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PIMCO's El-Erian Tells FAs, 'This Time It's Different!'

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(Chicago) Unlike the presidential candidates, the opening-address speaker at the 2008 Morningstar Investor Conference — held June 25-27 in Chicago — is not trying to sooth or charm his listeners. In fact, Mohamed El-Erian, the co-CEO and co-CIO of Pimco and author of When Markets Collide, wants investors and advisors to grasp the dramatic — and at times painful — sea changes at hand, including the fact that the markets currently think investing in Brazil and Mexico is less risky than investing in Goldman Sachs and Citigroup.

He told some 1,300 advisors and other conference guests that, “The unthinkable has become thinkable. This is not noise; these are signals, and understanding these signals is the difference between superior performance and the opposite.”

“I hate the notion of saying this time it’s different,” he explains. “But there simply is too much research showing that this time it really is different.” Important trends described by El-Erian, who has a Ph.D. in economics from Oxford University and served as the head of the Harvard Management Company before re-joining Pimco in late 2007, include the return of significant inflation and the realignment of global economic wealth. ”Don’t think we’ll go back to business as usual,” he shares.

Drivers of Global Changeo Gradual realignment of global economic powero Significant changes in global-wealth patterns, with a major shift to Asia and the Middle Easto Turnaround in inflationary dynamics, from global dis-inflation to inflationary pressureso Dramatic changes in market barriers to entry/exit

Source: Pimco, 2008

Bank runs occurred recently in the United States and United Kingdom, for instance. And the global banking system raised $350 billion in capital, which was later wiped out by write-downs; some of the capital raised came from emerging markets, he explains.

And then there’s inflation. “We are now living in a world of permanently higher commodity prices, if you compare ourselves to three, four, five years ago. This is not a world of reversion to the mean,” El-Erian insists.

As for the U.S. economy, “We think it’s going to take a longer time for the U.S. to recover, because you’ve got to work out the excesses in the housing sector and excesses in consumer sectors,” he says.

”(But) don’t forget that crises involve opportunities,” El-Erian adds.

“The image that I think of is you have a plane traveling on one big engine called the U.S. consumer. That engine is getting tired. That’s the bad news,” he explains. “The good news is that you have a number of smaller engines that have popped up — China, India, Russia, Brazil — that take over for the big engine. So, the global economy is not going to crash. But the trouble is going from one big engine to lots of smaller engines.”

For the financial-services industry, the opportunities (and risks) are: new players, new technicals, new strategies, new risk-management requirements, new products and new client-servicing requirements. “If you see worldwide change, you must change your client approach and have a new strategy,” he argues. “We must retool investors, firms and policy-makers.”

Investors should be given clarity about the need to expect bumpy returns in the global market. Advisors may also want to re-launch discussions with clients about risk tolerance and return expectations. “Ask if the asset allocation is forward looking,” El-Erian insists. (For its part, Pimco would like to launch a “forward-looking” index and use it as the base for a new global bond fund.)

His overall conclusion is that we are “living through a bumpy secular transformation” in which “new opportunities are wrapped in new and complex configurations of risk.” In such an environment, “Re-tooling is necessary, but it is neither automatic, easy or riskless,” El-Erian explains.

“Yet, passiveness is the worst choice,” he says. Instead, investors, advisors and financial-services players should rely on “constructive paranoia,” so they hard-wire themselves to “ask how the world is evolving” and not look in any rear-view mirrors.

This “new world” can entail more direct international exposure in client portfolios, according to El-Erian, or more holdings in large U.S.-based multinational firms that produce handsome earnings from sales outside the U.S. And diverse bond holdings should also be encompassed in portfolios, he says.

Implications for Investorso Clarity about return expectations and risk toleranceo Revising asset allocation for secular robustnesso Choice of investment-management vehicles in the context of a new configuration of risko Portfolio and manager reconciliation challengeso Risk management, including “fat tail” protection

PIMCO, which had more than $802 billion in assets as of March 31, is working hard “on a daily basis,” El-Erian explains, to resolve the issue of auction-rate preferred shares issued by its closed-end funds, which some investors have been unable to sell.

Janet Levaux, MBA/MA, is the managing editor of Research; reach her at [email protected].


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