PIMCO’s El Erian’s 6 Rules for Investors

One of the world’s largest bond investment funds, PIMCO recently held an investment summit where the company’s CEO, Mohamed El Erian spoke.

Fortunately the Reformed Broker took note of Mr. El Erian’s speech. Here are Mr. El Erian’s 6 rules for investors in the world of the New Normal and Interdependence: (along with my comments)

1. Protect yourself against the haircuts that come from not-strong balance sheets, weak income statements and bad management

Mr. El Erian must be referring to countries. Haircuts will come in the form of lost purchasing power and from direct confiscatory policies (higher taxes, bank deposit haircuts, etc…)

2. Don't give up all of your liquidity just to be "in"

Financial markets have been transformed into a loaded casino by central banks. Thus saving for the rainy day should be a prerequisite

3. Risk management: People used to think that diversification was good enough, but no more. "Diversification is necessary 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.

Mr. El Erian says that the world has become more than interconnected, but importantly, interdependent. “In an interdependent world, if your competitor has a problem, YOU have a problem.” This, for me, makes diversification difficult. That's because interdependent relationship means risk-reward tradeoffs are tightly distributed. Such is the RISK ON or RISK OFF seen in the financial landscape.

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.

In short, be aware of the boom-bust cycles.

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."

This is a wonderful example of the adage “past performance does not guarantee future outcomes”. History isn’t the future.

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).

Well, for now this seems true. But the essence of this advise appears also in conflict with its premise. The world is changing but Mr. El Erian holds that the US is fixed. If the world changes and are “fragmenting away from the existing world order”, then the US may or could lose its place as the “sun in the solar system”. 

Nonetheless apropos and useful insights from PIMCO's big boss.