I went to a very worthwhile talk last night at the Harvard Club by Mohamed A. El-Erian, President and CEO, Harvard Management Company, which manages the $29 billion Harvard endowment (as of 6/30/06). The endowment has had consistently impressive performance. As background, I’ve posted on the blog below an article I wrote for the Harbus, the HBS school newspaper, back in 1998, profiling Jack Meyer (Dr. El-Erian’s predecessor).
One of the marks of a sophisticated thinker is that he can make complex subjects seem simple. The global economy is certainly complex (especially now) but this talk boils it down to just a few key issues and tensions.
“Navigating a Fluid World”
Presentation to the Harvard Club of New York
Mohamed A. El-Erian, President and CEO, Harvard Management Company
and Faculty Member at Harvard Business School
Oct. 17, 2006
You’re obviously not Mets fans or else you wouldn’t be here.
Will discuss impact of global economy on investing. Internally, we’ve gone back to 1st principles as we rebuild HMC.
Signals from the market are increasingly inconsistent (i.e., confusing). We’ve come across issues that are systemic in nature, uncertain in impact. And we have lots of questions. Some will think we don’t know the answers. Some will think we know but aren’t telling. And you’re both right.
Market signals which used to appear sequentially inconsistent now appear simultaneously so. So very tempting to dismiss them as noise. Don’t dismiss them as noise—they’re consequential in terms of info content.
1. What are the markets trying to tell us?
Signals have gone from being sequentially inconsistent to being simultaneously inconsistent. 3 examples:
A) In the world’s most liquid markets, are US equities or US bonds correct? Equity market is doing well. Suggests vibrant economy. But bond market suggests economy is slowing down very quickly. Last week, both shape & level of interest rates suggest something more sinister than a soft landing.
B) What to make of the unusual dispersion in interest rate forecasts in the context of subdued volatility? Some suggest by Dec. 07, Fed will cut rates to 4%. Some suggest Fed will raise rates to 6%. I’ve never seen such a range in terns of magnitude and sign. Reason: we’re at an inflection point in the economy.
o Market volatility has declined (VIX index). Intra-market differentiation in developed markets has also declined (graph: FTSE All-europe valuation dispersion). EM Credit spreads have tightened in a quasi-linear fashion (graph: EM Sovereign spread over USTs). FX market volatility has collapsed (graph: avg. GX implied volatility).
C) Michael Cullen, New Zealand finance minister, says investors in NZ are “irrational”. “Just how badly do we have to do on the current account before investors notice? … I have to think someone would have to be slightly strange to take a bet on the NZ dollar right now.”
I can explain each of these inconsistencies, but not in a self-consistent way. Harvard prof told me about this: “This is complex. But in academe, we can just go to something less complex.”
2. What are the underlying drivers?
3.5 major structural changes ongoing:
1) Global productivity shock. Secular, long-term in nature.
Communications costs plummeting. Internet users spiking. Less and less capital controls. Transport costs down. More and more regional trade agreements. Greater involvement of new segments of the labor market.
2) Global terms of trade shock. Secular, long-term in nature.
Significant increase in demand (from China, India, etc.) which won’t go away.
3) A financial innovation shock. Secular, long-term in nature.
Proliferation of derivative-based instruments that lower entry/exit barriers and facilitate many permutations of risk securitization, tranching, and bundling.
3.5) New marginal price setters. Possibly short-term.
New set of marginal price setters have emerged: central banks, hedge funds, private equity, etc. (Graph: Notional amounts outstanding of credit default swaps have swelled enormously) This is ‘half a change’ because it’s not as yet clear whether it is cyclical or secular
Seemingly different objective functions, time horizons, and guidelines now have an important marginal influence. I’m particularly talking about central banks in emerging countries who have huge influence—China has $1trillian in reserves.
Compare playing the game of Risk. It’s a purely probability-driven game. You’ll win if you can calculate probabilities. When someone joins the game and behaves irrationally, all the others have to adjust accordingly. In the financial markets, these are the non-commercial players who have entered the marketplace.
A. Convergence in real economy indicators.
Standard deviation of global growth rate has converged to US growth rates. Global interest rates have also converged to US. US is the global locomotive of growth. It’s the Goldilocks economy.
B. Portfolio diversification and reduction in home biases.
Both assets & liabilities are becoming globalized. Countries own more and more of one another; so does the corporate sector in each country. Over 50% of US treasuries are held outside the US. This is a good thing—it’s international risk sharing.
C. Unprecedented global payment imbalances.
US current account balance is at -$800B. Largest deficit any country has ever run in terms of global GDP. In 1995, many countries ran a deficit. Now, the US runs a huge deficit and relatively few other countries do. We’ve never seen this imbalance. (Shows powerful slide from IMF.)
This is our “vendor-financing relationship” with Asia, aka “Bretton Woods 2”. Asia supplies goods (and India supplies services), and Asia also supplies credit for us to buy it. It’s like Ford financing your car. It makes great sense for the US consumer, using his house as an ATM—consuming above his income.
Why is Asia doing this? They don’t think about bits of paper. They think about the benefits of being massive export machine: creates jobs, which attracts foreign investors. Easier to import FDI (foreign direct investment). Lastly, once you acquire market share, it’s hard to lose it.
This all turbo-charges int’l reserve growth among oil exporters. They’re accumulating even more reserves than Asia.
3. What are the implications?
This is a “stable disequilibrium” (quoting PIMCO)
No agreement on lifespan of this. How long will Asia take bits of paper for their goods—when the bits of paper will lose value?
A. Optimists (“new paradigm school”) looks at: US productivity gains, demographics, entrepreneurship. Maturation of key emerging economies. Gradual resurgence of Japan/Europe.
B. Cynics. Others believe we’re on verge of large disruption: size of huge current account deficit, leverage in financial sector, bubble in housing market, risk of a change in the asset preferences of holders of US financial assets.
C. All the views in the ‘muddled middle’: those noting ‘dark matter’ (measurement error), enhanced policy credibility, system self-insurance.
This is a frightening slide. Endowments and foundations have to focus on long term, and there are question marks about what the long term is.
Future is function of four factors:
–Developments in the US in private consumption. Will consumption soft- or hard-land?
–Developments in surplus countries, including relative asset preferences and ‘managing success’ (suddenly being in surplus). Finance minister told him: “Managing success is more difficult than managing a crisis.”
–Interactions between the two. They’re two sides of an income statement.
–Prospects for orderly re-alignment of exogenous and endogenous liquidity.
The challenges for policy reaction functions in advanced economies:
– navigate payment imbalances
– understand and adjust to structural changes
– counter protectionist tendencies
The challenges for emerging economies:
They’re used to running a deficit—that’s what the textbooks suggest. How do they handle this?
Theoretical orderly global solution exists, and is discussed at every G7
+ Rebalance of US economy-US must consume less.
+ Structural reform in Euroland and Japan to grow faster.
+ Asia has to consume more.
+ Oil exporters provide cheap financing in the interim.
BUT: if any one of these parties moves first, they’re hurt. This is a classic game theory dilemma/prisoner’s dilemma. So without coordination, it’s best not to move.
G7 can’t act as a coordinating body because it excludes the countries in massive surplus. So we rely on IMF and other multilateral institutions.
At a time when int’l coordination is essential, legitimacy of multilateral institutions is being questioned due to: lack of representation, governance, resources etc.
Business models have to adopt: new two-way flows between advanced & emerging economies. Regional and local product development.
Just 5 years ago we thought emerging economies were a destination for capital; now they’re the major source of capital.
Most companies have outperformed lately because growth outside US has been stronger than envisioned.
Investment management is about 3 things: asset allocation, investment vehicles, and risk management. Not very complex.
Key questions for investors:
-striking the right balance between forces of economic synchronization and de-coupling.
-Portfolio positioning in the context of binary medium-term outcomes
-Appropriately handle the internationalization of investment management
-Dealing with asset class fluidity and correlation changes
-Ensuring value for money in accessing investment vehicles
-Navigating organizational challenges.
Buying real estate in Mexico is very different than buying bonds there.
Traditional classifications no longer make sense.
How to ensure value? Fees get very high when everyone wants a certain asset.
Risk management is going to be increasingly important. We’re rebuilding and reinventing the institution of HMC.
These signals are meaningful. Global economic convergence has continued while fluidity of int’l monetary system is increasing.
At public sector level, we need to test and retest robustness of nat’l policy reaction functions and global governance.
Q: As you know there are 8,000 hedge funds. Is this a problem?
Hedge funds are not asset classes; they are a means of managing investments. They do 2 things different from tradition: a) they leverage, b) they can go short and long. Like everything else, if taken to extreme, these actions can cause problems.
– Are they a threat to stability? Amaranth at least was not, despite losing more money than LTCM.
– Are they a threat to the small uninformed investor? Those investors shouldn’t be in them.
– Do they potentially contaminate economic relationships? Are they a level playing field?
Q: Insights on Africa, Egypt? On carry trades?
Most crowded carry trades in April were in NZ, Turkey-all funded by yen. You could borrow at 1%, get 10-17% returns in NZ, Turkey. Then certain markets dropped by 20-30%—and nothing blew up. Carry trades have tendency to become more crowded.
Q: How do you handle risk management?
1)Buy cheap insurance on fat tails
2) Analyze correlation of exposures across and within asset classes.
Q: What is optimal compensation scheme for outside funds and for your own employees?
Several new hedge funds have overly generous comp schemes, and we tend to avoid them.
For our own employees, we have clawback provision. If they don’t consistently outrperform, the carry they earn is clawed back.
Q: Aren’t US markets much more sophisticated? US markets providing a service to global economy.
There’s a view that Asians don’t trust their own markets. So they delegate capital allocation to the West. I think that’s an outcome, and not a bad outcome, but it wasn’t by design.
Part of the orderly solution is for emerging markets to develop more sophisticated capital markets.
At some point Asian populations will ask for bridges, schools, etc.
Q: Opinion on china?
HMC has increased the emerging markets allocation by $1b+.
One of the reasons managing success is tough is that the typical emerging market is not used to deal with large capital inflow.
How do you get out of overinvestment? Because China is mostly a closed economy, you can work off overinvestment over years, unlike the typical boom/bust of Thailand, Argentina, etc.
Q: Hedge funds account for ½ of NYSE volume. Doesn’t that call for regulation?
Have not thought about this.
Q: Where are you investing?
We think US fixed income market is near a secular top.
We think US economy will soft-land, either for endogenous reasons (housing market corrects but corporate investment picks up) or will soft-land because of enormous monetary market flexibility (Fed could cut rates). It’s hard to imagine foreign markets doing better than US when US goes into recession. So there’s no safe refuge.
If world goes into recession, you want a liquid market. We think of recession as a risk under our ‘fat-tail’ insurance.