PIMCO’s Mohamed El-Erian Talks to TIGER 21 on Sea Change in Global Economic Markets
NEW YORK (July 23, 2008) – Continuing to provide its members with access to the top minds in the financial world, TIGER 21 welcomed Pacific Investment Management Company’s Co-CEO and Co-CIO Mohamed El-Erian to its July all-member luncheon. Mr. El-Erian warned that the current market upheaval is much more than a downward trend or correction – a major retooling of all financial systems is needed. He walked the audience through factors that have contributed to the current credit crisis and financial system turmoil, what investors should be prepared for, and what they need to be doing about it.
A widely sought –after speaker, Mr. El-Erian has a new book, When Markets Collide: Investment Strategies for the Age of Global Economic Change, which has just been published by McGraw-Hill Professional. Mr. El-Erian was also interviewed prior to his presentation and that session will be the second installment in the TIGER 21 interview series with world’s top financial expert presenters (to view, visit www.tiger21.com).
Mr. El-Erian joins a list of top-flight investors and money managers that have presented to TIGER 21, including Stephen A. Schwarzman, Chairman, CEO and co-founder of the Blackstone Group; Alan “Ace” Greenberg; co-founder of the Caryle Group David M. Rubenstein; and oil and water mogul T. Boone Pickens.
“Mohamed El-Erian’s credentials are impeccable and his clear account of the market turbulence as well as the risks and opportunities it presents is invaluable,” said Michael Sonnenfeldt, founder and chairman of TIGER 21. “I am happy that we were able to secure his appearance and that so many TIGER 21 members availed themselves of the opportunity to hear him.
Mr. El-Erian argues that we are experiencing fundamental market change and that individual investors, institutions, and governments need to recognize this fact and adapt. To illustrate the extent of this change, Mr. El-Erian suggests that if a year ago he said that there would be trouble in the most sophisticated financial system in the world; that nearly $400 billion in capital would be raised and wiped out; and that an important source of that capital would be poor countries, most investors would dismiss him. “This scenario was unthinkable a year ago, but it is what has happened,” he reminded the audience.
He, along with his colleagues at Harvard Management as well as those at PIMCO – two institutions with long-term views – started noticing signs of trouble in 2006. He explains that the normal noise in the market – which can usually be disregarded – went from being sequential to simultaneous. This caught their attention.
Unfortunately, it did not get the attention of policy makers and most of the financial world. And when “the financial systems do not recognize signals and there are major inconsistencies between signals and systems, something is going to break,” he says.
Following are some additional highlights from his presentation to TIGER 21:
A lot of noise: Why signals went unrecognized – while the financial system is good at identifying each signal individually, the system was awful at understanding how they interact. We’ve realized that economic growth was shifting away from the U.S. to emerging markets like China and India – yet investors forgot that growth is non-linear – we go through long periods, then short spurts of rapid change. While many people realized that India and China were becoming more important, they underestimated how quickly this was going to happen.
Pace of change: Mr. El-Erian also underestimated how quickly the markets would change. “When I started writing the book last fall, I thought I was writing something forward looking. When it went into production I realized that it was current events, and I hope that it will soon be ancient history, although I have a sense that it will not. The basic theme of the book is that the markets of tomorrow are colliding with the markets of today.”
On Risk Management: Just in time risk management does not work. Mr. El-Erian is terrified by the extent that some very sophisticated risk managers rely on the new fangled assessment tools to let them wait for the turn in the cycle and then get out, rather than unloading an investment before the turn. Mr. El-Erian believes in old fashioned risk management – “Ask yourself how much money can I loose and am I willing to lose that much money. And if the answer is no, go out and try to clip your tail.”
Not going to get help from policy makers : Policy makers in the U.S. were taken by surprise according to Mr. El-Erian. “They are very smart and well-intentioned, but central bankers here have too many objectives. They get an A+ for effort, but a B+ for outcome. The transmission mechanism is broken and policy instruments are too blunt.
Retooling needed: What’s coming in the near term? The biggest risk is that credit crunch has morphed into something much more sinister: global economic slowdown. When you have a slow-down and a financial system that is trying to recapitalize itself, the only solution is a new balance sheet. All systems need to be retooled – and we cannot get there overnight. Mr. El-Erian suggests that there will be more market accidents and more policy mistakes.
Fasten your seatbelts: In the long term, Mr. El-Erian sees a world that is much more balanced. For the last 10 years or so the global economy was a plane flying on one very big engine – the U.S. consumer – and we made a tremendous effort to keep that plane at really high altitudes. This big engine is absolutely exhausted and the plane is losing altitude. In the future, the plane that is the global economy will be propelled by a number of smaller engines that will make for a much more stable ride. However, moving from the big engine to a lot of smaller engines will be a bumpy process so Mr. El-Erian suggests we “put our seat belts on.”
Silver lining: Mr. El-Erian said he was much more worried 1 ½ years ago – that was when you couldn’t find anything to buy because everything was too expensive. The good news in all the market changes since then is that there are lots of opportunities now– in terms of pricing. He points to municipal tax free bonds as the most extreme example– the yield is higher than the yield on taxable instruments with same credit quality.
He sees the same issues with high quality mortgages, bank debt, and swaps – in today’s world the value of an instrument is no longer strictly correlated to its fundamental attributes – it depends on whether you can finance the holdings. If you cannot finance the holdings the instrument will trade extremely cheap relative to its fundamentals.
Systemically important countries: Responding to a member question on how likely it is that the systemically important countries will be able to manage the success of their economies, Mr. El-Erian said that we forget how hard it is to manage success and that some countries will be better at steering their economy. The most important countries in this equation – China, India, Russia and parts of the Middle East will get it right. Which is why he is bullish on the global economy over the medium term. On the other hand, he suggests that the risk for failure is much higher in countries like Venezuela and Argentina.
How to weather the market:
In order to weather the storm that is the financial markets, investors need to know the answer to these four questions about their portfolios:
1 - How much home bias do I have? Your portfolio should not be too heavily weighed with U.S. investments, because the domestic market is becoming less dynamic. Portfolios need diversification.
2 - Do I have any inflation protection? –This was not needed during the past decade, but now we live in a world of inflationary pressures, although actual inflation is open for debate.
3 - What am I willing to put up with? Am I ever going to be forced to sell? If the answer is yes, sell now.
4 - Who is managing my risk – who is cutting off the tail of the distribution? Can you identify either an instrument or a manager who is doing this? If the answer is no – you need high cash element.
Investors are living through a very bumpy transformation. Once we get there it will feel good, Mr. El-Erian assures us. But the journey will be very difficult because a lot of retooling is required – for individuals, companies, governments and the multi-lateral system. He goes into great detail about this in his book and cautions that it will not happen overnight.
About TIGER 21
TIGER 21 is the nation's premier peer-to-peer learning group for high net worth investors. Building on shared collective intelligence, TIGER 21 members seek to enhance investment returns while limiting their investment risks to acceptable levels. There are currently sixteen TIGER 21 learning groups, representing more than 160 investors, with investable assets over $10 billion. Founded in New York, TIGER 21 now has investor groups in New York, California, Florida and Texas. For more, visit http://www.tiger21.com.
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