It’s a natural process of recapitalization, but it’s sequenced. The next sequence is the consumer, and that’s what stabilizes it for 2010 and beyond.

Are consumers going to be able to increase spending at the same rate they did previously? That was supported by increased home ownership and a big run-up in housing prices.

No. We expect that the consumer is going to increase their saving rates significantly. That’s another way of saying that consumption is going to come down. They’re going to build up cash cushions just like companies did in 2002 and 2003. That’s going to start providing a cushion for consumption to grow on a more sustainable basis from 2010 and beyond.

If U.S. consumers are going to save more and spend less, is there any need to worry about inflation?

In the old days, it was simple. If you got the U.S. right, you could determine with 90% accuracy what U.S. demand was going to do. Then two things followed immediately: you could have a pretty competent outlook for inflation, and you could have a pretty competent outlook for the global economy. Those were the old days.

Today, getting the U.S. right is less than half the picture. You’ve also got to get the rest of the world correct. In particular, the rest of the world that’s decoupling very quickly from the U.S. Those are the Chinas and Indias of the world. They’re now big enough to have an impact on the global economy. The inflation question and the global growth question cannot be answered solely on the basis of the U.S. outlook. That is a big change in the way we look at the world.

When we look to inflation, we’re worried that if you’re sitting in the U.S., you’re going from a situation where you had a disinflationary tailwind to a situation where you have an inflationary headwind. The disinflationary tailwind that we’re coming from was due to two factors. First, a very large pool of cheap labor entering the labor force. They came from Asia, they came from Central Europe, and they basically depressed costs around the world.

The second disinflationary tailwind came from the fact that the rest of the world was focused on production—not consumption. Looking forward, these disinflationary forces are turning into inflationary forces.

First, as my friend Paul McCulley often reminds us, you don’t go to heaven twice for the same deed. In this case, you can only bring in cheap labor once. Wage rates in India and China are going up, so you no longer have the reduction in global costs going on.

The second inflationary force is that consumers in India and China and other developing countries have now reached critical mass. They’re consuming more. They are pushing up energy prices. They are pushing up food prices, meat prices, etc. It’s a very healthy phenomenon because it shows you that poverty is going down. People can now afford to eat more and drive more, etc. But the world wasn’t ready for it.

So if you’re sitting in the U.S., the two forces that used to be disinflationary have become inflationary. Add to that the weakness of the dollar, and suddenly you’re importing inflation rather than disinflation. We see a world in which—even though the U.S. growth rate is going to slow down—inflationary pressures are going to go up.

Do you think the dollar will continue to stay weak?

We think that if you look at the next five-year period, the answer is yes. But we also are very aware that with currencies in particular, the moves are never linear. So the answer is yes over five years, but it’s going to be subject to lots of cyclical retracements.

Given that outlook, what are the implications for the investment environment in the next cycle?

What you’re looking at is a highly differentiated outlook for any investor. The first theme is to keep an eye on global differentiation. Keep an eye on changes in correlation. That speaks not only to asset allocation, but also to risk management.

Within the bond world, we think that there are a couple of themes that one has to keep in mind. One is the return of inflation. Two is what we call a capital-structure view of the world. In the world that I’ve just mentioned, if you’re only a U.S. investor, that’s really restricted. You’d want to be taking on risk now at the high end of the capital structure because these are the instruments that are being reliquified by policy action. So you’d want to be long high-quality mortgages, you’d want to be long bank capital, you’d want to be long swaps. All of this has been reliquified. But you’d want to be very cautious further down the capital structure because the transmission mechanism is not working as well. If you look at high yield, you’d want to be cautious of high yield.

The minute you open it up beyond the U.S., you would want to be conscious of the different interest rate cycles that are taking place the further east you go from the U.S. Those of us that are in the U.S. are very focused on the fact that the Fed is in an easing cycle. The question is now if we’ve gone from 5.25% to 2.25%, how much further down do we go? But if you happen to be in Europe, the ECB is on hold. The minute you open it up to a global portfolio, you want to be able to express different themes about interest rate cycles around the world—and as a result, different credit spreads around the world.

What’s your view of developing local market currencies and bonds?

We see over the long-term a realignment of the global economy. The world used to be basically a plane that flew on one big engine. That was the U.S. consumer. That was a big, big engine that kept the global economy afloat. Even though the global economy had to absorb various shocks including Japan having a lost decade in the ’90s, that engine was strong enough to keep the global economy flying. That engine now is dated. It’s aging. It’s sputtering. We have a number of smaller engines coming on stream. The world is in the midst of a transition from one very large engine that’s done extremely well but is now tired, to many small engines that are still coming on stream. That, by definition, is a bumpy process.

That doesn’t mean the plane crashes. It just means that the plane faces turbulence. Then it will find its equilibrium. When it finds its equilibrium, it’s going to be at a level where there’s going to be a repricing of assets in the rest of the world versus the U.S. So the exchange rate is one example. We expect Asian currencies, in particular, to strengthen significantly against the U.S. dollar over the next five years.

Local bond markets in these economies that are maturing very quickly are going to re-price, offering attractive returns. That’s how we think of the whole thing. But we tell people to just recognize that going from one engine to a set of engines is sustainable over the long term, but it’s a bumpy journey in the short run.

If the dollar continues to be weak over the next five years (so exports stay strong) but U.S. consumers spend less, what will be the impact on U.S. corporate earnings?

We’re going to see more of the same. That’s what the numbers in this earning cycle tell you. The companies with the most trade links will continue to do better than those that are domestically oriented. We expect that contrast to increase going forward. The more global the operations of a U.S. corporate, the better it will do relative to its peers.

Will real assets benefit from the increasing inflationary pressures you mentioned?

From the discussion of inflation, we think there are going to be two adjustments going forward that make sense. One is to take more and more the global perspective on the asset allocation—whether they be in bonds or equities. The other one is to take seriously something that you haven’t had to  worry about—which is inflation—for the reasons that I cited.

Therefore, you want a real-return bucket in your asset allocation. That bucket goes from vanilla, inflation-protected bonds around the world to other instruments that are much more volatile. Therefore, entry points become much more important. Those are commodities, infrastructure, etc. I think the general theme is that that real-return bucket is going to become an increasingly important part of a diversified asset allocation.

You and Bill Gross are co-CIOs at PIMCO and you sit on the investment committee with other senior professionals like Paul McCulley. Do your views generally align with theirs? How would you characterize your input and the vantage point that you bring to the discussions?

We have investment committee meetings four times a week from noon to three o’clock. We have a very active email exchange that unfortunately also covers the weekend. I think that you’ll see a pretty consistent picture with different emphasis. Paul’s emphasis has tended to be on policies. He’s very focused on what the reaction function of the policymakers are. My emphasis has tended to be on the technicals and the deleveraging that can take valuations well beyond what is justified by the fundamentals. I would put Bill in the middle. He reconciles both sides of that. If you wanted to force a distinction among us, that’s what it would look like. But that’s really a forced distinction. The idea is that we’re like an old married couple. We exchange views so often that we can finish other people’s sentences, but we continue to evolve. We do that because we meet on a regular basis, and we bring in people and new information.

—Stapp Financial Planning, PLLC

This information is also available at www.stappfinancial.com, or you can download a PDF version. If you do not want to receive future e-mail newsletters from Stapp Financial, link to our subscription form, or send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances.