Tuesday, July 8, 2008

Traversing wild market swings - Mohamed El-Erian

A year ago, I argued in the FT that we were “exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.” In a subsequent column, written in the midst of the sharp recovery from the mid-March market lows, I suggested “it is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.” How about today? Does the latest sell-off in global markets provide an opportunity for investors or is it another leg down in a secular bear market for all risk assets? Today’s markets are particularly tricky as they provide the duality of both great opportunity and enormous risk. And in contrast to recent years, investors will not be able to appeal to a few macro themes; be they bullish (”the great moderation” and ”goldilocks”) or bearish (”debt exhaustion” and the collapse of structured finance). Instead of the phase of highly correlated market moves, up and then down, we will witness the gradual assertion of fundamental differentiation between market segments and for instruments in the capital structures. To illustrate, let us start with the unpleasant side of the duality. Successful risk management must reflect the fact that markets are now in the grip of three distinct but reinforcing forces that will play out over a number of quarters. First, look for further balance sheet contractions in the financial sector that will continue to suck oxygen out of, and undermine risk appetite in credit and equity markets. This is part of a long-term process of de-risking that is currently driven by markets but will soon have a more important regulatory dimension. Second, markets are yet to adequately price the morphing of the credit crunch into a full-scale US economic disruption. Prepare for even stronger headwinds fuelled by declining real income and eroding household wealth. Third, there are no easy policy solutions. Instead, policy makers face an extremely difficult situation in which any action, no matter how well-intentioned, entails unstable feedback loops and impose distortions elsewhere. Collateral damage cannot be avoided, yet its exact characterisation is uncertain given the extent of still-hidden vulnerabilities in both the real economy and the financial sector. This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion. So much for the summary characterisation of today’s highly dualistic investment outlook; how about the implications for investment strategies? Interestingly, they differ significantly depending on where your investible capital stands with respect to some key structural attributes – an insight that also speaks to why we are likely to see more market volatility. The answer lies in a phased, multi-quarter approach by investors that benefit from the following structural attributes: a high degree of capital permanency that steers clear of the need to finance sudden withdrawals; a willingness to take long-term views that can be sustained through wild market swings; and a process that accommodates opportunities that, in some cases, do not fit well into traditional classifications of asset classes. If you possess these structural attributes, today’s markets offer opportunities that are high up in the capital structure and that, in a few years, will be looked at as having constituted incredible bargains. If you don’t, you are well advised to stay on the sidelines, focused on the probability that these same markets will also be treacherous for at least the remainder of this year.

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