Bond powerhouse Pimco sees a smaller euro zone, slow growth in developed markets and stronger gains in most emerging markets. By Steven Goldberg, Contributing Columnist May 31, 2012 U.S. stocks and bonds should beat Europe’s -- but that’s not saying much. Pimco’s newly unveiled economic and markets forecast for the next three to five years calls for dismal growth in the developed world, averaging just 1% annually. Emerging markets will continue to be the world’s economic stars, growing an average of 5% per year. But they, too, will suffer problems.SEE ALSO: Kiplinger's Investing Outlook for 2012 Mohamed El-Erian, co-chief investment officer of the world’s largest -- and probably most respected -- bond firm, thinks Greece will abandon the euro. After more heated political wrangling and more terrifying market selloffs, he and Pimco think the euro zone will evolve into a smaller, but more closely connected economic union. France, Germany, Italy and Spain will likely anchor it. In other words, perhaps only Portugal and Greece, and maybe Ireland, will ultimately abandon the euro. Despite this prediction, El-Erian sees a “risk of a big derailment” in Europe as the increasingly fractious negotiations bump up against hard deadlines. In other words, things could blow up a la Lehman Brothers. Advertisement Political polarization in Europe is as bad as it is in the U.S. Think of Germany, the architect of austerity, as the Republican Party, and France and southern Europe, which want more spending, as the Democrats. And just as the risks in Europe are huge, so are the risks of the “fiscal cliff” in the U.S. -- which is what some forecasters are predicting the U.S. economy will fall off if Congress fails to take steps before January to prevent massive tax increases and spending cuts. Pimco holds a forum each May, assembling its top people and bringing in outside experts for several days. In 2009, this forum gave birth to the phrase “the new normal” to describe the slow and bumpy road ahead. This year, El-Erian presented the forum’s major conclusions. Among them: The U.S. will continue to face a myriad of problems: too few jobs being created, too much debt, political paralysis, and the growing budgetary pressures caused by retiring baby-boomers. Pimco sees little likelihood of “grand political bargains” to resolve these problems. Rather, it anticipates more angry political skirmishes -- even after the November elections. Concrete Steps for Investors What’s an investor to do? Here El-Erian is quite helpful. In a nutshell: Invest in high-quality stocks and bonds, including those in emerging markets. Advertisement By high quality, El-Erian means companies that have a lot of cash, little debt, high profit margins and sustainable competitive advantages. They also operate in growing industries and, more often than not, pay dividends. High quality means mainly blue chips -- and only the strongest blue chips. High-quality bonds are those issued by the same companies, as well as by economically strong countries. It’s also crucial, Pimco says, to invest only in the most senior corporate debt. This is no time to stretch for yield by buying anything but the safest bonds. Municipal bonds -- particularly revenue bonds that finance essential activities -- are also attractive. You won’t get rich owning these bonds, but you’ll likely collect your interest payments and get back your principal without much risk. Ignore the constant refrain that bond prices will tumble and yields will skyrocket. That could happen late in the three-to-five-year period, so be prepared to reverse course. But a spike in rates seems unlikely for the next couple of years, given the lethargic growth in the developed world. Inflation, the biggest enemy of bond investors, remains tomorrow’s problem. Don’t overlook emerging-markets stocks and bonds. Many developing nations boast stronger balance sheets and more vibrant economies than the U.S. But prosperity among emerging markets will be uneven. China’s growth is slowing, but growth should fall to a sustainable 7% annually (the U.S. should be so lucky); don’t expect political chaos there. Advertisement Emerging markets will continue to grow rapidly, at least compared with the developed world. But they won’t grow nearly fast enough to keep the developed world humming. Pimco increasingly sees emerging markets claiming their places alongside developed countries as major economies. But that process is unlikely to be smooth either. Had enough bad news? Here’s more. Pimco isn’t even confident about its own forecast. The firm sees a much higher than normal chance that things could turn out to be much better or much worse. Much depends on policymakers. Germany’s president, Angela Merkel, could wake up tomorrow and decide that euro bonds are needed to support the common currency. Likewise, Republicans and Democrats in the U.S. could cobble together a major compromise that includes short-term economic stimulus and long-term debt reduction involving tax increases and entitlement cuts. But don’t bet on either happening. Advertisement El-Erian speaks of a “bimodal” outlook. That’s fancy talk for “We don’t really know what’s going to happen. Compared to our forecast, things could turn out a lot better -- or a lot worse.” Steven T. Goldberg is an investment adviser in the Washington, D.C. area. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Download the premier issue for free.