Mohamed El-Erian: Putting It All Together
In Part IV of the series of reports from the 10th annual Strategic Investment Conference, presented by Altegis Investments and John Mauldin, Mohamed El-Erian ties together the views of the previous presenters. You can read the previous presentations by clicking the links below.
I want to try and build on what you have heard so far. I want to focus, in particular, on two statements that have been made so far at this conference.
- The need to put the pieces together
- To make sure we give ourselves a chance to win.
So, how do we put the pieces together to give us the best chance to win? I will try and give you an answer.
If you knew nothing of the markets, and just showed up at this conference, you would be very confused. The world is awash in contradiction with stocks rising to new highs as interest rates reflect a slowing economy. It is an upside down world.
Individuals are both excited and anxious. They are excited by the rally in the markets as they see their portfolios increase in values but at the same timed overwhelmingly concerned about the economic future. It is a world with an enormous contrast between the markets and the real economy. That is the world we are navigating and it is incredibly unusual. This is why it is an unloved rally.
Therefore, I want to provide a simple framework to reconcile these issues. The long term view matters greatly - but the short term matters also.
First, acknowledge that we are here, in terms of current policy, for a good reason. Most countries are shifting from a growth model based on leverage and credit creation to trying to find a new growth model based on new realities. Emerging markets are shifting from exports to internal growth. Developed economies are shifting to a lower growth economic cycle due to ongoing deleveraging.
These shifts require assistance from the Central Banks. However, this assistance leads to disconnects.
"The question, however, is what the “hand off” from assisted support to organic growth will look like and when will it come?"
"The hand off is the 'destination.' The 'journey' is getting there. Investors must invest for both the journey AND the destination. Investing for only one part will lead to unhappiness during the journey or pain at the destination."
At Pimco this reality is what we call the “stable disequilibrium.” The world will not reset in cyclical manner and a “new normal” has arrived.
The look of the “new normal” is that the West will be stuck in a low growth and high unemployment cycle for quite some time to come. Conversely, the emerging world will continue to bounce back and begin to close the gap between wealth and incomes.
There are three speeds to the “new normal.”
- Slow: Europe and Japan that will live continue to live through lost decades.
- Medium: Countries like the US are healing - but not fast enough to get obtain “escape velocity.”
- Fast: Emerging countries with strong balance sheets and favorable business economies.
This is the reality of the world that we live in today. If this three speed theory is correct then there are three questions that must be answered:
- Can it persist and for how long?
- Will it add up?
- What do you do about it?
Yes, it can persist but not forever.
The timing, which is tricky, differs on where you look. For example, in Europe, Cyprus tells you much about the entire European structure. The Troika is no longer operating in an efficient manner. The creditors are also tired of supporting the Eurozone as they see no end to the checks they are writing.
Likewise, the debtors are tired from adjustment fatigue. The problem is that the majority of Eurozone countries not only lack growth but, much more importantly, they lack a growth model.
The financial markets don’t care because there is the ECB. Whatever happens - the ECB, as Mario Draghi promised last June, is willing and able to support them. However, the ECB only supports the journey – not the destination. The Eurozone is nearing the end of its journey and they will soon be forced to make tough choices. They will be forced to either opt for a stronger, and smaller, Eurozone which will begin to grow again, or, fragmentation which will end miserably.
In the U.S. - the Fed is fully engaged in artificial support to give the system time to heal. There is no question that the economy is healing. Corporations, banks, and housing are all healing. If this continues it will allow for a handoff from supported growth to real growth. If the structural problems don’t improve then we will slip back into a slow growth economy.
Emerging markets will either continue surge or slip back to moderate growth.
So, the reality is that when you live in an interdependent world your competitors are your friends. In an independent world your competitors can bring you down. The world, today, is unlike what we have ever seen before. Unfortunately, global policy coordination is really non-existent.
Historically, when the core has been weak there has been someone to step in to support it. After WWII the U.S. stepped in to support Europe. Today, with the entire world weak – there is no one large enough to support the core.
When it comes to investing the majority of recommendations to investors is not based on fundamentals but rather stocks are cheaper than something else. This is potentially very dangerous.
What Should Investors Be Doing
Ride the central bank wave. The more intervention done by one Central Bank forces other countries to do more. The Fed forced Japan into its policy shift. Japan has now forced the ECB to move further.
The Central Banks have little choice other than to continue on their current trajectory. They cannot get to their objective unless they make you feel better by boosting confidence.
However, it is also important to understand that all waves eventually break. The question is whether you crash or “walk off” the surf board. This wave will crash. When it does it will depend on how you are positioned that will determine whether you suffer or not.
Secondly, there are other waves out there. There are too few people looking for other waves where central banks cannot reach. In these areas there is genuine growth potential. These include selected currencies, bonds and other types of assets.
Third, understand that past models are broken. The world today is far different that it has been historically and therefore new models must be built.
Fourth, you cannot disconnect the markets from the fundamentals forever. There is a limit and when the reversion of markets to the fundamentals occur the devastation to capital will likely be severe.
Fifth, do not give up liquidity cheaply. In the world today it is very binary. It will either end well, or very badly, with no middle ground. Optionality and liquidity is the key to surviving and profiting from a binary world.
Finally, realize that risk mitigation is going to have to evolve. Cost effective tail hedging is going to be critically important. This is a choice that all investors must make: Do you leave some capital on the table as markets rise or suffer large capital losses later. The choice is critical.
Why is it that the Pimco’s of this world are not disciplining a system that is becoming more and more artificial? Why do we allow the manipulation?
In a classroom you can discipline a single a person. However, if the whole class misbehaves it is an entirely different issue. Currently the whole class is misbehaving and that is a very different paradigm than what we have seen in the past which has led to unprecedented, unproven and untried interventions that are likely to have far reaching outcomes.
Investors that are overly invested in stocks will eventually pay a very high price for taking on excessive risk. We are approaching the end of the journey for this experiment and it will either result in a return to organic growth or economic disaster. The problem is that we really don't know which it will be. What we do know is that eventually, regardless of the outcome of these monetary experiments, the disconnect between the fundamentals and the markets will revert which will prove painful for unhedged investors.