Pimco's Mohamed El-Erian at Morningstar Conference 2008

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.

Last Week in Review

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

Last Week in Review

Concerns over energy prices, weakening consumer confidence, a mixed inflation report and some increased activity in the merger-and-acquisition calendar caused U.S. stocks to experienced mixed performance for the week. The S&P500 Index was basically flat, falling one point to 1,360. After last week, the index was down just over 6.5% for the year. Large value stocks are the worst performing for the week and the year, down 7.8% year-to-date. Small and Mid Cap stocks are still out performing Large Caps.

Data last week pointed to continued weakness in consumer confidence, which acted as a drag on stock market performance. Historically, extremely low levels of consumer confidence have often presage market rallies. In fact, in the 12 months following the 10 lowest readings of consumer confidence over the last 30 years, stocks were up an average of 20%.

The big news last week was inflation. The CPI (Consumer Price Index) for May posted its largest monthly increase since last November, primarily due to energy prices. Core CPI inflation (which excludes energy and food prices) remained low. I do not believe that inflation is low even if you exclude food and energy. The government’s method of calculating inflation is flawed. It manipulates the calculation, substitute’s goods and then under estimates the price of improved goods. Inflation is a political hot potato and the incentive is to keep it low. The government has to increase social security benefits by the rte of inflation so low inflation equates to low benefit payout increases. Broad-based inflation in the U.S. is picking up and if our inflation is the same as most of the developed world then our inflation rate is around 7% which would mean we really are in a recession.

This leaves the Federal Reserve between a rock and a hard place. Deteriorating economic growth combined with the credit market issues has forced the Fed to keep dropping interest rates. On the other hand, the Fed is feeling pressure to increase rates due to rising inflation, the weak U.S. dollar and high oil prices. At this point, the Fed is talking tough (saying they plan to raise interest rates and that the dollar should strengthen) which is helping to bolster the equity markets. However, the Fed is unlikely to raise interest rates any time soon, given ongoing credit market problems. In fact it is entirely probable that the Fed may have to lower interest rates despite their hawkish rhetoric. The near term will continue to be bumpy in the equity and credit markets. The deteriorating economic climate here and abroad coupled with the worsening energy crisis will cause the markets to struggle for the next few months.

Commodities: Short Term Bubble

In January 2007 oil was $60 a barrel and this morning it is approximately $137 a barrel. It is a mind boggling rise in prices that has hurt consumers and attracted significant media attention.

Speculators are widely blamed for this rise. See the attached graph by JPMorgan which shows the marked increase in speculators participation. Speculators are partially to blame for this run up but there are sound fundamental reasons for this rise. There is more demand for oil (think emerging countries like China) and a tight supply. The third impetuous is rising political risks in the Middle East. It is very likely the U.S. and/or Israel will bomb Iran before Pres. Bush leaves office. This will destabilize the supply of oil causing the price to escalate further.

Goldman Sachs sees crude rising to $141 a barrel and possibly $200 a barrel in 2009. As with all bubbles it is hard to see where and when we will reach the top and how far and swiftly we will fall when it bursts. The bubble will burst as demand begins to wane (as growth in China continues to slow and demand in the developed country contineus to drop) and supplies stabilize. Speculators will leave the market like rats off a sinking ship. This might not happen for at least a year but it will happen. I do think long term that a 3% allocation to commodity futures is a good diversifying investment if you are using futures and the DJ AIG Commodity Index. The road will be pretty bumpy and beware of any erosion in the oil futures market.

Last Week in Review

The U.S. stock market fell sharply last week. The market consistently fell during the week with only positive trading day mid week. The bulk of the decline occurred on Friday due to new unemployment data for May and another dramatic rise in oil prices.
For the week the S&P 500 declined 2.8% and is down 6.5% year-to-date. Mid and Small Cap stocks held up better than the Large Caps last week and for the year. A trend not predicted by most market prognosticators, including myself.

Last Friday’s unemployment report showed greater weakness in the labor market than expected in May. The drop was significant, with payrolls declined by 49,000 and unemployment surged to 5.5%. Some economists postulate that this spike in unemployment may be a one-month aberration; however the labor market clearly has been weakening in 2008.

The negative side of the economic story is clear, with headlines focusing on housing and higher commodity prices. The primary main story rolling forward is going to be inflation, and its impact on consumers, interest rates and the markets. Inflation and tightening credit have restrained consumption in recent months and are likely to remain headwinds for some time to come.