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El-Erian: Greek Woes Will Keep Spilling Over

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. With Europe experiencing one of its worst weeks in the last 18 or 20 or so, it seems the sovereign debt crisis is spilling over and having more of a contagious effect than maybe was first anticipated.

We have the pleasure today of speaking with Mohamed El-Erian. He is PIMCO's CEO and co-CIO, and he's going to tell us a little bit about his take on what's going on in that region. Thanks for joining me, Mohamed.

Mohamed El-Erian: Thank you, Jason.

Stipp: First question for you, it seemed at first that a lot of people out there in the market thought that this situation was going to be contained. It obviously wasn't a great situation for Greece, but they thought it was going to be contained and handled there. It seems like that's not the case anymore. How much has this situation spilled over to really have an effect on a global level?

El-Erian: It is spilling over, and we should expect it to continue to spill over. One of the parallels is with subprime. At the beginning of '07 the general view was subprime is containable, it's isolated. We heard those same words being applied to Greece on the basis that Greece was just 3% of the GDP of Europe.

However, what we're learning is that we live in a very connected world and that a major disruption somewhere in the world has to be taken seriously because of this connectivity. And what we've seen happen is what started out as a Greek crisis has become a European crisis, and is now morphing into a global crisis. And the question is, what circuit breakers can be applied to contain what is now a spreading contamination of lots of markets.

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Stipp: You mentioned 2008 and the subprime crisis, and I think that one of the issues that we're wondering about is with the possible credit issues and also bank issues, is there a concern that Europe may see a credit problem like we saw in 2008 because of some of these effects we're seeing with the sovereign debt?

El-Erian: What's happening today is unambiguously deflationary for Europe. First we're going to see a lot more fiscal tightening in countries around Europe who will want to avoid what has happened to Greece. Second, we should expect banks to go into more of a rehabilitation mode and be less willing to extend credit. And thirdly, the private sector is likely to become more cautious and save more.

So for Europe as a whole this is a deflationary shock, which means that credit, both from the supply side and the demand side, will likely go down in the months ahead.

Stipp: Looking to your outlook for the region, then, and given that, who is losing here and who may benefit from the situation that's happening in Europe, and how is PIMCO positioning its portfolios based on that outlook?

El-Erian: There's two distinct trends going on. One is within Europe and one has to do with Europe versus the rest of the world. Within Europe we're seeing a flight to quality. So Germany is benefiting, especially the German bond market, as people look for quality. On the other side of that, countries such as Greece, Portugal, Spain, are feeling the pain of investors trying to sell what are very high holdings.

Remember, a lot of people in Europe--pension funds, insurance companies, institutional investors--a lot of them bought Greece, Spain, and Portugal on the basis that it was government interest rate risk. What it has turned out to be is default risk, which is much more volatile, and therefore they have to rescale their positions. So within Europe it's the classic flight to quality.

When it comes to Europe versus the rest of the world, there's two influences. One is positive, which is that some capital is actually bypassing Germany completely and coming out and ending up mostly in the U.S. bond market, so the U.S. is able to have lower interest rates than it would otherwise. However, people are also starting to recognize that what's happening in Europe will mean lower trade, lower exports to Europe, and more headwinds to maintaining this cyclical recovery.

And finally, what we're seeing virtually everyday is a lot more risk aversion as people worry about sovereign risk in general. And markets have become very edgy, very volatile, and liquidity has become patchy.

Stipp: Speaking about flight to quality, the dollar seems to have benefited from some of the tumult that we've been seeing. Could you characterize PIMCO's view on the dollar, and has it changed in light of anything that's happened over the last few weeks?

El-Erian: I cite here the concept that my colleague at PIMCO, Paul McCulley, always says. He says sometimes it's about wearing the cleaner shirt you have, and sometimes it's about wearing the cleanest dirty shirt you have. The dollar today is the cleanest dirty shirt. It has issues. It has issues because of the fiscal situation in the United States. But relative to other major currencies, it looks better.

So it's better in relative space than it is in absolute space. And because of that, because currencies are a relative price, the dollar has been benefiting. But something else has also been benefiting, which is gold. Gold is more of an absolute indicator. So you're seeing both flows into the dollar, but you're also seeing flows that are bypassing the currencies and going into gold.

Stipp: Mohamed El-Erian from PIMCO, thanks so much for joining us today and for giving us some context on the situation in Europe. We appreciate it.

El-Erian: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.