Mohamed El-Erian: My Money Has Mostly Been Into Cash as Central Banks Pump Asset Prices

Former PIMCO co-founder and now chief economic adviser at the Allianz Mohamed El-Erian, in a recent interview says why his portfolio has been mostly in cash.

Selected excerpts from OCGregister (hat tip Bloomberg) [bold mine]

Q. Why write a book on central banks?

A. This is a historic period in which central banks are the only game in town when it comes to policy. But central banks do not have the tools to deliver what the global economy needs. We need more potent reinvigorated growth models.

The West fell in love with the wrong growth models 10 years ago. It fell in love with finance as an enabler of prosperity. The whole society fell in love with leverage and credit as a way of prospering. We were entitled to accumulate debt! People bought homes they could not afford. Governments borrowed money that they could not pay back.

Regulators believed that finance was so sophisticated that you could lessen regulations on it. This romance with the wrong growth model fell apart in 2007 and 2008...

Q. Where is your money? Stocks? Treasuries? Bonds?

A. It is mostly concentrated in cash. That’s not great, given that it gets eaten up by inflation. But I think most asset prices have been pushed by central banks to very elevated levels.

Q. So we’re nearing a bubble?

A. Go back to central banks. Central banks look at growth, at employment, at wages. They are too low. They don’t have the instruments they need, but they feel obliged to do something. So they artificially lift asset prices by maintaining zero interest rates and by using their balance sheet to buy assets.

Why? Because they hope that they will trigger what’s called the wealth effect. That you will open your 401k, see it has gone up in price, and you’ll spend. And that companies will see their shares are going up and they will be more willing to invest. But there is a massive gap right now between asset prices and fundamentals.

It's interesting to see how changes has been happening at the margins to the point that risks appears to be seeping into mainstream awareness.

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.

PIMCO’s Mohamed El-Erian on Emerging Markets: Focus On Fundamentals, Aggressive Policies Will Help In Time

Vetting on the wisdom of PIMCO’s Mohamed El-Erian who recently wrote about the current crisis (all highlights mine)…

Mr. El-Erian: ``Many developing countries were fortunate to enter this crisis in relatively strong shape. They had large holdings of international reserves, limited leverage and relatively low indebtedness. Policy flexibility was also considerable, as reflected in the ability to prudently use monetary and fiscal policy in a countercyclical manner. And internal consumption was picking up momentum.

``The robust initial conditions have served to partially insulate the developing world from the effects of the global financial crisis that most observers rightly classify as the worst since the 1930s. Contrary to what would be expected on the basis of the experience of the past 30 years, there has been no dramatic collapse in growth and consumption; widespread defaults have not materialized; and many governments retain their core policy credibility.”

My interpretation:

Emerging markets are stronger and more equipped today to cope with the present crisis.

There have been little signs of the prospects of a global depression.

Mr. El-Erian: ``What's more, the favorable initial conditions will provide little comfort for emerging-market equity investors. The long-term story in these markets may still look good, but investors are sitting on large losses now. Why? In major global dislocations like the one we are experiencing, fundamental drivers of value get totally overwhelmed by "technicals." Foreign investors, facing large losses at home, all scramble to repatriate their funds at the same time. The emerging-market equity door is simply not big enough to accommodate them all without a large and disorderly decline in prices.

``Provided they are sufficiently liquid and that their portfolios are not overly concentrated, investors should think twice before joining this stampede. As a rule, long-term value investors should not become distressed sellers on account of technical factors alone. They should be guided primarily by their views on fundamentals, which will once again assert themselves over time. Moreover, help is on the way. Emerging markets will be aided, albeit neither immediately nor smoothly, by the aggressive policy decisions now being taken in industrial countries.”

My interpretation:

Deleveraging, Fear and Momentum trades have basically driven EM equities to the cellar.

Investors should avoid the bandwagon or herd mentality effect and ruminate on fundamental issues instead. Those who focus on fundamentals will be promptly rewarded.

Like us, Mr. Mohamed El-Erian thinks that aggressive policy decisions by Industrial nations will help EM markets overtime. In Global Market Crash: Accelerating The Mises Moment!, we also noted ``So while today’s market has almost gutted most of the global financial markets (equities, commodities, bonds and currencies-yes newspapers focus on stocks but contagion has been across the board) as a result of massive deleveraging and stress in the global banking system, once such policies sink in or diffuse, we are likely to see divergent economic performances that should be reflected on the markets once the panic subsides.”

So we have a growing chorus of bullish contrarian gurus in a world driven by fear. The very same clique who successfully foretold of this crisis.