The current perception of risk and asset allocation will have undergone a fundamental shift by the time the global economy rights itself, says the CEO of PIMCO.
Mohamed El-Erian, who is also PIMCO’s co-chief investment officer and author of the book When Markets Collide: Investment Strategies for the Age of Global Economic Change, told the Toronto CFA Society on Friday, Oct. 9 that although the world economic markets are on a journey to the “new normal” the world is currently at the point of maximum confusion.
He compared the economic recovery to a roomful of people who are unconscious due to a lack of oxygen; some economies will wake up and get to their feet more quickly than others due to their physical fitness.
One thing that will apply to everyone, he said, is that the new status quo will not resemble the old.
“Global markets and the global economic system will not reset to where we were before the financial crisis occurred,” El-Erian said.
Specifically, the concept of asset allocation will change. Investors will build portfolios based on risk classes—as opposed to asset classes—classifying investments in terms of their exposure to equity risk, default risk, inflation risk and public policy risk.
Further, financial markets—while acting rationally in terms of the ‘old normal’—have not yet come to terms with the impending changes, said El-Erian.
The average investor seems to assume that the economic recovery will resemble those of the past, and that pre-crisis growth levels will return. However, much of the recovery to date is a result of stimulus efforts as opposed to genuine consumer demand, and valuations in the market are far too optimistic. A correction is likely to occur once markets realize the weakness of the recovery, he said.
Investors are likely to be more diligent in their analysis of investment vehicles when it comes to the risk/reward ratio, and while portfolio diversification will not be abandoned, its reputation for managing risk will be dialed back.
“It is not a sufficient risk mitigation tool,” El-Erian said, adding that more extensive risk management efforts will be necessary.
El-Erian also feels that the global economy will ultimately have lower growth potential, higher levels of financial sector regulation and a general increase in the cost of capitalization. The United States will see higher unemployment rates and higher savings rates, and lose the status of ‘consumers of first resort.’
“The new normal is a world in which the growth potential of the United States, and therefore the growth potential of the rest of the world, is lower.”
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