I am retired and take educated guesses on all things financial.

September 30, 2009

September 30, 2009: Pimco's El-Erian Warns Investors (Again)

Mohammed El-Erian, Chief Executive and Co-Chief Investment Officer at Pimco has again warned investors of the investment climate ahead.

Through an op-ed piece in the Financial Times, El-Erian warns investors to begin to think and act in terms of absolute and current facts - not the rates of projected change. He used a recent, blunt quote from the Governor of the Bank of England as the foundation of his article. "It's the level, stupid - it's not the growth rates, it's the levels that matter here." Investors have not accepted the reality that absolute levels of income, debt, wealth and unemployment are what really matters today. The outlook for major countries will continue to be driven by the levels of these key variables.

El-Erian goes on:

First, consumer debt is still too high relative to income expectations and credit availability. This will hold back any sustainable bounce in aggregate demand.

Second, many banks' balance sheets are still being manipulated for the comfort of regulators or their own managers. This will inhibit them from lending to important components of the real economy.

Third, unemployment has risen well beyond expectations and is likely to prove unusually protracted. It will take years for US unemployment to return to a natural rate. This will dampen the recovery of consumption and investment, stress social contracts that assume a flexible labor market and endanger political support for essential structural reforms.

Fourth, public debt has grown so rapidly as to spark concerns about future debt dynamics. This would inhibit the effectiveness of future stimulus measures, as well as complicating the formulation of exit strategies. It would also erode the medium-term ability of the US to fund cheaply its large deficits by undermining both the global standing of the dollar as world reserve currency and the attractiveness of US financial markets.

Taken in total, these four issues will make it tough for the global economy to attain Obama confidant Larry Summers' view of "escape velocity" - which translates to the US achieving a sufficiently high and sustained growth to propel the world into recovery.

El-Erian warns that current market valuations assume companies will be able to robustly grow earnings through higher revenues, not renewed reliance on cost reductions that have juiced up earnings over the past six months. This assumes depending on what is likely to prove to be an elusive high-growth scenario for 2010.

Investors need to focus on levels now rather than rates of change later. We are in uncharted waters and predicting a future earnings without taking into consideration the above four issues is a big mistake.