Pacific Investment Management Co., home to the world's biggest fixed-income fund, is shying away from risky assets as it sees a growing disconnect between the performances of financial markets and the global economy.

“Especially with ever-elevated prices, and absent a favorable growth shift, we will continue to bring down risk postures of portfolios,” said Mohamed El-Erian, chief executive officer of Newport Beach, California-based Pimco, outlining the company's investment strategy over the next three to five years.

In a report posted today on Pimco's website, El-Erian said the world economy is undergoing a “stable disequilibrium” that could end in financial turmoil, greater social tensions, and beggar-thy-neighbor national policies. Egged on by “hyperactive” central banks, investors are playing down the dangers and pushing financial markets higher, he said.

He warned of a risk of “severe air pockets” in financial markets if economic growth proves disappointing and said investors should be prepared for more restructurings of corporate and sovereign bonds.

Seeking to craft a medium-term outlook that will guide Pimco's investments, El-Erian said U.S. growth will remain limited to “not much greater than 2 percent on average” while Japan will face challenges in sustaining an initial surge in activity on the back of an “historical” policy-regime change.

Europe's 'Zombification'

In Europe, the immediate threat is what El-Erian called “zombification,” where companies and banks continue to operate without adding much to the economy.

China is projected by Pimco to expand an average 6 percent to 7.5 percent annually.

As for global inflation, the money manager tilts toward the possibility that it will be “higher and less stable” over the next three to five years, he said.

Pimco's co-founder Bill Gross, who serves as co-chief investment officer alongside El-Erian, has already been advising investors to sell riskier assets and buy government debt, including inflation-linked securities and nominal Treasuries as central banks pursue unprecedented stimulus measures.

Gross raised holdings of Treasuries in his flagship fund in April to the highest level since July 2010. In Europe, Andrew Balls, the company's head of European portfolio management, said April 24 that Pimco had been scaling back exposure to Spain and Italy as part of a reduction in credit risk.

El-Erian's report summarizes three days of internal discussions last week on the global economy and financial markets. Former World Bank President Robert Zoellick; former Spanish Finance Minister Elena Salgado; and Adam Posen, president of the Peterson Institute for International Economics in Washington, took part in the talks.

The annual strategy session came against a backdrop of rising global equity prices and stepped-up stimulus from the world's central banks. Since the start of the year, Japan's Nikkei 225 Stock Average has risen by more than 40 percent, while the Standard & Poor's 500 Index has climbed almost 15 percent.

“Investors are enticed to take more and more risk at ever more elevated prices,” El-Erian said. “But if growth fails to materialize over time, reality will snatch back the returns from investors in the period ahead.”

Rate Cuts

Four years after the deepest recession since World War II, central banks are still combatting sluggish economies with interest-rate cuts and asset purchases. So far this month, monetary authorities overseeing a quarter of global gross domestic product have lowered rates, including those of the euro-area, Australia and Israel.

The central banks “have inserted a remarkable wedge—a disconnect—between market prices and underlying economic and financial fundamentals,” El-Erian said. Yet they “are still unable to deliver sufficiently robust growth and jobs.”

He predicted central banks would keep experimenting in their efforts to bolster their economies. More will follow the Federal Reserve in targeting growth and jobs more explicitly and may also try to support small and medium-sized enterprises or broaden the set of assets they buy, he said. Their actions, though, “are likely to become less effective” over time as the risk of collateral damage mounts, according to the executive.

He said investors should be wary of holding too much of the currencies of those central banks that are easing, yet lack the reserve currency status of the U.S. Portfolios also should be hedged against the risk of catastrophic outcomes, he wrote.

Pimco is now looking “more intensely” for opportunities in areas not so affected by the wave of liquidity provided by central banks, El-Erian said. Revolutions in shale energy and digitalization provided some “exciting investible stories,” he wrote.

El-Erian, who popularized the phrase “new normal” to describe an era of lackluster growth, said economies are nearing a fork “where the current road eventually ends, giving way to one of two contrasting outcomes”—a fast, sustainable expansion or a slowing world economy with countries “competing for a smaller pie.”

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