In this book, Dr. El-Erian focuses on the changes taking place in the world economy. It is a big picture executive summary of the evolution taking place in world of finance across the globe. The author attempts to emphasize these changes by saying that these are signals and not noise. He then goes on to provide a framework for future investments and/or asset allocation.

At hindsight, this book may appear to be chaotic hodge-podge of multiple topics which does not provide any benefits to the average main street investor. It may seem to be oriented towards institutional financial managers; however, there is a lot one can learn from this book. As every coin as two sides, this book also has its positives and negatives. Putting the negativity aside, I viewed it in the context of broad overview and framework alone and not as a workbook for investments. I think that was author’s objective.

In this book, El-Erian is discussing three major themes in world financial markets, which are:

1. Use of derivatives and lack of financial infrastructure;
2. Changes taking place in emerging markets; and
3. Money Flow – role reversal due to Sovereign Wealth Funds.

Use of derivatives and lack of financial infrastructure

Over the last decade, the financial companies and institutions have started using different forms of financial derivatives. The notion in all these financial derivatives is that one can securitize any financial transactions. The logic of this securitization process was that by grouping “many small units” in a “large single package”, the risk of any one small unit holder defaulting would be greatly reduced. However, one key element that went missing was that the financial infrastructure was not in place to govern these types of derivatives.

Let me put this in the context of real-estate financing. In general, traditional banks have changed their business model. They have stopped issuing mortgages for their own investment portfolio. They have started issuing mortgages to capture the loan origination fees. In the process, the banks (mortgage originators) shifted their focus from the borrowers’ long-term credit worthiness to accumulating the short-term gains. The goal was on quantity and not quality of loan. Anyways, originators then sold these individual mortgages to investment banking institutions for inclusion in bigger packages. These bigger packages were securitized and then were marketed to other investors. In absence of any governing mechanism, investors in these securitized mortgages had no idea of how to evaluate the risk of these securities and associated derivatives. The system broke down when bad quality of small unit (i.e. individuals) started defaulting in-mass.

Additionally, the financial system is also affected by how the money is coming into market, how it is used in markets, and how leverage is being used by institutions. Present system is designed for banks to be the only mechanism for money in-flows. However, now there are different ways such as hedge funds, private equity funds, investment banks, and domestic and foreign partners. Since these are not formal banking entities, they are not subject to the same regulations. The author expects this to change (Note – the book was published in early 2008).

This shapes author’s view on excessive use of derivatives and lack of governing infrastructure.

Changes taking place in emerging markets

Until over a decade ago, the overall economic performance of emerging markets (BRIC, Mexico, South Africa) was highly dependent on exports to the developed countries. The domestic consumption and demand was very small component and hence, did not have any significant effect on their state of economy. However, now, the economic scenario in these emerging countries is moving towards increased domestic consumption and demand. At the same time, the dependence on exports to developed countries is reducing. This is helping emerging economies to provide some level of internal support. This is reflected in increasing trend in their domestic savings and investments. Additionally, this is also aided by shifting patterns of demographic distribution. At least in China and India, with more than 2 billion population, the demographic is getting skewed towards younger generation. This is one aspect of change which the author is saying it is not a noise (it is a signal).

Money Flow – Role Reversal due to Sovereign Wealth Funds

The roots of Sovereign Wealth Funds (SWFs) can be traced back to oil producing countries (and Singapore to certain extent). These countries had significantly high inflows of cash from oil earnings. This cash flow was (or is) much higher than they can perhaps consume internally. Therefore, it was deployed in developed world in the form of short-to-medium term government debt instruments. The author believes this is role reversal. The developed countries are being subjected to capital flows governed by SWFs (i.e. other nations). This is another aspect that author believes needs to watched closely. Depending upon the monetary and fiscal response of developed world, it is likely that SWF money managers may change their investment strategy from government debt instruments to equities and/or high interest rate instruments.

With these three major themes, the author than goes on to demonstrate how these themes were used for asset allocation model at Harvard Endowment Fund. There is an interesting viewpoint of this asset allocation (here and here) from the context of asset correlation. This asset allocation model is more oriented towards the institutional investments with large funding base. The investment vehicles, resources, and perhaps their accessibility are not from the average investor’s viewpoint. Unfortunately, this is where the book gets disconnected from the main street investors like me.

In the next post, I will discuss my interpretation of these conceptual framework and themes from the perspective of do-it-yourself investing.