“The M&A boom rolls on, slowly but surely changing the financial and corporate landscape,” writes Mohamed El-Erian, who manages Harvard University’s $30bn endowment, in Wednesday’s FT’s Insight column.
Advice from the understated Mr El-Erian, a Cambridge University-trained economist who made a hugely successful transition about nine years ago from the IMF to managing Pimco’s emerging markets bond fund, is usually worth heeding.
In mid-January, Mr El-Erian made a $1.6bn bet on behalf of Harvard Endowment that markets around the world were overvalued, and he sold off stocks representing 5 per cent of Harvard’s total portfolio, as the New York Times reported.
With the Dow Jones industrial average down about 3.5 per cent in the ensuing few months, his hunch paid off, noted the NYT [via Blogspot]. ”We had been in a global Goldilocks world,” he told the paper. ”We felt that valuations were stretched and that they had gone up too quickly and we were reminded of May of 2006 where there were similar signals that people were stretching for returns,” he added.
In March, he warned in the FT about massive shifts in liquidity being driven by the inexorable rise of private equity. “The best positioned investors”, he said, “will be those that have mitigated risk through appropriate asset diversification and the purchase of insurance”.
Now, Mr El-Erian is concerned about widening discrepancies in investment patterns. He notes how the M&A boom has helped accentuate the contrast between buoyant market valuations and concerns about a US economy saddled with a difficult housing market, a subprime mortgage debacle, high energy prices and large consumer debt
“The joy of equity investors, especially leveraged ones, also contrasts vividly with the frustration of others. Investors betting on continued historical aberrations in market trends have continued to benefit so far. In contrast, those looking for markets to ‘revert to the mean’ have been left frustrated”, he writes.
So what’s the smart investor to do? Citing the “Theory of Second Best”, based on the 1956 work of economists Kelvin Lancaster and Richard Lipsey, Mr El-Erian looks at how investors have had to adjust their approach to account for the way in which emerging economies are allocating their large and increasing reserves.
Large “non-commercial” purchases of US fixed income products by these emerging economies have introduced — and sustained – significant pricing distortions, he says. “And, as the ‘Theory of Second Best’ suggests, the next-best solution for investors has implied betting on additional historical anomalies in other markets.”
Not so. “Over the longer term, valuations will be excessively divorced from the underlying economic realities, especially if the US economic slowdown intensifies,” says Mr El-Erian. In addition, he warns, the risk of regulatory and political backlash will rise; and finally, the distortion that lies at the heart of it all – the non-commercial allocation of sovereign wealth funds – will slowly fade as emerging economies face pressure to increase the rate of return on their reserves and to allocate more funds to domestic uses.”
Therefore, the basic challenge for investors is to adopt an outlook that is “inherently fluid and potentially dualistic”, he concludes: “The solution may well have three principal components: a strategic asset allocation that emphasises secular themes and a long-term destination; portfolio overlays that recognise the reality of an historically unusual journey; and a risk management process that is sensitive to the nature and evolution of the underlying market distortions.”
Simple.