Mohamed El-Erian, the co-CIO and CEO of the world's largest mutual fund, was on CNBC last week. During the interview, El-Erian masterfully avoided naming any specific stocks, yet he clearly expressed Pimco's current investment philosophy. According to El-Erian, both the tragic events in Japan and violence in Middle East countries provide more volatile days. There will be triple digit ups-and-downs, which will create opportunities for those who are ready for it.
His response to whether we should buy Japan now was:
We purchased some Japan for the Global Market Multi-Asset Fund. We did it on a tactical basis because the markets were over-shocked. Having a structural position depends on how quickly and how effectively is the re-construction program going to be. This is more complicated than 1995.
There are companies, which will benefit from the re-construction program: Hitachi (HIT) and Caterpillar (NYSE:CAT) produce, lease and operate construction machines. There will be an explosive demand for them during Japan's re-construction program. Kajima (KAJMY.PK), Shimuzu (TYO:1803) and Taisei (TISCY.PK) are Japan's largest construction companies whose stock prices soared after the tsunami. American contractors, Fluor (NYSE:FLR), KBR (NYSE:KBR), Jacobs Engineering (NYSE:JEC), URS (NYSE:URS), Shaw Group (NYSE:SHAW), AECOM Technology (AECOM) and Quanta (NYSE:PWR) might also participate in Japan's massive rebuilding efforts.
El-Erian's view about the events in Middle East reflects his conservative position:
There is a lot going on. It is not just Libya. There is the Gulf. Protests going on in Syria and Morocco. Repression is not going to work this time around.
El-Erian is bullish about commodities, but he suggests avoiding unstable regions:
I will look for countries that are benefiting ironically from all this. They tend to be oil exporters, commodity exporters, and on the other hand, they tend to live in quiet neighborhoods.
If you are holding ETFs such as ME Dividend (NASDAQ:GULF), Gulf States (NYSEARCA:MES), Powershares MENA (NASDAQ:PMNA), Emerging MENA (NYSEARCA:GAF), you might want to reconsider your portfolio. Egypt (NYSEARCA:EGPT) already lost 20%. If the violent events in Middle East turn out to be a radical revolution, your investments might disappear.
It is a nifty idea to invest in broader commodity ETFs such as Oil (NYSEARCA:OIL), Natural gas (NYSEARCA:GAZ), Coal Miners (NYSEARCA:KOL), all of which had outperformed S&P 500 (NYSEARCA:SPY) since January. Alternative Energy ETFs such as Carbon (NYSEARCA:GRN), Environmental Services (NYSEARCA:EVX), Solar (NYSEARCA:TAN), Wind (NYSEARCA:FAN) are also very profitable with double digit returns. However, after the nuclear disaster, the Nuclear ETF (NYSEARCA:PKN) lost 6%.
El-Erian is bullish on agricultural commodities, as well. Agricultural commodity prices have risen to insanely high levels recently. Cotton (NYSEARCA:BAL), Coffee (NYSEARCA:JO), Corn (NYSEARCA:CORN), and Cocoa (NYSEARCA:NIB), ETFs returned 44.7%, 12.4%, 8.3%, and 6.8% in 2011. Diversified Commodity (NYSEARCA:GSC) returned 13%. Whether this has anything to do with global warming, or speculative bets, is worth investigating further.
Latin America is El-Erian's favorite pick. He particularly mentioned Brazil as a stable region of growth and development. Commodity exporting countries such as Brazil
... are ironically net beneficiaries from what is going on right now.
In an interview in 2008, El-Erian stated that the roles of emerging markets and developed markets have switched. Thus, the economic growth will come from emerging markets, whereas financial crises will arise from the US-EU-Japan trio. He turned out be remarkably accurate.
Last year, investors in Latin American markets made considerable profits. For investors willing to invest in safe commodity producers, Emerging Latin America (NYSEARCA:GML), Latin America 40 (NYSEARCA:ILF), Brazil (NYSEARCA:EWZ), Brazil Infrastructure (NYSEARCA:BRXX), Argentina (NYSEARCA:ARGT), Peru (NYSEARCA:EPU), Chile (NYSEARCA:ECH), and Colombia (NYSEARCA:GXG) offer a good starting point. PetroBrasil's (NYSE:PBR) CEO aims to become the largest oil company around the world soon. Petrobras (NYSE:PZE) is also another highly profitable oil company.
El-Erian's opinion on China is not that bullish:
China's economy is slowing down. They are tapping the brake. It is going to be a soft landing engineered by authorities.
His response to whether Pimco is buying Chinese equities was interesting:
We are certainly buying the currency. Over time, the currency will continue to appreciate.
That makes very good sense: Chinese authorities used to manipulate Yuan (NYSEARCA:CYB) below the market rate. Recently, this policy started to change. Naturally, Yuan is expected to appreciate. Mexican peso (NYSEARCA:FXM), Brazillian Real (NYSEARCA:BZF), Russian Ruble (XRU), Indian Rupee (NYSEARCA:ICN) are other currency ETFs whose year -to-date returns were 4.0%, 2.1%, 8.7%, and 1%. In the same period, the Dollar bullish (NYSEARCA:UUP) return was -3.7%, whereas those bearish on Dollar (NYSEARCA:UDN) gained 3.5%.
El-Erian expects QE2 to end in June, but he believes the treasury will continue massive issuance of debt. However, he does not see sufficient demand for the bills at the current yields. The current yields are below their fundamental risk factors, namely inflation:
All of us are navigating this tug-of-war... That is why we prefer to stay out and see the yield adjusted to a new reality.
So far, he is right. The year-to-date nominal return of aggregate (NYSEARCA:LAG), short term (NYSEARCA:BSV), and long-term bonds (LCW) turned out to be negative, whereas inflation protected TIPS (NYSEARCA:IPE) gained 1.3%. Long-term corporate bonds (NYSEARCA:CLY) did not perform well either. At the same time, international bonds did much better; inflation protected (NYSEARCA:WIP), short-term (NYSEARCA:BWZ) and international government (NYSEARCA:BWX) bonds gained 3.2%, 3.6%, and 2.9% respectively. Bonds might seem like a safe return in short-run, but they are subject to inflation erosion in long-run. Therefore, it is better to invest in a diversified portfolio with inflation protection.
El-Erian's view on the economic landscape is cautiously optimistic:
The economy is healing. Certain sectors of US economy are doing really well. Particularly large companies and multinationals... Japanese economy will have a V-shaped recovery, but it will take some time.
What shall we do during this volatile environment? El-Erian has the answer:
Focus on safe returns. Look for high returns adjusted for the reality of inflation, volatility and various risks. Opportunities exist in the global market, not just domestic!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long on several mid-cap emerging market stocks whose share prices are highly correlated with Brazilian Real (BZF) and Emerging Latin America (GML).