A Roundup of Global Markets
What this historic time for U.S. markets means for the rest of the world…

When we look back at the events over the past weeks, I think we can honestly call this is a historic time in U.S. financial markets. Starting with the Bear Stearns’ failure and moving onto the Fannie Mae and Freddie Mac bailout, the AIG bailout and the Lehman Brothers fallout, it has been nothing short of amazing.

What’s critical to see is that we are now facing problems that have been built up for years. It’s a sobering experience, as every financial company that’s hitting the skids got there due to reckless risk-taking. They took on leverage, cooked the books, and finally, left us with financial statements that were all a pack of lies.

There are two questions that now come to mind. One is, with the average person skeptical of a company’s balance sheet, and the “big boys” not having a clue how to how to assess counterparty risk, how can we start rebuilding a foundation of trust?

The other critical question involves the government and bailouts. At what point do they draw the line for handing out life support? Will they bail out other banks, car companies, insurance companies, the airlines? This is something we will have to watch, and it will be telling to see where the line in the sand is drawn.

One thing still seems certain to this editor: Ben Bernanke’s helicopter will not remain idle. No, he is firing up the engines, and this was clear on September 17, when the Treasury announced a special series of bill auctions to help the Fed expand its balance sheet. Translated, my friends, this means the Fed is going to print money to buy treasuries so the Fed can go on lending to all these ailing institutions.

Is it any wonder that gold, after getting hit in recent weeks, rallied over $100 an ounce in 10 hours on the same day of this announcement? This is just the beginning, and I’m sure we’ll see much higher prices in tangible assets as the dollar heads south.

It’s also no accident that on the same day China’s People’s Daily was on record stating that the world was “threatened by a financial tsunami.” Its message was that countries need to start building a new financial order that is not dependent on the U.S. and the dollar.

And it doesn’t stop there. Prince al-Walid bin Talal from Saudi Arabia said he will not be making any investments in the U.S. This kind of talk is not friendly to the U.S. dollar. After all, if you were China or the Middle East, would you want to be paid by a printing press?

We will most likely continue to see deflation in financial products, but it seems as though inflationary forces will rule the day in tangible assets.

Four Major Trends Shaping Financial Markets: When Markets Collide

When Markets Collide, a new book out by Mohamed A. El-Erian, puts a fresh perspective on globalization and market dislocations. He is no stranger to global markets, coming first from the International Monetary Fund (IMF) and into the aggressive trading world of Solomon Smith Barney in London. Since then, he has been manager of Pimco’s emerging fund and served as president of the Harvard Endowment. Today, he has come back to Pimco, serving as co-chief executive and co-chief investment officer.

One is a realignment in global growth. For years, the U.S. consumer was the mover and shaker of global growth. The voracious appetite for goods drove global demand, but this is changing. The U.S. consumer is exhausted and now new players with big appetites are driving demand. China, India, Russia and Brazil are smaller players, but this transition from one massive consumer (the U.S.) to multiple consumers alters the playing field. The author describes this as a bumpy transition.

Another big trend is the return of inflation. We are moving from a world of disinflation into a world where higher costs for the things we need will become the norm. This is the transition from countries being only producers to now becoming consumers.

The third trend is how the innovation of structured finance has lowered the barriers to entry. He points out that, in the beginning, this can lead to destructive forces as overproduction and overconsumption take over. Think of the buildout of mortgages and the “mushroom” effect of derivatives. We are smack in the middle of this phase now where the time has come to clean up the excess.

The fourth area is the transfer of wealth that occurs as debtor countries become creditor countries. We can see this firsthand in China, Russia and the Middle East. It is evident in the large surplus of cash sloshing around in these areas. It is also responsible for the creation and liquidity of the sovereign wealth funds. These are massive funds formed by various governments who have budgetary surpluses and little or no international debt. These funds are then used for investment purposes, savings or to create a war chest for uncertain times.

Four Major Trends Shaping Financial Markets: Drivers of Change

A point made throughout the book is the idea that market participants are not typically adept at identifying and understanding the implication of anomalies in global markets. As a result, we become out of step with the big picture and continue investing in “yesterday’s world.”

He sees the new actors, instruments and products as “drivers of transformation.” They are the game changers, and they’re realigning the whole global system. It’s during this time that we will experience upheavals, shocks and ongoing imbalances as the world adapts to the new playing field.

Viewed in this context, the credit crunch and financial problems we have today make sense. The good news is, over time, a new secular paradigm will emerge that will have greater elements of stability.

Four Major Trends Shaping Financial Markets: Investment Opportunities

Mr. El-Erian explains these transitions and secular trends in a concise and logical manner. His conclusions make sense and many of his investment themes speak to the message we have been saying here in Taipan.

As investors, there are many important ideas we share with this book. First, we agree that inflation is going up and we need to own natural resources. The emerging markets now provide a “demand floor” for many commodities.

In addition, the continued emergence of new products will allow investors exposure to baskets of commodities, like exchange-traded funds (ETFs).

A second theme is to own companies outside of the U.S., as that is where the growth will be; and third, to own companies in parts of the world that have been recapitalized.

Originally published October 13, 2008.

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