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Hi Fools,

I’m excited about the potential discussion we can get going on When Markets Collide by PIMCO Co-CEO/Co-CIO Mohamed El-Erian, the third book in our Global Gains curriculum.

Anything in the book is up for discussion, but I wanted to put out a little background on the book and three discussion topics to get us started. With that said, let’s get going!

Why it was chosen
When Markets Collide, was selected to cap the first section of the GG curriculum, because of the up to date view on where global markets stand today and the roadmap it provides for the future. As a former emerging markets bond manager at PIMCO, CEO of the Harvard Management Company, and IMF staffer El-Erian has a diverse investment background and provides a broad look at the changes global markets are experiencing, why the changes are happening, where we’re likely to end up, and how investors can successfully navigate the coming years.

Some things worth discussing
As I mentioned above anything in the book is open for discussion, but I thought I’d kick things off with the three themes I found the most interesting.

1. Sea change
One of El-Erian’s overarching themes is that the world is going through an economic sea change where developing economies are gaining in importance and some developed economies could find their standing in the world reduced (in absolute and relative terms) if they don’t adapt and compete in the new world.

El-Erian sees regulators and international institutions such as the IMF and World Bank having to change and adapt too. For example an IMF that walks in and puts emerging countries on a rehab plan in exchange for loaning funds at a reasonable rate isn’t very useful when so many emerging economies sit on substantial reserves. There’s also the interesting dynamic of developed countries having weaker balance sheets, but having more control over institutions such as the IMF.

In this area El-Erian also points out that some of the unusual economic events that we’ve experienced in the last few years such as equities rallying at the same time the yield-curve failed to respond to interest rate hikes in 2005 aren’t “noise,” but valuable data points that provide insight to the changes we are experiencing.

Another example is how well emerging markets have held up relative to developed markets in the credit crisis. This isn’t because they’re de-coupled from the U.S. -- their growth has slowed or turned negative too. But in the past a contagion would be more likely to start in these markets or easily spread into them. In this crisis emerging markets have actually been a stabilizing force, because they were able to put their own safety nets and stimulus in place, because their economies are fundamentally stronger.

2. Where we’re going
It’s no longer sufficient to just understand the US, Europe, and Japan, emerging markets must be considered and investors that ignore them are likely to suffer from subpar returns. The growth of these markets is the primary reason, but it’s also because their consumption is increasingly determining trade flows, and how they and their sovereign wealth funds allocate their reserves has an effect on asset prices globally.

El-Erian sees the combined strength of multiple emerging market growth engines gradually becoming more important than the big economic growth engine of the US. This is a when it happens event, not an if it happens. How bumpy the ride is for the global economy as these engines ramp up depends on how long it takes for the world to recognize the “sea change” and adapt to the fundamental changes that are happening.

One example is how long will it take for the G7 to give stronger emerging markets more of a voice in economic discussions and planning. El-Erian also thinks it is important for emerging markets to realize that in some cases what is best for them and the global economy might not immediately be what’s easiest to implement or the best short-term solution. China’s effort to rely less on exports and more on domestic consumption is one example of this.

3. Managing risk
Since markets and investors are likely to go through an adjustment period or multiple adjustment periods in coming years El-Erian sees risk management as a critical tool all investors need to have handy. El-Erian admits that even with short positions and buying puts this can be difficult for retail investors to do at a reasonable cost. And in the case of shorts can add risk. Many institutional investors that can afford to regularly buy insurance (puts for example) don’t, because they hate the on-going cost / "negative carry."

In Chapter 8, he does provide an example where PIMCO entirely avoided Argentina in 1999 - 2001, because they feared a default was unavoidable. That’s a strategy anybody can implement, but it’s still unconventional. Many peers went “underweight” Argentina instead, which is to say if an index held 15% of its funds in Argentina the fund manager might hold 10% or 12%. They argued avoiding the market altogether was going too far, and risked missing any potential recovery. PIMCO stuck to its strategy, but hedged a potential recovery by searching for investments that do well when Argentina does well (ie. Highly correlated investments). The strategy worked out well, because Argentina did default and the average position fell 65%. I think there’s a strong argument that the smaller and less integrated the investment you’re trying to avoid is, the better this strategy will work, but it’s one more risk management strategy to consider.

What are your thoughts?

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