If money managers want to invest successfully in this highly volatile, largely negative financial environment, they must adapt their financial forecasts and decision models, according to Mohamed El-Erian, the CEO and co-chief investment officer of Pacific Investment Management Co. LLC (PIMCO).

"What we are witnessing goes well beyond a cyclical economic shock and a consolidation of the financial sector," El-Erian said in an interview. "We are also in the midst of a prolonged increase in precautionary behavior among entities that have suffered massive wealth destruction and face a multi-year cleanup of assets and businesses. Without further adjustments, there will be an aggravation of the negative feedback loops that have been so detrimental to global welfare."

Pumping money into the system will help, he said, but massive stimulation by the United States and other countries may only be a short-term fix to help push the world out of a recession. Investors must abandon their thinking that a government bailout will result in "business as usual."

Money managers must take "irrational investment pricing" into consideration when making their decisions, El-Erian said. Some experts view irrational investment pricing as just "noise," but he argues that the noise signals risks, as well as opportunities, that will influence the markets in the years ahead.

"Global growth is now being heavily influenced by nations that previously had little influence," he said. "Former debtor nations are building unforeseen wealth. They are enjoying unprecedented influences and face unusual challenges. New financial investment products have changed the behavior of many market segments and players. Despite all these changes, the system's infrastructure is yet to be upgraded to reflect the realities of today's and tomorrow's world."

The recession is not just a "cyclical economic shock and a consolidation of the financial sector," he said. Governments and all types of investors are being extremely cautious, because their wealth has declined dramatically, so it could take years to recover from this financial mess.

Historically, according to Standard & Poor's Corp. data, when the stock market has declined at least 20% from a high, it has taken an average of five years to recoup the losses. After the Great Depression it took 25 years. On the other hand, the market regained its losses in six months after the 1987 stock market crash.

The current bear market has matched the average loss during the 14 worst bear markets since 1900, according to S&P.

"It is time to suspend unquestioned faith in a quick return to the past and adjust to the reality of change," El-Erian said. "The shift in thinking means spending less time looking for a market bottom and more ensuring that cash and collateral management keeps pace with disruptions that are global in nature and indiscriminate in impact."

Governments must take several steps to jump-start economic growth, he said. Intervention should continue in limited sectors, such as the commercial and money markets, with the gradual normalization of the housing and financial sectors.

Also, governments should partner with the private sector, El-Erian said; in most cases, that would involve voluntary co-investments, but the U.S. auto industry, for example, may require coordinated burden-sharing among stakeholders. In addition, governments should address how they are going to exit their investments, and financial reforms are needed, because crisis management can not solve the global problems.

On the investment side, El-Erian recommended that money managers avoid automatically rebalancing portfolios, because Wall Street and the U.S. government are in a state of crisis management.

There will still be disruptions in the capital markets, he said, so rebalancing portfolios into stocks is not going to help, even though stocks are down and values look attractive.

He favors investments in the capital structure and debt obligations.

PIMCO's view, he said, is "to shake hands with the government and make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond."

Investors should anticipate what the government will buy, El-Erian said, and buy it first. PIMCO favors agency-backed mortgages, bank preferred stocks, and senior bank debt, along with triple-A securities backed by assets such card and student loans and auto receivables, in anticipation that Uncle Sam will be buying them.

"An Obama administration will quickly be confronted by the need to provide those hundreds of billions of dollars to states and large municipalities," he said. "Their requests total nearly $1 trillion; to think California or New York City would be allowed to fail is, well, unthinkable."

Today, municipal bonds are attractive for individual and institutional investors, El-Erian said, because they are selling at historically high ratios relative to Treasuries. In addition, Treasury inflation-protected securities will perform well when the economic stimulus begins to have an impact the economy.

Register or login for access to this item and much more

All Digital Insurance content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access