Mohamed El-Erian: Tough times ahead
Pimco's CEO says individual investors must change their investing style, such as being less U.S.-centric.
(Fortune Magazine) -- Mohamed El-Erian has earned his status as one of the investment world's rock stars with surprising speed. After a 15-year career with the International Monetary Fund, he joined Pimco just 10 years ago and began managing the firm's emerging-markets bond fund.
That fund's knockout performance, combined with his deeply intellectual approach to investing and understanding the larger financial world, caught the attention of Harvard University, among others.
When the legendary Jack Meyer stepped down as manager of the university's mammoth $30 billion endowment in 2005, Harvard hired El-Erian to take over. He didn't stay long, but in his one full fiscal year at the helm, the fund returned a market-whomping 23%.
El-Erian returned to Pimco's Newport Beach, Calif., headquarters in late 2007, just before the global recession took hold. He's now the firm's CEO as well as co-chief investment officer, with Pimco's famous founder, Bill Gross.
The firm, the world's largest bond investor, has benefited from investors' flight to quality over the past two years and now manages about $1 trillion in assets. El-Erian, 51, is still thinking large and deep thoughts; his book, "When Markets Collide: Investment Strategies for the Age of Global Economic Change," won the Financial Times Goldman Sachs business book of the year award last year.
He sat down recently with Fortune's Geoff Colvin to talk about threats to individual investors, the best framework for an investment portfolio, how the 2008 financial meltdown was like a double-drive-through McDonald's, and much else. Edited excerpts:
Geoff Colvin: We've had one quarter of solid economic growth. Is the recession over?
Mohamed El-Erian: Yes, but an important, qualified yes. We've had one quarter of economic growth, which is probably going to be revised down, but it's going to be in the 2½% range for the third quarter. The fourth quarter will probably be in the 3% range. The question is, Can we sustain growth in 2010? And our worry is that it's going to be very difficult.
What does it depend on?
It depends on this handoff from very artificial sources of growth, first and foremost the stimulus. We've had the biggest stimulus in history, fiscal and monetary, and we're feeling the benefits of that.
And there's a natural inventory cycle -- you come to a point where inventories are run down, and some building up begins. That's what the second half of 2009 is. These are not permanent sources of growth.
So you need to hand off to the private sector -- to consumers and companies -- and for that to happen, a lot of very positive things have to occur, and they are unlikely to occur.
Why are they unlikely to occur for the consumer?
The consumer is facing tremendous headwinds. First is persistently high unemployment. The official figure is 10.2%. By the most comprehensive measure of underemployment and unemployment, it's 17.5%. That is a problem because when you get to those levels, it changes the behavior of the employee.
You worry. When you see unemployment not just high but persistently high, you become more cautious. You consume less. So even the employee who has the income starts feeling more cautious.
Second is what economists call the wealth effect. We've all taken a big hit on our retirement. We now have to save, and therefore take away from consumption.
Third, the ATM has disappeared -- for a number of years we all used our houses as ATMs. So it's very difficult for the U.S. consumer to continue carrying not only the U.S. economy but also the rest of the world.
Which is the way it was for years and years.
Think of the image of a plane flying at a very high altitude. It has one huge engine called the consumer, and the fuel is debt. Now, as long as you have enough fuel, that engine can keep the plane high.
Once fuel becomes difficult because there's a limit to how much debt the household can take on, then suddenly the plane loses altitude, and it's very difficult to stabilize the plane.
But in the long run, if American consumers start saving more, isn't that a good thing?
It's absolutely a good thing. The rest of the world starts being all these other engines, and we move from a world of excessive dependence on the U.S. consumer to a multipolar world. That's also a good thing.
The trouble is this transition. So go back to my image. Would you like to be on a plane when the captain comes on and says, "I'm going to be switching from one big engine to lots of engines?" You don't want to be on that plane. You want to be on that plane once the switch has happened.
So in the long run, which is probably five years, we will all be better off.
From the perspective of an individual investor, is the multipolar world a good thing or a bad thing?
It's a good thing in the sense that it's a more balanced world. I think most of us would rather be on a plane with multiple engines. So as long as we can get out of our comfort zones, this is actually a better world if we know how to invest. But it means doing things differently.
What are the most important things that individual investors need to do differently?
The average investor has two issues today. First, the average investor is too U.S.-centric. There's a reason for that; the behavioral finance people will tell you that we like the familiar, so we tend to invest in names that we know, that give us comfort.
The problem is that you don't want to be too U.S.-centric in a globalizing world where the center of gravity is shifting. So the first thing for the average investor to recognize is that the asset allocation of tomorrow is much more global than the asset allocation of yesterday.
Second, most of us have been very lucky -- we haven't had to worry about inflation for a long time. We're moving toward a much more fluid world in which, at some point, inflation will come back.
What makes you confident of that?
We're looking at a world where not only is demand going to pick up, but there's also going to be a lot of supply disruption. The old normal was a world where credit was freely available. Well, credit will no longer be easy. So we're going to have demand picking up, and we'll also have supply coming down.
So you think, Okay, there's a recession going on -- I should be able to buy a plane ticket cheaply. And initially you can. Then suddenly they take a lot of planes out and park them in the desert. They take the supply out, and you get inflation coming back.
Toward the end of next year, with all the liquidity that's been put in place, at some point we're going to face an inflation risk, and most people are not prepared for that.
What's the best protection for an individual investor against inflation?
The most direct protection is buying TIPS, which are Treasury bonds that are inflation-protected. You get complete certainty. A lot of people feel that that's not good enough, so they're willing to do something more uncertain with greater protection -- gold.
Gold is doing what it's doing because it's bringing together people who are worried about all sorts of things -- people worried about inflation, those worried about geopolitical issues, those worried about the dollar, are all buying gold.
What's the right big-picture approach for individual investors today?
It's actually not that hard to have a framework to invest. The framework has three parts. First, you have to have an asset allocation that is forward-looking, not backward-looking.
Second, you have to find the right vehicle to express that asset allocation. I'm always amazed by how many people get the asset allocation right, but then when they express it, they choose the wrong vehicle.
And third, you've got to be humble. You've got to realize that managing risk is hard, and this old notion that "as long as you're diversified, that is enough" is no longer true.
Diversification is necessary but not sufficient. You also have to ask, What mistake can I afford to make if diversification doesn't help me? And that is a question that unfortunately not enough people ask themselves.
In your book you present an asset allocation for a typical U.S. investor. Only 15% is in U.S. equities, which is much less than most U.S. investors hold. And only 14% is in bonds, U.S. and non-U.S., which seems like not very much. What's the logic?
On the equities, recognize that the meaning of an asset class is changing. I talk to a lot of people and ask them how they're invested, and they say in the U.S. And I say, Okay, how do you invest?
Answer: I go to the S&P. And I say, Where do you think half the profits of the S&P come from? Well, they come from overseas. So I say, If you're willing to invest overseas, why don't you invest overseas directly?
The reason the U.S. allocation is relatively low is that it reflects the notion that if you want to bet on future growth, then you should have a non-U.S. component that is as important as your U.S. component.
Bonds are tricky. Bonds are facing the prospect of a massive amount of issuance. We ended fiscal 2009 with a deficit of $1.4 trillion, a truly amazing jump in a single year. For next year we're probably looking at a deficit of $1.5 trillion. The government has to finance this. How? By issuing debt.
So do I really want to buy something that's going to be issued in abundance? The answer is, do it very carefully.
You've said that this asset allocation -- which includes many other elements [see table to the right] -- could be expected to return 5% to 7% a year in real terms over the long run. Many investors believe that U.S. equities will return much more over time. Is that just not correct?
We've had a tremendous amount of return expectation inflation. Somehow, we are optimistic by nature. It's like buying a lottery ticket -- we just buy them. There has to be a certain realism as to what your investment portfolio can do for you, and it cannot produce double-digit returns on a sustainable basis. That's just a reality.
So return expectations have to be more realistic, unless you're willing to go from the liquid markets to truly illiquid markets. There it's very different. It's all about completing markets. It's a very different game, but you don't have the liquidity that most people need.
Examples of illiquid markets would be?
Investing in a mortgage company in Brazil. You've got to do it knowing that it is a long-term investment and that liquidity is not going to be there.
But think about it. You go to developing countries where the middle class has become relatively well off. There is a housing stock, and there are savings, but there's no one to link the two things because there isn't a tradition that we have in the U.S. of borrowing against your future income, and you don't borrow against your future income till you achieve a certain level of wealth.
So linking up markets that now make sense -- that's where the double-digit return is going to be. But that is not something that's accessible to the average person.
A lot of new financial regulation is in the works. Is it going to be, as it so often is, regulation that will prevent the crisis that just happened and not regulation that will prevent the next crisis?
Take the image of a freeway. There was a recognition that the speed limit was too high, and we didn't enforce the speed limit. We're going toward a world where we're going to lower the speed limit, and we're going to increase enforcement. That is certainly going to reduce the accidents, but it's not going to eliminate them.
Within a few years someone is going to come along and say, "You know what? The speed limit is too low. It's inefficient. Our people aren't getting to their places quickly enough, so let's increase the speed limit again."
I suspect that if we were to sit here in four years, we would be talking about government failure, how the government "overregulated," and if we were to sit here in about 10 years, we'd be talking about market failure, which is that the market got ahead of itself.
The cycle will have gone all the way around once again.
The cycle will always go around because it is very difficult to run complex systems.
After the September 2008 crisis, you mentioned in Fortune that you'd asked your wife to withdraw cash from the bank. What was your life like?
I would kiss my wife good morning at 2 o'clock in the morning. I would tell her, "You've got to watch TV. This is really important." I normally get up at three, but I moved it forward to two.
And we worried about things we never thought we'd have to worry about. We worried about, Where's our cash? There was a day when I called my wife and said, "Please go to the bank and get cash." And she said, "Why?" I said, "Because I don't think the banks are going to open tomorrow." That's how close it got.
What really happened back then?
You go to a McDonald's. You order, you go to one window, you pay; you go to the next window, you pick up your food, and you go. You normally can do it within 30 seconds.
Now imagine the following. There's a payment window where you pay, and there's a settlement window where you take the burgers. Now imagine that you go to the first window, and they tell you, $5. You say, "Where's my food?"
And they say, "It's at the next window." You say, "I heard what happened at Lehman yesterday. At Lehman someone paid but didn't collect. So I want my food now." And they say, "I can't give you your food now."
The whole system is built on trust -- that you're going to trust for 10 yards. And you say, "Well, that's what Lehman did. I'm not going to do that."
Now what happened to that system? First, you go away hungry even though you had money. And the second window has the food but can't sell it, so the food goes rotten. The system breaks down because no one trusts 10 yards between the first window and the second window.
That is what happened after Lehman. It was the most amazing thing, where nobody trusted what we all take absolutely for granted, and therefore you couldn't match people up. That's why we saw these amazing collapses around the world.
What's your bottom line advice to individual investors in today's environment?
Start with a very clear identification of your objectives. Why are you investing? Many people say, "I'm investing to make money." I say, "That's not enough. You're making money with a view to what? Are you protecting your retirement?"
You have to think, Is there a liability behind the investment I'm doing? We came from a world where it seemed everything was going up, where we lost sight of the fact that different objectives require different ways of investing.