Notes from the PIMCO Investment Summit with Mohamed El-Erian
Courtesy of Joshua M Brown, The Reformed Broker
I've heard just about all of the great investors of our time speak by now and suffice it to say that the bar for me to be impressed is pretty high. But PIMCO'S CEO and Co-CIO Mohamed El-Erian was spectacular this morning at the 2013 Investment Summit in New York City.
In my mind, no one else has as good a grasp on the macro crosscurrents affecting the investment landscape paired with the innate ability to communicate them so simply. He must be the smartest guy in most rooms he walks into but he is also probably the most engaging as well.
Speaking at the Grand Hyatt to an audience of wealth managers and advisers, El-Erian took us behind the scenes of the vaunted PIMCO Secular Forum research event and on a macroeconomic tour around the world.
My notes and reactions are below, where you see direct quotes it is El-Erian speaking, elsewhere I am paraphrasing:
Contrasts and Complexity
The world is full of contrasts, but there is nothing "irrational" about them. Inside of these contrasts there is important information to be learned, these contrasts describe the world we're in. PIMCO uses a term to describe this concept, "Stable Disequilibrium". It sounds like an oxymoron but it is not, it is a way to describe imbalances that are longer-lasting than they otherwise should be.
The biggest contrast of the moment is the Unloved Rally – "17% S&P returns this year! How is it that you can have such wonderful achievements and yet have such anxiety about them at the same time?"
PIMCO strives to take this contrasts and put them into a simple framework, one which explains 85% or so of what is happening. El-Erian believes that the greatest thing we can do as investors and observers is to "simplify complexities". (Interestingly, he's a fan of Thomas Friedman's NYT columns because of Friedman's ability to do exactly this.)
The New Normal – Still
"In 2009 we came up with 'The New Normal'" – characterized by persistently slow economic growth, elevated unemployment, high levels of geopolitical tension with social inequality and strife. It's pretty amazing how spot-on PIMCO has been with this concept. They also produced the idea of multi-speed recovery in 2011 – an idea that perfectly encapsulates this dichotomy between multi-national corporations (they have never been stronger) and low-income households (quite a different story).
"When we first introduced the concept of The New Normal, it was dismissed at idiotic and even fatalistic – by now it has become conventional wisdom, so widely used that even the IMF has adopted it."
Re: the popularity of the term New Normal, "We probably should have trademarked it, there is even a TV show that's using it."
T-Junctions
Mohamed talks a bit about these T-junctions he sees ahead. The description comes from the roads in England where at the end there is a T-like split, you can go left or right but no longer forward. This is his metaphor for the coming decision-points faced by all of the world's major economies but Europe's T-junction is coming up on us the fastest. "Europe cannot persist with the stability bought by central banks while the underlying economies have no possible growth."
The US faces a T-junction of its own but further out and more manageable. In one direction, we can grow the economy and reach escape velocity (3%-plus GDP) which will allow for true deleveraging to occur and costs to be rightsized. Obviously, the other direction is a continuation of the trap, where we never poke above stall speed.
China's T-junction appears to Mohamed as a big wild card. He notes that this hand-off that China is attempting from government-funded infrastructure and exports to the emerging middle class consumer is not a given. Never before in history has any other society achieved this in the timeframe that China is attempting it in.
Bernanke
He likes Bernanke (which is weird considering what a PIMCO whipping boy the FOMC has been) and says "Bernanke is an incredibly honest person in terms of telling us what is happening." He references a 2010 admonition from Bernanke that a central bank can adopt unconventional policies when needed – but then the longer it remains unconventional, the bigger the risks of something going wrong.
El-Erian believes that the solutions to a lot of the world's imbalances and issues will come in the form of haircuts like what we've seen in Greece and Cyprus. "These haircuts are fine, critical to the process – so long as people don't get up and walk away from the financial system entirely."
Growth and Interdependence
"it is not that we don't have growth, it is that we don't even have growth models that will work." El-Erian explains that the old growth models were credit and debt, they allowed everyone to grow but we are not going back to that model anytime soon. It's over. The new models, like shale gas and American manufacturing, are exciting – but they are still micro stories and not affecting the macro enough yet to be considered a model for the nation's growth. And in the meantime, while they grow up, we've needed a bridge to growth from the old model of debt, which is what the Fed has been providing.
"Political and social systems don't respond well to low growth."
Going back to a recent Friedman column, El-Erian explains that we are not merely an inter-connected world, we are an interdependent one. This is a key distinction – "In an interdependent world, if your competitor has a problem, YOU have a problem." He talks about how a setback for our competitors in Europe or China does not necessarily create an opening for us, it weakens the whole system instead.
Waves and Lifeguards
"When you watch CNBC, what you hear most of the day is to buy this investment because relatively-speaking it is cheaper than that one." Everyone seems to be playing this same relative game and "you almost never hear someone recommending something because it is strong on its own."
He talks about the central bank liquidity trade as though it's a massive wave that everyone is surfing…
"As investors, there are two types of mistakes we can make. Type 1 is we wait in the water for the perfect wave, which never appears and we miss a lot of other waves go by without us. Type 2 is jump on this central bank wave and we don't think about what happens when this wave breaks or crashes over us." PIMCO is more comfortable making the Type 1 error is the point.
Mohamed digresses from the wave analogy to explain the benefit of writing so much – "One of the reasons for why we do it is not just because we have an obligation to our investors, but because of the great feedback we get from you all, other than the 10% which is hate mail." He says that in response to the wave thing, someone wrote in and said that they were missing another key point – it's not just the waves in this analogy, it is the lifeguards themselves who are exhausted. I'm presuming he means policymakers and bankers.
Bottom line: "PIMCO is currently actively walking away from risk. We are not running, we are not sprinting, but we are walking away. Of the two types of mistakes, it is much less costly to get off the wave early than to stay on too late."
El-Erian encourages us to "look for opportunities away from the central bank wave, do something else." He thinks that because there is so much emphasis on this central bank trade, lots of other opportunities are being overlooked by investors. Specifically he talks about manufacturing and energy companies.
Mohamed's Rules for Investors
He lays out the rules we should run our portfolios by…
1. Protect yourself against the haircuts that come from not-strong balance sheets, weak income statements and bad management
2. Don't give up all of your liquidity just to be "in"
3. Risk management: People used to think that diversification was good enough, but no more. "Diversification isnecessary for any investor but it is not sufficient when central banks have distorted prices." He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you'll need it. He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.
4. Be reasonable about your return expectations. "Central banks bring growth from tomorrow into today – but markets price this future growth in quickly." He is saying that we have pulled forward a lot of future growth in the returns we've seen already.
5. Beware backward-looking labels. Back in the day, China and Brazil bonds were considered to be credit risks because they were emerging countries and Greek and Cypriot bonds were more interest rate risky, not credit risky, because they were considered to be "developed" countries. But that was then – nowadays China and Brazil's fundamentals mean that their bonds are more interest rate risk, it is Greece and Cyprus that become credit risks (both have defaulted). "Ask yourselves whether or not your labels still make sense as the world changes."
6. Be Resilient and Agile. The world is changing. The US is the sun in the solar system that is the global economy around which everything else revolves. There is nothing to replace the US just as there is no replacement for the sun. That being said, at the fringes, things are fragmenting away from the existing world order. The evidence of this can be found in the many bi-lateral agreements being struck between non-US partners (China and Brazil, Brazil and Africa etc).
He also discusses the major handoffs that have to take place from the world we now inhabit, like China's middle-income handoff, as well as the major policy experiments in Europe, the US (QE) and Japan.
"If you believe that all of these major handoffs and experiments play out without any problems or glitches, then stocks are undeniably cheap right now. But is that what you believe?"
Awesome Analogy
My favorite part of the talk Mohamed gave was this bit about how, after listening to CEOs discuss their brands, he realized that central banks were essentially brands unto themselves.
He says basically a brand is like a wedge you can shove in between fundamentals of your company or product and raise prices. But that brand wedge is finite and cannot keep things apart or elevated indefinitely, there is a limit to what a brand can do. he cites the limits of Apple's brand once competitive realities asserted themselves. He talks about how Facebook's brand allowed it to sell stock at a level far above where the fundamentals would have dictated.
El-Erian says Gold is also a big brand "all over the world gold's brand is that it protects your money from risk. But look how easily Gold's brand was damaged and how fragile it turned out to be – on just the rumor of Cyprus selling its gold reserves to pay for the bailout, gold lost 15%. On just the rumor, not even the act! Because then everyone started counting up the gold reserves in Italy and Spain and elsewhere, all of a sudden gold's brand was damaged."
Central banks are also a brand. The brand is "we can deliver outcomes today to improve the future." Right now people believe in the central bank brand, watch out for when that belief in the brand turns. Right now the psychology about the Fed's brand is positive, "but psychology goes both ways."
(Josh here, I wonder if this is what we just saw happen in the Japanese bond and stock markets…)
Miscellaneous
El-Erian took some questions from the crowd at the end. The first one was brutal "You guys have gotten all the macro stuff right but we would have been better off investing differently than you've been advocating." Mohamed asked the guy if he was really Joe Kernan from Squawk Box and the room cracked up. So smooth. El-Erian admitted that they were too cautious and that they had made the Type 1 error of leaving money on the table. He also ate some shit over the firm's "short treasurys" call from 2011, "Terrible call, without a doubt. But we reversed and then made back all the alpha we missed really quickly."
He thinks the beta heavy lifting is probably over in asset markets. In bonds, he says the capital appreciation returns from treasurys, corporates and high yield bonds are done too.
Lastly, someone asked him a Vanguard-related passive indexing question. Mohammed tells a killer anecdote from early in his career about how EM bond indexes were once made up of 22% Argentinian bonds pre-default, and that the other managers who were hugging that index got hammered. He says that passive makes sense only if you'll be driving in reverse up a road that is completely straight. Because you're essentially looking at snapshot of the way things were.
"There are tines when a simple passive approach is going to get you into trouble."
***
Just want to thank PIMCO for having me there today and thanks to Mohamed El-Erian for the vast amounts of wisdom he shares with us and the many ways in which he simplifies complexities.
And for you guys, I hope these notes have been helpful! – JB
