Chrystia Freeland, FT US Managing Editor and Rebecca Knight, the FT’s Boston and New England Correspondent interviewed Mohamed El-Erian of the Harvard Management Company, in Boston on March 13. This is an edited transcript of the interview.
FINANCIAL TIMES: Thank you very much for joining us, Mr El Erian.
MOHAMED EL-ERIAN: It’s a great pleasure.
FT: I wanted to start by asking you how concerned you are by the problems we’ve seen recently in the sub prime market.
EL-ERIAN: The serious problem that we are seeing is a shake out of certain creditors out of the market. I think it was long overdue. The big question is: Does it spread? And do you see a more general credit tightening? So far, the evidence is you won’t, but I think that it is something that needs to be watched very carefully.
FT: What are the factors that you are watching?
EL-ERIAN: We’re first seeing how much withdrawal you are going to get from credit extension. In the past, the withdrawal has tended to be much more generalised. We saw that in 2002. We saw it in 1988. The second issue is a bigger economic issue - how much inventory comes to the market, and what does that do to the price of housing, and what does it do to consumption?
FT: Beyond the subprime market, what do you see as some of the main factors behind the market turbulence we’ve seen recently?
EL-ERIAN: We’re living through a technical correction, and most of us who have been in the market ask: Why did it take so long? There has been a significant amount of excesses, and it is good to get this correction. It is not surprising that you are seeing technical corrections that come in waves. The big question is going to be the self stabilisers. Are they sufficient to stabilise the market, or are we going to be concerned that what is a technical dislocation becomes an economic dislocation?
FT: You refer to the derivative products. Now, some people argue that those products have actually made the market much more stable, because they allow people to hedge. What is your view? Have they made it more stable?
EL-ERIAN: I think in most states of the world they have made the market more stable, but in the extreme, more unstable. What these products allow you to do is basically to tranche risk very finely, to bundle risk, but they also allow lots of new entrants to markets that otherwise wouldn’t be there. If we think of sub prime, if we think of exotic mortgages, they are after all derivative products, and they’ve allowed lots of people to come into the housing market that shouldn’t be there otherwise. So in most states of the world, these products are stabilising, but when you get a shock because barriers to entry have been lowered so much, you will get a technical reaction. That’s what we’re living through now, and that’s what we will continue to live through occasionally, going forward.
FT: And how about private equity? We’ve seen one record deal followed by another. Some people say that means we’re approaching a private equity bubble. Do you agree with that, or do you think it is still a good investment?
EL-ERIAN: At Harvard Management we call it a private equity phenomenon. It is so powerful in terms of re-pricing different markets that one has to respect that, and so far all the conditions are enabling for this phenomenon. You have a migration of capital to alternatives, so people are looking at private equity vehicles. You have enormously enabling debt markets, so private equity can leverage very easily, and of course you have companies with lots of cash on their balance sheets, so it is a very good, sweet spot for private equity.
The big question comes later on, which is: Do these vehicles which have temporary capital develop permanent capital? If they do, then the impact of private equity will be a once and for all positive impact on markets. If they do not develop these permanent sources of capital, then we will see a reversal of companies coming out of the private domain and back into the public domain, and it will feel very different out there when that happens.
FT: And how likely is that shift to permanent capital? We’ve seen the fortress IPO, which some people see as an important harbinger of that shift.
EL-ERIAN: Yes, and I think we’re seeing the beginning of it, but it is still the exception, not the rule. Now, private equity locks up capital for seven to ten years, so this is not a day one issue, but this is an issue that long term investors, like ourselves, have to take into account.
FT: What about emerging markets? What role are they? In particular, their growing external balances, playing in market conditions right now?
EL-ERIAN: You know, a few years ago I would have never believed what I am about to say, but I truly believe it today. As a group emerging markets have become stabilisers in the system. In the old days we thought of them as disruptors. These days they are stabilisers. Why? First, they are growing much more rapidly and maintaining global growth at a time when the US is slowing down. Secondly, their ability to produce cheaply and bring in more of their labour force into the world system has kept prices down, so it has helped inflation, and thirdly, their willingness to recycle their surpluses back in the US has kept interest rates lower than they would have been otherwise. So when you combine these effects, you now have a group of countries that are stabilising the system, and we used to think of them as being a source of systemic risk, not being a source of stability.
FT: Moving back to the United States, what do you think the outlook for rates is here?
EL-ERIAN: I think that if this were normal conditions, the Fed would be looking to cut rates. The economy is slowing. The housing market is under pressure. The corporate sector is not spending. However I think that policy makers are increasingly aware of the source of endogenous liquidity, the liquidity that the market itself creates. Private equity is a perfect example, where a dollar that comes out of the public market, becomes $4 or $5 when it goes back in, through the private equity mechanism. So, I think that policy makers will wait for unambiguous evidence that the economy is slowing, before they move, lest they contribute to excess liquidity.
FT: And what is your investment strategy right now?
EL-ERIAN: We think in terms of three specific factors. First, because of the nature of the endowment, we take long term views. So, we increasingly are looking for new opportunities, and we’re seeing these open up in different parts of the world. The second issue is we also recognise that because of these technical conditions, we will get sharp market corrections once in a while. So every once in a while, and that is the exception, rather than the rule, we feel that there is a reason to either be under or overweight on long term exposure, and right now we’ve been underweight in this exposure, because we were worried about the amount of complacency that has got into the market.
FT: Are you still worried?
EL-ERIAN: Getting less worried, and we have been gradually reducing our under weights. We were on the sideline, and we’re now participating more, but we still think that the dislocation is not totally done. The third issue, and this is important for any investor, is to ask the question: What happens with fat tails? I think of it as living in California. If you believe that the earthquake will happen, you wouldn’t go and live there. However, if you believe there’s a small chance that the earthquake will happen, you will live there, and if someone is willing to offer you cheap insurance, you’ll buy it. One of the very strange phenomenon in our market today is the ability to buy very cheap tail insurance, that is insurance against a really bad state of the world. So, we think three terms, which is constructive on global capitalism from a long term perspective, short term cautious, and willing to pay for this extreme, cheap fat tail insurance, in the event that global imbalances truly prove to be unsustainable.
FT: And it’s the global imbalances, that is, that earthquake event you’re most concerned about?
EL-ERIAN: That, and the possibility of a geopolitical shock. There are lots and lots of different risk factors that right now are not priced into the market, and one can buy relatively cheap insurance against those.
FT: Could I ask you to be more specific about the first part of your strategy, where you said there are some new opportunities that people can pursue?
EL-ERIAN: We are increasingly internationalising the endowment, because we think that there are attractive opportunities in emerging economies, in Japan, in Europe, so the first element is a continued and stepped up internationalisation of the endowment. The second, which is a bottom up view, is a move to newer segments of markets, where in particular, because of our long term view, we are in a position to complete the market and wait for it. Harvard Management is very famous for having done this with timber. When Harvard Management started investing in timber, it wasn’t even a financial asset class, and Harvard had the first mover advantage, which has benefited the endowment and the university tremendously. So, that’s what we are thinking of and we’re playing the smarter game, as the global economy evolves.
FT: At Harvard, are you sticking with the Harvard Management’s hybrid investment approach?
EL-ERIAN: Yes, we are. We think that that offers us the best way of both maximising return and managing risk. If you look at the return side of the equation, there are certain attributes that Harvard has that cannot be outsourced. We cannot outsource our triple A balance sheet. Most of the hedge funds we deal with are probably triple B’s. We cannot outsource our long term vision, nor can we outsource our stability of capital. So there are certain activities that take direct advantage of these attributes, and we do internally. At the same time we recognise that we don’t have all the expertise. We recognise that we’re small, so we also want the ability to deal with external managers.
FT: Are you confident that you can pay enough to attract the best managers?
EL-ERIAN: That was a real question mark. We went through a compensation controversy, and we lost quite a few people. We’ve had in fact six spin-offs, and there was a question mark as to whether we would be able to attract people, and it took us twelve months, but we’ve now attracted all the senior talent we needed. We found that people come to Harvard Management for one or more of three reasons.
First, they believe in the mission, and in Harvard’s case the mission is very clear, which is our support of the University and of education. Secondly, this is the pure investment job for a portfolio manager. No marketing, no client relations. All day long, he or she can do what they like doing most, which is investing money, and thirdly, because we’ve been seeding new hedge fund managers, because people have spun off on Harvard Management and have done well, that is actually an advantage in attracting people, because people believe that they can stay here for five, ten years and then, if they want to, they can spin off, and the five and ten years that they’ve spent here will be highly valuable.
FT: How about those controversies to which you’ve just referred? Are you concerned that you and some of these people that you’ve brought in might face renewed attacks from Alumni groups, over your salaries?
EL-ERIAN: I think there is better understanding now as to the system we have, which is that we pay people on the basis of performance. We pay them less than we would pay otherwise for the same service provided outside, and we subject our internal portfolio manager to a clawback, which means that if they earn 100 units for the year, they don’t get 100 units that year. They get part of that and they only get the subsequent part if they continue to outperform. I think when you look at it, it is a much better deal for the University, both in terms of cost effectiveness, and in terms of incentives, and I think people are understanding this more and more.
FT: Thank you very much.
EL-ERIAN: Thank you.
And now, the prediction:
EL-ERIAN: My prediction has two parts. The first part is that we will be surprised at the extent to which growth in the rest of the world is going to compensate for a slow down in the United States. The second part of my prediction is despite this rather constructive global outlook, we will continue to have these periods of very sharp market corrections, because technicals remain unbalanced.