A Peek at Pimco's Long View
Editor's note: This is an extended version of a story published in the May 19, 2008, issue of BusinessWeek magazine.
Each spring, employees of Pacific Investment Management (Pimco), which oversees $810 billion in assets, come together to paint a big-picture view of what secular trends will drive markets. The location and timing of the forum are closely guarded, but it is expected to take place in early May. In 2005 it yielded a prediction that increased leverage would undermine the financial system, so the Newport Beach (Calif.) firm cut exposure to risk well before the subprime crisis began. The call was early, which hurt in 2006, but the firm's funds had big returns in 2007. Personal Finance Editor Lauren Young spoke with Mohamed El-Erian, Pimco's co-chief investment officer and co-chief executive, to get his views on the investment environment and themes Pimco may explore this year.
What do you get out of your forum?
I really understood the point of it during the two years I spent away from Pimco at Harvard Management. I met with a lot of investment managers marketing products to Harvard. Very few were anchored by secular, or long-term, views. Even fewer had thought to do what Bill Gross [Pimco's founder and co-chief investment officer] does to great effect using hard-wired, disciplined thinking on such issues as the end of the Cold War, the spread of capitalism in emerging markets, the U.S. productivity surge, and the rise of China's influence on the global economy. If you don't have secular anchors, you get sucked into bad trades.
How does the secular forum work?
We meet once in the spring for three days, and we bring in outside speakers, which helps us blend outside views with internal expertise. Then we have a vigorous discussion. The speakers are given a general topic, but we tell them to take us where they want to go. In 2000, when a speaker focused on China and its emerging importance for the global economy, it touched a nerve. We brought another speaker back in 2002 to talk about more about China. As a result, Pimco was an early identifier of the influence of China on the global economy and markets.
After the forum ends, it's not as if we go back to our desks and forget about it. Every quarter we meet again and talk about cyclical trends and how they can impact the secular outlook.
In your new book, When Markets Collide: Investment Strategies for the Age of Global Economic Change (McGraw-Hill, $27.95), you talk about economic disruptions as part of a maturation process for the global markets. Can you tell us more?
Today's economic and financial disruptions are part of a much larger phenomenon that is yet to be fully embraced by markets and policymakers. The global system is attempting to accommodate the breakout phase in the growth and wealth dynamics of a number of countries. The system is also trying to absorb the financial innovation inherent in the proliferation of structured products. Too many participants in the global system embarked on this journey with blunt instruments, inadequate monitoring, and risk management systems as well as a backward-looking mindset.
The result is an inevitable series of market accidents and policy mistakes. Accordingly, and drawing on what the markets have been signaling, the book documents these fundamental changes. It also suggests ways in which investors and policymakers can navigate the new global realities—by taking advantage of the new opportunities and, critically, also reacting appropriately to the new configurations of risk.
So what is anchoring the markets today?
We're seeing a much-needed recapitalization. Over the past decade you've seen the balance sheet of the emerging markets get recapitalized. Then it was the turn of the U.S. corporate and industrial sector on the back of Enron and WorldCom. Today we're seeing the recapitalization of the U.S. financial system. A massive amount of capital has been issued in the past two weeks, some in the form of preferred stock. Once we get through [this period], we'll all look back and realize that it's positive.
Is the worst behind us?
We're three-quarters through a major dislocation that has repriced the U.S. financial system. The risk going forward is less about Wall Street and more about the small and midsize banks. They missed much of the current crisis because they never really got into structured products. But they're heavily tied to commercial real estate and the consumer. Consumers have come under growing pressure as they've coped with shocks from housing, inflation, and the credit crunch. Yet somehow they've been able to maintain balance. An added shock is coming from employment, which is absolutely key for the next six months. If too many people lose their jobs, income and consumption will be thrown off balance.
How can the consumer's problem be fixed?
The solution is not simply a U.S. solution. Other consumers around the globe need to step up to the plate, in particular in China and India. We need to see a handoff from what is tiring U.S. consumers who are subject to headwinds to consumers in emerging countries who are empowered by a growth in the middle class, higher income, larger wealth, and legitimate aspirations. But as these countries get richer and consume more, they also put pressure on commodities, so it's a very complicated world we live in right now.
Do you expect rising corporate defaults?
Defaults haven't happened because the corporate sector started in a much stronger position than in the past. A lot of companies raised cash from 2001 to 2003. The crisis we've seen is from the overuse of financial leverage in an alphabet soup of structured products.
In that case, is high-yield debt a good buy?
This not the time to go out and buy any credit risk. We're saying something different. To use a sports analogy, rather than just play defense or offense, you also need to play special teams. We're focusing on senior parts of the capital structure with very high-quality bonds, including the financial sector as it goes through this healthy recapitalization.
Are we at a point in the economic cycle where policy can make a difference?
Yes, the financial problem is now finally morphing into something that's recognizable; therefore, the instruments we have are sharper.
Suppose I was writing a report card on policy makers. For effort, I'd give them an A+. They are doing the utmost, coming up with unthinkable and novel policy actions. What grade would I give them for their impact or effect? I'd give them a B. The difference between the A+ and the B is that they were using instruments that were too blunt for the realities at hand. No wonder they have had to create new financial windows that institutions like investment banks didn't have in past. There has also been innovation in terms of the kinds of collateral the central banks will accept. These major steps are being taken to reliquify the system.
On May 2, the world's central banks coordinated an international effort involving the European Central Bank in Germany, the Bank of England, and the U.S. Federal Reserve to increase lending mechanisms by 50%. They also increased the range of collateral that can be accepted. The aim is to reduce the tension in the inter-bank market.
You returned to Pimco last December after overseeing Harvard University's $35 billion endowment. What's different now that you are back?
Well, I found out that I am the typical American homeowner. When we moved to Boston, we bought a house in Cambridge, but we also kept our house in California because my wife was coming back every month to see her family. We put the Cambridge house up for sale, but we got such low offers that we pulled it off the market. We are renting it. The housing market still hasn't hit its bottom—and I don't think we will see the bottom anytime soon.