9 september 2011
The Changing Landscape of Global InvestingArticle Introduction

By PIMCO’s CEO Mohamed El-Erian

•Investors face the challenge of recalibrating some of the traditional parameters that are key to managing risk and delivering returns.

•There are also implications for investment management firms which are yet to be sufficiently reflected in the thinking and actions of the industry as a whole.

Adapted from material dedicated to the Second Swedish National Pension Fund (AP2) 10-year anniversary anthology.

Today’s investors have repeatedly been confronted with evidence of national and global realignments. It comes in many forms – from debt dramas in Europe to systemically important emerging economies increasingly closing the income and wealth gap relative to advanced countries; from America being stripped of its sacred AAA sovereign ratings by S&P to the possibility that at least one Eurozone economy will have to restructure its debt; and from disturbingly sluggish growth, muted job creation and unusual policy ineffectiveness in America to overheating economies in the emerging world.

These realignments are fundamentally and durably changing the global landscape. Yet, in PIMCO’s opinion, they may not be sufficiently reflected in a commensurate evolution of global investing approaches, as well as in the thinking and actions of the investment management industry as a whole. If this is indeed the case, changes are needed if investors are to be the beneficiaries, and not the victims of global realignments.

Balance sheets and multi-speed growth dynamics

There are many ways to characterize the ongoing changes in the global economic and financial landscapes – indeed, so much so that one can get easily overwhelmed by the complexity of this historic period.

At PIMCO, we have found it useful to think in terms of two distinct, though inter-related sets of dynamics.

The first speaks to the need to rehabilitate balance sheets in countries that accumulated way too much debt during what we have labeled the “great age of leverage, credit and debt entitlements;” and the second speaks to the ability of countries to sustain high economic growth and create new jobs, or the lack thereof.

Each is consequential. Together they speak powerfully to why both America and Europe are having so much trouble “safely delevering,” and why China and other emerging economies have been able to prosper up to now despite the woes of the advanced economies.

Powered both by innovations that lowered barriers to entry for many borrowers and by an over-eager banking system in pursuit of super-normal profits, western economies excessively levered their balance sheets in the middle of the past decade. This was particularly the case in the finance-dependent economies (such as Iceland, Ireland, U.K. and U.S.) and those with weak public administration (e.g., Greece and Portugal).

The initial phase of excessive indebtedness led to a sequential contamination of balance sheets. In one set of countries the sequencing was from the housing sector, to banks, and to households and companies; in the other, it went from governments, to banks and to households and companies. In both cases, the result was backbreaking leverage overall.

Excessive levering can be followed by too rapid, and too disorderly a delevering process. This is what happened during the 2008-09 global financial crisis when too many sectors were forced to contract simultaneously. And it is what pushed governments and central banks, that were rightly fearing an economic depression, to aggressively use their balance sheets to compensate for the delevering of the private sectors.

Some countries – such as Greece, Iceland, Ireland and Portugal – ran out of domestic balance sheets and had limited policy flexibility overall. Accordingly, they were forced to seek bailouts, thus accessing external balance sheets. All four countries went to the IMF and, with the exception of Iceland, also tapped emergency facilities at the European Central Bank and the European Union (including the European Financial Stability Fund or EFSF).

By the end of this process, it was no longer just a question of over-stretched private balance sheets. Public balance sheets were also contaminated as illustrated by the dramatic surge in budget deficits, debt-to-GDP ratios, and central bank “unconventional” policies (including outright asset purchases).

This would not be altering the investment landscape to such an extent were it not for the second set of dynamics – those impacting growth.

Economic growth is key to safely delevering balance sheets. Indeed, fast growth can both maintain living standards and, simultaneously, generate incremental income to pay down debt.

This option is not available to most western over-indebted economies. Due to a host of structural impediments, they are only able to sustain tepid growth. No wonder unemployment rates have remained worrisomely and persistently high while the average duration of joblessness continues to rise in a disturbing fashion.

The policy mindset has also acted as a hindrance to safe delevering. Rather than address structural problems with structural solutions, governments romanced for too long easier (and more conventional) cyclical solutions. No wonder policy outcomes have disappointed – and not only in an absolute sense but also relative to what policymakers themselves expected (and communicated to the public, thus also undermining their credibility).

Then there is the complicating role of politics in many countries. The combination of hesitant governments and polarized parties has been another headwind to good economic governance. This was illustrated vividly in the case of the U.S. where a self-manufactured crisis – namely, political squabbles that severely complicated a usually routine increase in the legislative debt ceiling – took the country to the brink of a technical default and, thereafter, contributed to the loss of the sacred AAA sovereign rating. It was also apparent in Europe where political frictions undermined proper coordination and follow up.

While all this has been going on, a set of successful emerging economies (Brazil, China, Indonesia, etc.) have achieved two previously unlikely outcomes. First, they have continuously improved their balance sheets, as reflected in declining debt-to-GDP and larger international reserves; and second, they have maintained growth despite the weakness in their major trading partners in western economies.

Emerging economies have continued to migrate up the income and wealth curve, narrowing the gap vis-à-vis the west. Indeed, the economic and financial performance of these countries has been such as to attract massive capital from abroad. The resulting surge in inflows has contributed to an overheating of the economies, forcing policymakers there to tap the policy brakes. These dynamics are at the root of PIMCO’s New Normal framework.

Starting back in early 2009, our analysis suggested that the recovery from the global financial crisis would not be a traditional reset. Instead, it would involve major structural changes and balance sheet aspects that would, inevitably, lead to tensions and frictions. Indeed, we labeled the post crisis outlook as “a bumpy journey to a New Normal.”

Our thinking has evolved over the last two years due to further in-depth analyses of the underlying characteristics of both the journey and the destination.

Not surprisingly, a lot of focus has been devoted to the multi-speed growth dynamics – specifically, how long would it take for the west to overcome the structural impediments and how would this be done; and whether emerging economies would continue to manage well their success and, critically, if the world would continue to accommodate this success.

As regards balance sheets, our focus has been twofold.

When it comes to the over-indebted western economies, we have been looking into the four ways governments can delever when growth is not sufficient (namely austerity, debt restructuring, financial repression and inflation) – on a stand-alone basis and as different combinations.

For emerging economies, the question is very different. Here it is an issue of potential safe re-levering, particularly on the part of households that now have the wallet but still do not have the will to spend.

Impact on the investment landscape and the industry

All these changes can be thought of as involving shifts in the tectonic plates of the global economy, as well as within certain key individual countries and markets. As such, we believe that they have important implications for the investment landscape and, therefore, for virtually everything that an investment management company does daily to deliver high value to its clients. We focus below briefly on five specific issues.

Investment Strategy

Structural changes inevitably impact how risk is managed and returns are generated. They involve changing correlations among asset classes. In some cases, they even alter the analytical characteristics of individual asset classes by modifying the mix of underlying risk factors.

These considerations assume added importance in the context of the balance sheet and growth issues discussed earlier. For example, investors need to be explicit about both the “what” and the “how” of delevering. They have to be global in their search for returns and in their risk management. And portfolio optionality commands a greater premium, thereby impacting the traditional scaling of individual trades, as well as the mix between secular, structural, cyclical and tactical positioning.

Investors must also recognize that the traditional classifications of risk are morphing. Indeed, old classifications can be harmful in some cases. This is particularly true in Europe where what was viewed previously as pure interest rate risk – investing in a diversified set of Eurozone government instruments – has evolved into a volatile mix of credit and interest rate risks. A similar, albeit reverse morphing, has been taking place in the emerging world: from pure credit risk to a mix of credit and interest rate risk.

Risk management also needs upgrading. Most importantly, changing correlations and evolving asset class attributes translate into an uncomfortable reality. Asset class diversification, while remaining necessary for risk mitigation, is not sufficient. Investors need to manage more actively the tails of their distributions of possible returns – either directly through active tail hedging, or indirectly by appropriately adapting the asset allocation methodology.

Then there is the issue of foreign exchange. A shift in the tectonic plates of the global economy has important currency implications as, more than any other, this asset class speaks to relative as opposed to absolute prices. Investors – be they in equity space or fixed income space – need to adjust to this reality, by understanding better how currency markets work and how they relate to “hard assets” (particularly commodities that are viewed as a store of wealth and/or have limited supply responsiveness).

The final consideration relates to economic policies, politics, and governance. Whether we like it or not, these three aspects have a huge influence on market valuations when balance sheets are in play. Accordingly, they must be well analyzed, understood and translated into portfolio implications.

Witness the consequential impact of the political bickering and squabbles in America and Europe. Also recall the impact of QE2, the Federal Reserve’s attempt to use asset purchases as a means of stimulating economic growth. This had an enormous impact, but only temporary, on valuations and correlations. And the legacy aspects will be with us for a while.

Product Design

A bumpy journey to a new destination requires products suitable for each part.

Journey products are focused on exploiting large market dislocations, along with major economic and financial transitions (including global handoffs). Destination products must be agile enough to reflect durable global and market realignments.

When stated in this way, it becomes clear that investment management companies will be challenged to make another transition – from offering just products to also providing clients with global solutions that combine journey and destination elements, along with appropriate tail hedging.

This is something that PIMCO has been involved in for awhile. In the process, we have found that it entails much more than design and engineering aspects. It also translates into much deeper interactions with clients, and has consequences on how we invest in people, technology and analytics for the PIMCO of tomorrow.

Client Interactions

A client truism becomes even more critical when the investment landscape is changing: know and understand your clients’ needs very well.

We have found that, given the changing investment landscape, it is necessary to go well beyond the timely provision of information and analysis to clients and the offering of appropriate investment products and solutions. It is also critical to link in a very detailed fashion their asset considerations with the realities of their current and future liabilities.

Like product/solution management, this emphasis involves more than challenging engineering tasks. It also requires a high degree of external and internal cross-fertilization.

Accordingly, we have evolved the way our client facing professionals are organized in America – from a regional focus to “hard channels.” Such a structure allows them to understand much better the detailed institutional circumstances of our clients – individually and as a group. It deepens internal collaboration, most importantly between client facing and each of product management and portfolio management to help ensure client objectives are fully understood and achieved across the value spectrum. And finally, it strengthens partnerships with our clients, thereby enhancing active dialogues and allowing us to deliver global solutions across the capital structure that help our clients adapt to and capitalize on the changing investment landscape.

Business Management

On the business management side, firms must quickly invest to reflect the changing global landscape. We have found that this involves the three areas of talent management, technology and analytics.

It helps to have resources to do so – especially as there is another important claim on revenues in this changing global paradigm. Simultaneously, firms are required to staff up their legal and compliance resources in order to deal with the growing and changing sets of regulations emanating from the global financial crisis.

These considerations lead to another important business realization. The New Normal also has implications for the structure of the investment management industry. It is likely that we will see another phase of consolidation – through mergers, acquisitions and failures.

This will be driven by much more than initial conditions – namely whether firms are in a position (financially and otherwise) to meet the requirements of this changing investment landscape. It also speaks to the growing economies of scale and scope that materialize in such a world, and that can be better captured through size and global footing.

Thought Leadership

None of these factors can be done well, and in a sustainable manner, without the anchor of forward-looking intellectual content. Given the changing global investment landscape, this involves two key aspects. First, a disciplined approach that deals with each of the journey, the destination and their combination; and second, significant intellectual and framework agility.

At PIMCO, our long-term investment process serves as the anchor for not just “what” we think but also for “how” we think about the world and the changing investment landscape.

After active discussion and valuable input from external thought leaders, our annual Secular Forum sets out the three-to-five year outlook (baseline and risk scenarios), together with the implications for investors. These outputs are complemented by our Cyclical Forums, which occur three times per year and are platforms that enable us to refine our thinking over the 3-to-12 month horizon.

Over the years, innovation has been a key tenet of PIMCO’s culture. Indeed, it is highly encouraged and rewarded.  And to make sure we tap as broad a reaction as possible, we encourage colleagues to write and publish on a variety of topics related to the global economy and our investment strategy.  This is a great way to generate disciplined thoughts and interactions internally; and it has proven effective in getting thoughtful reactions and insights from around the world. (And, believe me, there are quite a few people out there that are not shy about sharing their views!)

Concluding remarks

The global economy is in the midst of consequential change. This will play out over a number of years, with non-linear dynamics and, at times, with considerable friction, tension and noise.

The paradigm shifts will involve two drivers in particular – balance sheets and growth – and will lead to a different global investment landscape; one that is already changing in a visible and, for some, unsettling manner.

As we continue on the bumpy journey to a New Normal, investors will face the challenge of recalibrating some of the traditional parameters that are essential to both managing risk and delivering returns, including reassessing asset class variances and covariances. It also means taking an even broader global view of markets, including currencies, and positioning for a multi-speed world with blurring lines between developed and developing economies.  And finally, it means recognizing the influence that politics and policies have on global financial markets.

The implications for investment management firms are profound and go beyond just investment strategies. Indeed, they impact the range of other activities that deliver value to clients, from product/solution design and client servicing to thought leadership and business management.

It appears that, as yet, the investment management industry may not have come sufficiently to grips with the global realignments, the changing investment landscape and what is at stake. The longer this situation prevails, the greater the risk that investors become inadvertent victims of change rather than beneficiaries.