Mohamed El-Erian warns of the consequences of a rise in inflation and higher interest rates. In addition, the internationally renowned economist who coined the term «New Normal» explains how he navigates through today's challenging market environment.
Hardly anything can unsettle the markets: Whether it's a potentially more dangerous mutation of the coronavirus, the Democrats’ surprising majority win in the U.S. Senate or the images of an angry mob storming the U.S. Congress: the bull market in stocks continues undeterred.
However, Mohamed El-Erian sees one risk that could get investors into serious trouble. «One of the most under covered stories is what’s happening to the US yield curve,» says is President of Queens' College, Cambridge and chief economic adviser at Allianz, the corporate parent of PIMCO where he was CEO and co-chief investment officer.
In this in-depth conversation with The Market/NZZ, which has been edited and condensed for clarity, Dr. El-Erian explains why growing inflation expectations and higher bond yields could endanger the stability of the financial markets. He also discusses the outlook for the global economy and says how he navigates today's challenging stock market environment as an investor.
Dr. El-Erian, after last year's strong recovery, stocks trade at challenging valuations. What's your advice for investors who want to invest their money in a reasonable and prudent way in this environment?
The hardest part about this question is how to invest «in a reasonable and prudent way» because you have such an enormous disconnect between fundamentals and valuations. Most people understand why they are disconnected, and most people can see a way over a number of years where this disconnect is reduced by improving fundamentals. But the risk comes with what you do on the journey to get there.
What do you mean by that?
The global economy is going to look rather shaky, both for the fourth quarter of the last year as well as the first quarter of this year. With the exception of Asia, most countries will experience slowing economic growth, and in the case of Europe a double-dip recession. That has become clear because, once again, it is proving very difficult for countries in the West to optimize public health, normal economic activity and individual freedom at the same time. Switzerland is no different than the United States and many other Western countries. We are looking at a rough four months ahead even though we have a vaccine, the vaccine is getting deployed and it promises some sort of herd immunity down the road.
Yet, markets are looking ahead and are already celebrating the return to growth and to a more normal life. Rightly so?
Since stocks roared back from the lows of March 23, we saw many record highs. It’s important to recognize that the narrative justifying those record highs has changed. Before the pandemic, the narrative was that Trump was going to win, that we are going to have continuous tax cuts, and that companies are going to benefit from more deregulation. Then, that political narrative gave way to: We’re going to have a divided government, and that’s good for markets because it keeps the government out of the way. Next, the narrative changed again to: We’re going to have a blue wave and massive stimulus. Now, it’s all about the big reopening trade. When so many narratives are being used to justify price action, it tells you that the price action reflects something else completely.
So what’s the real reason for record high stock markets?
When you are an institutional investor and you put a lot of money in an investment, you ask yourself always one final question after you go through the fundamentals, the valuations and everything else: Who is going to buy after me? If the buyer after you is someone with a printing press in the basement, who has a willingness to use it, doesn’t care about valuation and isn't buying to make money, that is incredibly reassuring.
Does this mean that the bull market is based solely on the central banks' super easy monetary policy?
There was no doubt that two central banks in particular, the Federal Reserve and the European Central Bank, are going to provide ample and predictable injections of liquidity, and that they are going to be continuous buyers with no limit to how much they can buy and at what price. That is the reason why we’ve seen prices going from one record high to another despite completely changing narratives. Forget about the «great reopening», the «Trump trade» and all this other stuff.
What are the ultimate consequences of these permanent liquidity injections?
We have stumbled into very unhealthy codependences; codependences between central banks and investors, between central banks and debt issuers which are governments and companies, and between central banks and politicians. They are all in this unhealthy codependency. It’s like a bad marriage: They’ve ended up relying on each other, and they just don’t know how to get out of it. Every time the central banks have tried to get out of it, the markets were at risk of becoming disorderly. Remember: When Chairman Powell came in, he tried to reduce the support of the Fed for the markets, but then he had to do a massive U-turn in the fourth quarter of 2018. When Christine Lagarde came in at the ECB and made that comment about Italy, she had to make a U-turn within a day.
How long can this go on?
I don’t think central banks quite realize how much irresponsible risk taking is going on. In 2010, Ben Bernanke talked about the benefits, costs and risks that come with unconventional policy. He added, the longer you maintain it, the lower the benefits, the higher the costs and risks. This was ten years ago. At that time, Bernanke was thinking of unconventional policy as an economic bridge. Now, it has become a destination.
What are the implications of this change?
There is abundant evidence that the beneficial economic implications are low, and the costs include irresponsible risk taking, higher inequality, distortion of financial markets such as negative interest rates and misallocation of resources. There is abundant evidence, but no one knows how to exit. Every time, central banks even hint at exiting, the markets become disorderly.
Does that mean investors can't actually do anything wrong, because central banks will always bail them out if the worst comes to the worst?
It depends. There are certain things that central banks clearly buy: investment grade paper and government debt. In the case of the Fed and the ECB, they even buy high-yield respectively peripheral debt. All these assets are under a strong central bank umbrella. You can stay under that umbrella, and you are fine. But investors tend to be greedy. In their mind, they have stretched the coverage of the umbrella to include other asset classes, for instance emerging market debt. But the further you go away from the umbrella, the higher the default risk - the one risk central banks cannot protect you against. It’s reasonable to continue betting on central banks. Yet, valuations are leading you to be less and less cautious - and that’s going to be the big balancing act in 2021.
There are more and more signals suggesting inflation will return this year. How would the markets react to such a scenario?
One of the most under covered stories is what’s happening to the US yield curve. It’s on a consistent move up, and that puts the Fed in a very difficult position, because if it allows the curve to continue to steepen it can undermine financial stability. If the Fed wants the yield curve to stop steeping, it has to implement yield curve control, or what they like to call yield curve targeting. But yield curve targeting is a huge step in policy. It would distort the US Treasury market completely. So keep an eye on this, because this is starting to get to dangerous levels.
This week, the yield on ten-year Treasuries rose above 1% for the first time since March. What’s behind this development?
People are starting to get more sensitive to inflation risk. We have gone through a massive move of disinflation, of downward pressures of prices. It has to do with our behavior, and I call it simply the Amazon, Google and Uber effects: Amazon allows us to disintermediate the middle person in the supply chain, and that lowers pricing power. Google makes us smarter and much more price-sensitive consumers which again limits how much we can be charged. Uber is about using existing assets like cars more efficiently, increasing supply in a way that limits price hikes.
And why could these trends change now?
The assumption has been that these forces are repeatable. But now, with new regulatory actions and other factors, it’s not clear that we will get the same disinflationary effects on the supply side. The nightmare for the Fed and the markets is that you get less disinflationary supply side effects, demand takes off and we get more inflationary demand side effects - and the market is starting to sense that.
However, the Fed recently declared overshooting inflation its new target of monetary policy. How high can interest rates rise before central bankers get nervous and intervene?
That’s hard to tell. All I know is that this Fed is very concerned that they will lose their influence on markets. The central banks want more flexibility, but the political system is going to want to give them less flexibility. For years, the Fed hasn’t been able to achieve its 2% inflation target. So why are they willing to aim even higher now? It doesn’t make sense, but it shows that they are in this paradigm that’s very difficult to exit from. The Swiss national bank has that issue too. It’s not easy to be in the periphery of an ECB. But that’s the way it is.
Just a few weeks ago, the U.S. Treasury Department classified Switzerland as a currency manipulator. Is this action justified?
I was very surprised to read that, and I didn’t quite understand why the US did this. Switzerland is just trying to manage through the monetary policy regime it is importing from the European Central Bank. It puts Switzerland in an almost impossible situation because this is not something that the Swiss National Bank has free choice in.
Does the verdict from Washington have serious consequences?
The real question is if this will be used for something else. I don’t know, but there are all sorts of things the US can put pressure on Switzerland, for example banking sector reform. The risk is less with the incoming Biden administration. The Trump administration clearly showed its willingness to weaponize tariffs and investment sanctions for non-economic reasons. I don’t know whether the Biden administration would have the same inclination to weaponize, but if we had four more years of Trump, I would be much more worried for Switzerland than I am now.
Under Trump, the conflict between the US and China has intensified significantly. Unlike a year ago, however, China is in a better economic position today than America. How will this situation evolve further in 2021?
You are looking at a marathon, and after the first few kilometers, China is clearly in the lead. China is in the lead because it doesn't have to worry about individual freedoms. It has an ability to control people's behavior that the West does not have. Additionally, other Asian economies like Korea and Taiwan have a sense of collective responsibility that you don’t get in the US or Europe. Here, policy makers have to worry about normal economic interactions, public health and individual freedoms. The Chinese government doesn’t have don’t have to worry about individual freedom, and solving a two-variable equation is much easier than solving a three-variable equation. So it’s not surprising that China is sprinting out in this marathon of recovery much faster.
Then again, a marathon is an endurance discipline. In the end, the winner is the one who manages his energy best. Is it possible that China will run out of breath on the way?
In this world, the trouble of going slower is you end by people dying. Then again, in the past, China was always able to use the global economy as a tailwind, and it facilitated reforms. Last year, China has not been able to use the global economy as a tailwind. For the most part of 2021, it will not be able to use it either. That means China will only be able to continue to sprint if it accelerates reforms. So as they go further into the marathon it’s going to be harder to keep the same lead. Today, people are extrapolating China’s growth in the past to predict that China will be the largest economy by 2035. I wouldn’t do that just yet.
Against this background, where do you see opportunities for investors?
Honestly, I’m really happy that I don’t manage other people’s money. That’s because I know I would go back to doing something that is very tactical in nature: I would be like a surfer on a wave, knowing that the liquidity will end at some point, but going to be on it for as long as I can. I would look around and see that many other surfers are riding the same wave, and I would start wondering what happens if we get into each other's way or if the wave breaks. So I would be a very nervous investor.
What are you doing now when it comes to putting your money to work?
I always think of three levels of investments. In the old days, the first two were big, and the third one was small. These days, the first two are small, and the third one is big. The first level refers to the secular position, investments that I believe will work out over time. For me, technology was a secular position, and emerging markets as well. These are now fully valued. Therefore, my allocation to them has become much smaller. The second layer is what I call structural: Certain areas in the investment world that are attractive because of some market imperfection. There used to be many of these. Inflation protected bonds for example, because many people did not understand them. Now, they are gone as well.
And what about the third level?
The third level is tactical, opportunistic. Like everybody else, I have become much more opportunistic. But I’m very cautious. Think of me as an uncomfortable investor. And that’s the problem now: I don’t take as much risk as everybody else because I have a much lower risk tolerance. For instance, I don’t buy treasuries for my risk management. I stay in cash, because in Treasuries, once you go beyond three- or four-year maturities, you face the potential of higher yields and lower prices. It’s become a very different world.
Do you still find attractive investments at all?
Unless you’re under the central bank umbrella, you have to do a lot of granular analysis to make sure you have another form of resilience. I put a lot of emphasis on balance sheet resilience, on the ability to manage through a liquidity crisis. That’s really important because companies have gone on a huge borrowing spree. They have borrowed enormously and you have to go into that balance sheet to understand what’s the nature of this debt. So the granular analysis is a very granular credit analysis. That’s the first element.
What is the second element?
It’s important to understand liquidity: Understand, where people would want to go. For instance, I don’t have any particular understanding of Bitcoin. But it was clear to me that when Bitcoin was below $5.000 that this was a purely technical effect: You had a lot of people who had bought for the wrong reasons and they were all being shaken out. Then, at $19.000 I sold. I didn't know if the rally would end, but I wasn’t comfortable anymore. Today, Bitcoin is at more than $36.000. So I got that completely wrong, but I understand why I got it wrong, and I’m willing to live with that mistake. You have to be very clear about the liquidity risk you’re willing to take and you’re not willing to take. Right now, people are taking enormous liquidity risk. They think that this wave we all surf on is going to last forever, that it won’t break at all.
In which areas do you also see risks in this regard?
High yield debt. People have a relative mindset. It’s like in this story where dad comes home and declares to his family that he just bought a dog for $30.000. Of course, the family is stunned. But he declares: «It’s one of the best deals ever, the cat was selling for $50.000». When you have a relative mindset, things get totally disconnected. Just take Greece: People are buying Greek bonds at negative yields. Why? Because they say it’s a yield pick-up relative to German bonds. Liquidity encourages a relative mindset; you start really mispricing things. Then, one day, you ask yourself a different question: Is a negative yield compensating me for credit risk in Greece? Of course, it’s not. But we never know when the relative mindset changes to an absolute mindset.