Pimco's Mohamed El-Erian: It looks like an 'exciting time for investing'

Ask Mohamed El-Erian about the very real financial problems threatening the developed world, and you get a surprising response. Rather than reeling off dire numbers about unemployment and sovereign-debt levels, the chief executive and co-chief investment officer of Pacific Investment Management Co. LLC said that it is actually “a very exciting time for investing.” Indeed, Mr. El-Erian pointed out that investment opportunities invariably arise from such troubled times. “When the world is changing and there are realignments, it means the nature of risks and returns change,” he said. “You have to invest for the world of tomorrow, not for the world of today.” For the pragmatic Mr. El-Erian, investing for the world of tomorrow means paying closer attention to the faster-growing and more fiscally stable emerging economies. Those economies can provide a hedge against potential problems in many developed countries, he said. To help cope with a complex and quickly changing investment landscape, the man at the head of a $1 trillion asset management juggernaut offers a simple suggestion: Make two lists. On the first, write down what you believe to be true. That list should form the basis of your investments. The second list is what you don't know, and that is where you keep your options open. “When the world changes, you have to acknowledge there are things you don't know,” Mr. El-Erian said. “So you keep more dry powder because you're not sure of all the outcomes.” For the invested portion, Mr. El-Erian said, “portfolio diversification is necessary, but it's not enough, because most of the benchmarks are capturing the world of yesterday.” Investing for the world of tomorrow, he said, means thinking through scores of possible scenarios. What if protectionism emerges out of the high unemployment levels? What if China is unable to manage its economic success? What if one or more European countries default on their debt? “In that kind of world, you will find that most asset classes will get very correlated,” Mr. El-Erian said. “So you have to ask yourself what your portfolio looks like in a [rare but potentially significant] tail scenario.” In the United States, unemployment looks like the wild card. Even before the jobless rate reached its recessionary peak of about 10.1%, Mr. El-Erian was forecasting that the country would have to deal with above-average unemployment levels for several years. At this point, while most economists concur with his original forecast, he said that the “composition of unemployment is less understood, even though it matters as much as the level of unemployment.” The fact that 25% of people between 16 and 19 in the United States are unemployed reflects a larger structural threat to the overall economy, Mr. El-Erian said. “The longer a person is unemployed, the more difficult it is for them to re-enter the work force and get jobs later on,” he said. “There is skill erosion, the unemployed become less mobile, and that prevents the unemployed from meeting the demand for workers.” That scenario, Mr. El-Erian said, puts pressure on the safety nets, such as unemployment insurance, “and that makes the employed even more cautious, and it makes companies more cautious.” This all points toward a structural issue that Washington is still treating like a cyclical issue, he said. “The government has to move from a cyclical to a structural mindset,” Mr. El-Erian said. “Washington hasn't even looked at the structural side of this, because they're still debating about stimulus or not stimulus.” The structural economic changes, Mr. El-Erian said, are evident in the economy's muted growth, which is reflected in the re-pricing in the equity and credit markets. “The markets are in the process of re-pricing the reality of two different halves of 2010,” he said. “The first half was growth fueled by stimulus and inventory restocking, and the second half is slower growth.” Fundamentally, Mr. El-Erian said, the economy isn't getting the needed kick-start from the government's stimulus spending. “There are encouraging signs of stronger exports, but that's relatively small,” he said. “Less encouraging is the lower level of consumer consumption and investment.” The head winds facing consumers, Mr. El-Erian said, include slower economic growth, a sell-off in the equity markets that reduced the wealth effect and “major uncertainty about the future of taxes.” And underneath all of it, he said, the United States is adjusting to two substantial realignments. “There's lower liquidity and lower credit, and the balance sheets of consumers have to adjust to that,” Mr. El-Erian said. “Next there's the global realignment that has China and other emerging economies entering the breakout phase, and that is systematically important.” As a result, both corporations and consumers are “self-insuring” by holding on to cash “because of uncertainty over final demand, taxation and regulations,” Mr. El-Erian said. Indeed, the ultimate reality for debt-laden developed countries such as the United States is more taxation and less spending. “The U.S. has to move over the next five years from a high deficit to a low deficit,” Mr. El-Erian said. “That means you need economic growth, higher taxes and lower government spending,” he said. “But to do that, Washington needs to reconcile the matters of growth and austerity.” E-mail Jeff Benjamin at jbenjamin@investmentnews.com.