Pimco's El-Erian: Why Zombies Threaten Markets

The “zombification” of companies living on easy credit could hurt investors who are not prepared.

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Will zombies own the road ahead for financial markets or can the global economy sustain itself without central bank transfusions? That's the question posed by Pimco's cerebral chief executive officer Mohamed El-Erian in a new report that suggests the economy is still haunted by the legacy of the last crash and spoiled by the easy money that has been pumped into it since.

He says the global economy is struggling against "zombification" from companies living off easy money but not investing in growth.

El-Erian sees a chance that growth could recover, but it's still unclear. He says there are "multiple possibilities of what the British would call a 'T-junction' – where the current road eventually ends, giving way to one of two contrasting outcomes."

El-Erian is not sure which fork the economy will take, but is preparing for both.

[Timeline: Why Dow 14,000 Was One of the Toughest Market Milestones Ever.]

"In economic terms, the current setup would yield either to a sunny road (in terms of growth and financial rebalancing) or to a stormy one," he writes in the Pimco report. Either way, there will be a fork, writes El-Erian, who, like his co-chief investment officer, Bill Gross, leaves investors with market forecasts that are like riddles. The two helped pioneer the notion of a "new normal" a few years ago to describe the latest run of low growth, high unemployment and high debt. Now, as that scenario plays out, investors face "consequential elements of a 'stable disequilibrium," El-Erian writes.

It's an oxymoron worthy of Yogi Berra. What he is saying is that something has to give. Disequilibrium can't be permanent. Corporate managers must move to true sustainable growth that is less dependent on interest-rate plays (borrowing cheap and investing cash in short-term gimmicks like stock buybacks, for example) or they will sink into slowing growth and global financial instability. They must do something. As baseball philosopher Berra says, "When you come to a fork in the road, take it."

But where and when? This season or next? El-Erian gives no timetable, but says a gradual unwinding of the Fed's support of the bond market would be the most beneficial. Others agree that the gradual approach helps, but with the market at record levels, it could still be a difficult period.

David Edwards, president of Heron Financial Group/Wealth Advisors, agrees that a change is coming and investors should be ready – though it should be no surprise. "The thing that is fascinating about the present outlook is that there does not seem to be a single investor in the world who does not know that rates are going up in the next two years," Edwards says. "Everyone has made decisions to hedge what they can. It's been so gradual. People have had time to do it."

His view is that the stock market's 20 percent rise since November is likely to spur a 5 percent to 7 percent correction this year. For people investing with his firm right now, he is suggesting putting half of their funds in cash and half in stocks until the pullback hits. He expects a bigger pullback if corporate earnings fail to go up when interest rates rise.

[Read: Low Rates Will Limit Many Investors' Options.]

El-Erian's advice is a bit less specific, though it's packed with warnings that investors won't benefit much by relying on history to understand what's unknown about the markets and economy now. Here is his food for thought in his fork-in-the road outlook, taken from this week's Pimco investment letter:

• "Look more intensely for opportunities away from the central bank wave," El-Erian writes. He mentions no specifics, but banks have been huge beneficiaries of the low interest-rate policy of the Fed, and bank stocks have surged. But once the Fed easing slows, you don't want to be there.

• El-Erian writes: "Do not lose sight of the extent to which asset prices have been disconnected from fundamentals and, thus, require major eventual validation by fundamentals." Again, no specifics, but Heron Financial Group's Edwards says if interest rates rise without a similar increase in corporate earnings, stocks will be overvalued. He figures that if benchmark interest rates rise two percentage points and corporate earnings fail to rise, stocks will fall by 16 percent. But those are just "ballpark figures," he says, since any gains in earnings will need to become game-time decisions.