I am attended the 2008 Morningstar Conference in Chicago. I am trying something unusual. I am going to try and post my notes on the most compelling speakers and publish them. The opening address was given by Mohamed El-Erian from Pimco. He presented his current Investment Outlook. Here are my notes:
Notes Morningstar Conference 2008
June 25, 2008
Mohamed El-Erian, Pimco
Investment Outlook
New book
When Markets Collide
Co CEO and co CIO of Pimco
Objective is to share my thought about opportunities in the markets. It is a very fluid and uncertain environment. I will use a simple framework which speaks to what is happening and sheds light on opportunities and risks that we are facing.
It is hard to believe what has happened over the last year. The unthinkable has become thinkable. This is not noise, this is a signal. Understanding these signals is the key to managing money well.
A year ago, none of us would have predicted that the next crisis would occur here and not a third world country. That bank runs would occur here in the US and United Kingdom versus the rest of world. That our banking system would raise $350 billion of new capital to replace a similar amount it had to write-off. What is even more significant is that this recapitalization is from the poorer third world countries and not from traditional money centers. I could not have made these predictions a year ago.
I would submit that the markets are trying to tell us something.
If you were in the FOMC meeting, you would hear the members discuss how worried they are about inflation, employment, and the dollar. The issue: the Federal Reserve cannot fix these all of these problems simultaneously. They must pick between growth and inflation. Unlike the European central banks, whose mandate is to focus on inflation, the US Federal Reserve must respond to multiple factors.
There were signals early on of the problems to come. They cropped up as conundrums, puzzles, and anomalies. We have gone from serial inconsistencies (or sequential) to all-together simultaneous inconsistencies.
It is important to understand these changes and navigate thru portfolio asset allocation and rebalancing. These represent great opportunities but great risk. Retooling is critical but don’t fall in love with answers.
#1. Disruptions this time are taking place in the heart of the US financial system. This system is crucial to our economy. It is like the oil in your car - without it the car grinds to a halt. (Additional Explaination from Libby - Restructuring the Financial sector is the equivalent of the U.S. economy getting a heart transplant).
This is a story about systemic risk and how the banking system itself mispriced the risk.
As the market looks at risk it currently is re-pricing it through the market. Currently the market is saying through pricing that Citigroup and Goldman are riskier then Brazil and Mexico. So the contamination is very different this time. Our impact on the world is different this time.
In 2000, the breaking of the technology bubble had a greater impact on the global markets than the US. This time the origins and the impacts of this crisis are different.
The Casualties:
1. The Credibility of the most sophisticated financial system of world
2. Effectiveness of policy and the credibility of our policies
3. Highly leveraged institutions and transactions have been hurt the most
4. Just-in-time risk management system has been debunked, due to lack of confidence
5. Comfort with the “originate and distribution” model
On the whole the rest of world didn’t get hurt by this but has to deal with consequences.
Imagine a horse race. In February 2007 three horses started running a race.
“Deleveraging Process” was first out of the starting gate
“Capital Raising” – the most hesitant horse until it saw how far ahead the deleveraging horse was, then started galloping
“Policy” was the sleepiest and saw the race was long. It started only in August
The distance between horses is shrinking. You must be cautious when the distance between horses is lengthening. What counts is the distance between horses for each asset class.
We have had a sequential re-capitalization process for a while.
In the early 90s, it was the Emerging Markets.
In the early 00s and mid 00s, it was corporations like Enron.
Today it is the re-capitalization of our financial sector.
This is inherently risky to do because it is at the center of the capitalist system. (Like heart surgery – you’ve got to keep the patient alive).
Tomorrow it is the US Consumer due to the housing market and consumer debt levels.
We will end up with a stronger system after it is all over. We are very lucky these things have all happened sequentially versus simultaneously.
But the implications go beyond this. There are drivers of global change. The markets of yesterday are colliding with the markets of tomorrow. There are handoffs. The developed countries are handing off to the developing economies.
The growth handoff – the gradual realignment of global powers, has now reached critical mass. No longer will the handoff be slow. We think in linear terms like markets and infrastructure but development is now non-linear. We are use to nothing happening for a long time, but change is speeding up and now it will happen all at once. (Change in these growing markets overseas will be exponential.)
Next is the Wealth handoff. Wealth will shift to Asia, the Middle East and other Emerging Economies. There has been a turnaround in inflationary dynamics from global dis-inflation to inflationary pressures, which helps these countries.
Last:
There has been a change in the barriers of entry to markets. Emerging economies are now driving global growth. A trillion dollars of accumulation and consumption has now moved out of our economy.
The US Consumer market has hit a harsh head wind. Consumers can’t access house equity – the ATM card is gone.
It is near the time when people en masse will walk away from their homes. It has already begun - people are falling behind in their mortgage payments before falling behind in other things. Historically, this has never happened before.
There is a trader in a hot air balloon floating in the sky. He spots a man on the ground. He asks where am I? The man answers: You are in a hot air balloon floating above the ground. The trader is disgusted. This does not help him at all determine where he is. The trader yells back – Are you an analyst? The gentleman on the ground says, Yes how did you know. The trader responds, you gave me accurate information that is totally useless. The Analyst yells back, Oh you must be a trader. The trader says how did you know? The analyst responds, You don’t know where you are, how you got there and where you are going, and you are still blaming the analyst.
There are going to be opportunities and risks, and if you are like the poor trader you will not survive.
You need to have total clarity about return expectation and risk tolerance. Revisiting asset allocation for secular robustness is crucial for success. The choice of investment management vehicles in the context of this new configuration of risk will make all the difference. Portfolio and manager must reconcile challenges. You must ask yourself - What mistakes do I usually make and what could happen? Then analyze what the outcomes could be of these mistakes in this new world. Your risk management analysis should include “fat tail” protection. It is essential to set up proper procedures and structure, so don’t fall victim to human nature.
You must have a mentality of constructive paranoia. Openness to appropriate re-invention and internal mechanisms will avoid second guessing. You must have Secular and cyclical anchoring.
Understand the pitfalls of “rational fools.”
A sociologist and animal behaviorist created a test. They took a starving donkey and set up a situation where the donkey had to pick between the same amount of hay spread out or concentrated in a pile. The donkey saw no difference between the piles and refused to pick, thereby starving to death.
The moral, if we get paralyzed and do not change then we lose. Doing nothing is not a choice.
Don’t treat this as a one-time disruption. This is going to be a bumpy journey. Don’t think we are ever going back to business as usual (or the way it was before the sleeping emerging markets woke up). Don’t forget that this crisis involves opportunity and a new capital structure.
We are living through a bumpy secular transformation. Old and new markets are colliding. New opportunities are wrapped in new and complex configurations. Re-tooling is necessary for survival.
Soft decoupling process. In the past, when our economy hit the skids we took the world with us. Now we are in a process of slowly decoupling our economy from the rest of the world. Now when we slow by one unit the rest of the world will still slow, but by less. So world will outgrow moving along with us.
We will continue to experience demand shocks to commodities because the Emerging economies are driving growth. They are making new and bigger demands. They are inefficient users of commodities. Conservation is not a word they know. Commodities are now expensive and more volatile and will stay this way. The very shift in prices itself signals a new and different volatility.
Question: What will it take for the market to recover?
The key to our recovery lies in the housing market and consumer.
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