PIMCO's El-Erian Says Trading Desks Need to Evolve
January 26, 2009
If money managers want to invest in this highly volatile, largely negative financial environment, they must change the way they invest.
That is the mantra of Mohamed El-Erian, chief executive officer and co-chief investment officer of PIMCO. The current worldwide financial infrastructure can't keep pace with innovations in the securities markets, El-Erian said.
Plus, the always present factor of fear and greed can result in unintended consequences that disrupt financial forecasts and decision models.
"What we are witnessing goes well beyond a cyclical economic shock and a consolidation of the financial sector," said El-Erian, whose book, "When Markets Collide: Investment Strategies for the Age of Global Economic Change" (McGraw-Hill, 2008) was recently released on compact disc by BBC Audiobooks America. "We are also in the midst of a prolonged increase in precautionary behavior among entities that have suffered massive wealth destruction and face a multi-year clean-up of assets and businesses. Without further adjustments, there will be an aggravation of the negative feedback loops that have been so detrimental to global welfare," he said.
Pumping money into the system will help, El-Erian said. However, massive stimulation by the United States and other world nations may only be a short-term fix to help push the world out of a recession. Investors must abandon their thinking that the government bailout will result in "business as usual," he said.
Money managers must take "irrational investment pricing" into consideration when making decisions, he added. While some experts view irrational investment pricing as just "noise," El-Erian argued the noise signals risks as well as opportunities that will influence the markets over the years ahead.
"Global growth is now being heavily influenced by nations that previously had little influence," he said. "Former debtor nations are building unforeseen wealth. They are enjoying unprecedented influences and face unusual challenges. New financial investment products have changed the behavior of many market segments and players. Despite all these changes, the system's infrastructure is yet to be upgraded to reflect the realities of today's and tomorrow's world."
El-Erian stressed that the recession is not a "cyclical economic shock and a consolidation of the financial sector." Governments as well as all types of investors are extremely cautious because their wealth has dramatically declined. So it could take years to recover from this financial mess.
Historically, according to Standard & Poor's data, when the stock market has declined at least 20% from its high, it takes an average of five years to recoup the losses. Following the Depression, it took 25 years. On the other hand, the market regained its losses in six months after the 1987 stock market crash. Currently, the bear market has matched the average loss during the 14 worst bear markets since 1900.
"It is time to suspend unquestioned faith in a quick return to the past and adjust to the reality of change," he said. "The shift in thinking means spending less time looking for a market bottom and more ensuring that cash and collateral management keeps pace with disruptions that are global in nature and indiscriminate in impact."
Governments must take several steps to jump start economic growth, El-Erian said. Intervention should continue in limited sectors, such as in the commercial and money markets, with the gradual normalization of the housing and financial sectors.
Second, governments should partner with the private sector, which, in most cases, would involve voluntary co-investments. But the U.S. auto industry, for example, may require coordinated burden-sharing among stakeholders. Third, they should address how the government is going to exit the situation. Fourth, new financial reforms are needed because crisis management can not solve the global financial problems.
On the investment side, El-Erian recommended that money managers avoid automatically rebalancing portfolios because Wall Street and the U.S. government are in a state of crisis management. There will still be disruptions in the capital markets. As a result, rebalancing portfolios into stocks isn't going to help, even though stocks are down and values look attractive. He favors investments in the capital structure and debt obligations.
PIMCO's view, he said, is "to shake hands with the government and make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond."
Investors should anticipate what the government will buy, he said, and then buy what they buy-only do it first. PIMCO favors agency-backed mortgages, bank preferred stocks, and senior bank debt, along with Aaa-rated asset-backed securities such as credit cards, student loans, and auto receivables in anticipation that Uncle Sam will be buying these investments.
"An Obama Administration will quickly be confronted by the need to provide those hundreds of billions of dollars to states and large municipalities," he said. "Their requests total nearly $1 trillion; to think California or New York City would be allowed to fail is, well, unthinkable."
Today, municipal bonds are attractive because they are selling at historically high ratios relative to U.S. Treasuries. In addition, Treasury inflation-protected securities will perform well when the economic stimulus reinflates the economy.
(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.