Mohamed El-Erian of PIMCO on Four Major Trends

On June 1 issue of Barron's, there was an interview given by Mohamed El-Erian linked here, who is Pimco's co-chief executive and co-chief investment officer and former president of Harvard Endowment Fund. In the interview, he laid out four current major trends of transformation in the global economy. I agree with three of the four, but have some reservations on the 3rd one.

1) Realignment in global growth. What he means is that the world is transferring from a big single engine called the U.S. consumer which is getting exhausted, to many smaller, new engines from the BRIC countries. The transfer itself is a bumpy process.

2) Return of inflation. As these BRIC countries go from being just producers to being both producers and consumers, commodity prices will go up and a world of disinflation becomes a world of inflation. If I may, I would also add that the return of inflation is also due to many years of easy money in US, from both our monetary and fiscal policies, subsequently causing and forcing easy money on our trade partners of other nations, resulting an out-of-control overflow of international liquidity and fiat currencies.

3) Structured finance, as a major innovation, has diminished the barriers to entry. The first round tends to be destructive, leading to the subprime crisis. Now after the current clean-up process, we've lowered the barriers to entry and we're not going back to old-style mortgages. Partially true, but I don't see blue sky ahead for structured finance and large profit returning to this sector. (see my discussion below)

4) Transfer of wealth. Debtor countries are now creditor countries. Managing success isn't an easy task. It's a bumpy journey for the now wealthy BRIC countries. I would add that US, the largest debtor country, will also have to go through a bumpy and painful process.

The trends 1), 2) and 4) are actually related and straight forward. It is interesting that he put the structure finance in the middle of this discussion, and I am not sure I agree with him fully on this one. Mohamed is probably a little biased too since PIMCO is the largest bond house, and they are dealing with many structured finance products as an essential part of their business, revenue and profit, even not in the subprime area.

To me, structured finance "innovation" during the past 10 years is not that different than the junk bonds and Savings & Loans era in 1980s or the convertibles and REITs in 1990s. All of them had barriers to entry by individual investors initially, but through bond funds, REITs and other vehicles, the barriers have diminished quite substantially.

Using the junk bond as an example, in the 1980s, Milken at Drexel almost single handedly created and controlled the junk bond market and earned a huge markup and lucrative profit for Drexel by structuring and trading them with their favored institutional customers. It was a big innovation and revolution at that time when no one paid much attention to junk corporate bonds before Milken. As Mohamed said, the 1st round was destructive, and there were huge losses. After the clean-up phase, junk bonds sort of came back, but have never returned back to the old glory days of lucrative profit for banks.

I see the same thing happening to structured finance. Those lucrative "profits" composed of over half of the investment bank's income and bonus in previous years are likely gone forever. They will still provide some profit to banks, probably at the same level of what the current junk bond sector offers. Volume will shrink substantially since there will unlikely be as many yield-hungry institutional investors eyeing structured finance as before, just as in the junk bond situation from 1980s to now.

This is why I don't see investment banks returning to the same earning power as before, until, of course, the day they find the next "innovation" and revolution which has nothing to do with structure finance, securitization and mortgages. But until then, there will be many years after the current deleveraging process finishes, and the timin is difficult to predict.

Comments

[jjason:]

Thomas, How does trading in commodities affect inflation?

Have you read Professor Michael Greenberger's report to the US Senate Committee at:

www.commerce.senate.go...

and an article by Ed Wallace at:

http:star-telegram.com/ed_w...

Also read on SeekingAlpha the articles written by Phil Davis and Anthony Schneider on speculators driving up the price of commodities.

2008 Jun 17 03:10 PM

[Lockstep In...:]

Another good article Thomas.

2008 Jul 18 05:07 PM