How long can the good times last?

Mohamed El-Erian does not see a recession coming this year, but he’s moving more of his personal portfolio into cash

January 3, 2020 BY JEFF BENJAMIN

Mohamed El-Erian, chief economic adviser at Allianz and former chief executive at Pimco, believes the United States is riding a “liquidity wave” that can’t last forever.

With that in mind, he recommends advisers embrace a combination of “resilience, optionality and agility” to navigate several unprecedented realities of the current global economy.

We sat down with Mr. El-Erian in December for a candid conversation about everything from global monetary policy and what’s driving the stock market’s historic run to how he’s allocating his personal portfolio and which team he thinks could win the Super Bowl.

Jeff Benjamin: What factors continue to hold up this historic stock market?

Mohamed El-Erian: There are three things keeping it so strong. One is massive liquidity support from central banks, which has been turbocharged by strong corporate balance sheets that have allowed for significant M&A activity.

Two is the hope of a handoff to more comprehensive pro-growth policies, particularly in Europe.

And three is the fact that it has been the most unloved rally, which means it has had technical support throughout its duration.

JB: Is the U.S. economy heading into recession anytime soon?

ME: I’ve repeatedly dismissed the notion that the U.S. will fall into recession in 2020. In fact, given the strength of the household sector, it’s hard to get the numbers to show a recession unless you assume a massive policy mistake or a very big market accident.

Without that, the U.S. will continue in a 1.5% to 2.25% growth range. I’m much more concerned about recession when it comes to Europe.

I think there’s a general complacency around the economic risks facing Europe. And I think that there’s a high probability that Europe will hit stall speed, which means show growth rates of around 1%, but that won’t be fast enough to overcome headwinds. That will be followed by a recession.

JB: President Trump’s tax cuts: good or bad?

ME: The combination of deregulation and tax cuts is one of the reasons why the U.S. has economically outperformed other advanced economies.
Economists disagree on two things regarding the tax cuts: Were they efficient and were they fair. There should be a lot of disagreements on these issues.

What they don’t disagree on is that tax cuts have given a short-term boost to economic growth in the U.S.

The longer-term boost has come from the deregulation measures. And the hope, which remains a hope rather than a reality, is that the third leg of this pro-growth policy effort would be infrastructure spending.

JB: How worried should we be about the threat of global trade wars?

ME: One of the big uncertainties of 2020 and beyond is whether we have simply pressed a pause button on globalization or whether we are pressing the rewind button on globalization.

If it’s just a pause, then the market is right to react short-term to every indication of where the discussions between the U.S. and China stand.

If, however, this is a much bigger process, a secular process, then the market must ask the question that it has not asked itself, which is how do you rewire the global economy for de-globalization?

That is such a basic question, and it’s one that the market has not dealt with yet.

JB: Is that a big part of the risk in the financial markets right now?

ME: I view it as one of the major uncertainties. What we have in the financial markets is short-term supportive dynamics and major long-term uncertainties. And these uncertainties speak not only to the globalization issue, they also speak to the effectiveness of central banks, they also speak to the collateral damage and unintended consequences of all this liquidity that has been pumped into markets, and they speak to the political uncertainties, where we are seeing country after country move more toward inward-oriented policies that have less respect for the global rule of law.

JB: What is your take on the roughly $13 trillion worth of negative-yielding sovereign debt outside the United States?

ME: Negative-yielding bonds, an issue that was dismissed in most textbooks until it became a reality, are yet another example of the unthinkable becoming fact. And this list of unthinkables is getting quite long. They include not just negative-yielding bonds, but negative policy rates in much of Europe. The fact that the U.S. has gone from being the champion of free trade and globalization to be the most protectionist advanced economy is among other unthinkables.

So far, we have dismissed as a marketplace each of these as noise, and we have not taken the more valid interpretation, in my opinion, which is that they are signals of underlying tensions in the global economy.

As to the direct answer, a prolonged period of negative rates would break a market-based economy. And we are already seeing concerns grow about the unintended consequences of negative rates.

They start with the extent to which they undermine the financial system — not just banks, but most importantly the providers of long-term protection services, financial protection services to households, including life insurance and retirement plans. These are very difficult to run at negative rates.
Secondly, they encourage excessive risk-taking by nonbanks.

Third, they support what I call zombie companies and therefore retard the process of rejuvenating a capitalist economy.

And fourth, they encourage economywide misallocation of resources.
I think even within the [European Central Bank] today, which has been the main proponent of the negative rates policy, they are starting to question the equation of benefits and costs and risks.

I believe the benefits of negative rates have become overwhelmed by the costs and risks, and I believe that we are going to look back on this period of negative rates as being problematic to the functioning of a market-based economy.

JB: Could we see negative bond yields in the U.S.?

ME: I think that’s very unlikely because the Fed fully understands the risks and the costs. And secondly, it’s very unlikely because I do not believe we’re going to go into recession.

I do think one of the reasons why U.S. yields have been so low is because they have been depressed by what is happening in Europe.

JB: How concerned are you about the nearly $4 trillion balance sheet the Federal Reserve built up through several rounds of quantitative easing in the immediate wake of the financial crisis?

ME: The Fed has a very large balance sheet, and after a period of attempted normalization, it has reversed again and is now increasing that balance sheet. It is not calling it [quantitative easing], but the markets have behaved as if it is QE.
The reality is, there was an attempt at normalization. But it turned out that the markets did not want normalization, and they forced the Fed into a very dramatic U-turn at the end of 2018, and now we’re seeing an expansion again, not just in the Fed balance sheet, but also in the ECB balance sheet, which is a contributor to how well equities did in 2019.

JB: You were recently quoted saying you are building up cash reserves in your personal portfolio. Does that suggest you’re feeling risk-averse?

ME: Like many other investors, I have benefited from a very unusual trifecta, which is, one, significant returns; two, correlations that have broken down in favor of investors, in the sense that both risk assets and risk-free assets have gone up in price; and three, extremely low volatility.

Having said that, the longer this trifecta continues, the greater the risk of a change. So what I have done is very slowly and very gradually reduced my exposure to public markets, both equities and fixed income, and allocated that reduction to two alternatives.

One is cash, which provides two things in this environment: risk mitigation and the optionality to pick up good companies at depressed prices should we have a liquidity event.

Then, with a smaller portion of the reduction in exposure to public markets, which has been very gradual and slow, I’ve looked for two types of opportunities. One is distressed situations where the sell-off far exceeds the worsening fundamentals, and second is what I call market failures.

What it looks like from the outside world is a gradual move to a more barreled approach. The middle of the curve is slowly coming down. One side is the true risk-free asset, which is cash, and that’s going up. The other side is the less liquid, more opportunistic exposure, and that’s slowly going up.

JB: What is your general outlook on this year’s presidential election?

ME: I’m not a political scientist and I don’t have views on how the election will play out, because I think there’s lots of uncertainties.
What these elections represent is what we have seen play out over the last few years and is also playing out in Europe, which is the difficulty of the political center to gain traction and a greater attractiveness to political positions that are on either side of the political center.

We see this in terms of the lack of traction so far for a centrist candidate, and we see that in terms of the support that President Trump, and Elizabeth Warren and Bernie Sanders combined, attract. That speaks of a more general phenomenon, which is, years of growth — that has been too low and insufficiently inclusive — has been hollowing out the middle distributions politically, economically, socially and institutionally.

That is a phenomenon that will continue to play out until we get a pivot to higher and more inclusive economic growth.

JB: What do you view as the biggest areas of concern going into 2020?

ME: Whether they apply only to 2020 or 2021 is hard to say because timing is really difficult in technically driven markets, and we are in technically driven markets that are underpinned by liquidity.

But I worry about a few things. One is the big medium-term uncertainties we talked about earlier: globalization, policy effectiveness, political support for rule of law, weaponization of economic tools. There’s a lot of uncertainties.

Second, I worry about the big valuation gap that has appeared between high market prices and struggling fundamentals. And I worry that the gap is getting bigger and bigger. I worry that the system has overpromised market liquidity to the end users, that we have seen a proliferation of less liquid products that are liquid for now.

And what we have seen in the past is when the paradigm of liquidity changes, you get contagion. In other words, when investors can’t sell what they want to sell because there isn’t enough liquidity, they’ll end up selling what they can sell, and that generalizes liquidity strains.

JB: What about areas of opportunity in the year ahead?

ME: In the short term, it’s about being able to continue to ride this liquidity wave. Over the long term, I think you want to have the combination of resilience, optionality and agility.

Resilience to navigate a potential liquidity shock without having to sell things you don’t want to sell.

Optionality to keep your mind open as to the timing of the transition from supportive short-term dynamics to more uncertain medium-term issues.
And agility to act quickly when opportunities arise, which will be name-specific to begin with and then asset-class-specific thereafter.

JB: Setting aside your loyalty to the New York Jets, what’s your prediction for this year’s Super Bowl?

ME: My fear is that it will be the Patriots again. As much as I respect the coach and the quarterback, they appear recurrently in my nightmares. If you are a beaten-down Jets fan, you’ll understand why.

My hope is one of the NFC teams — whether it’s the 49ers or the Saints or the Green Bay Packers — one of the NFC teams will ultimately prevail.

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