With Mohamed El-Erian, Chief Economic Advisor at Allianz SC, Chairman of President’s Global Development Council
The New Normal: On the Brink of Unwinding?
We are privileged to be joined today by Mohamed El-Erian, illustrious author and economist who is currently the Chief Economic Advisor at Allianz SC (parent company of PIMCO) and Chairman of The President’s Global Development Council. Steve begins the conversation by asking El-Erian to comment on an oft-repeated phrase used to describe the economy and markets: “the New Normal.” He explains that the “New Normal” is made of three elements:
- Sustained low growth instead of the usual cyclical bounce back.
- An outsized policy role for Federal Reserve meant to benefit markets
- Messy politics that portends uncertainty but doesn’t alter the growth and market equations.
Steve notes that the Fed’s actions stabilized markets and added liquidity to the economy, but this didn’t help the economy as much as it did markets, leading to an “uncoupling” of the two.
According to El-Erian, the “New Normal” is “feeding the element of its own destruction” and is in danger of imploding on its own contradictions. Either we pivot to much higher growth, or we face “something much worse” in the next two years because of the contradictions entailed in complex economies growing slowly and to the benefit of a small segment. These “economic, financial, political, and institutional contradictions” are the reefs and rocks on which markets and real economies may crash.
Trump’s Economic Policy and Markets
Steve comments on the perception that Trump’s stated goals of deregulation, tax reform, and infrastructure might be drivers of a “pivot to higher growth” that El-Erian has declared as being necessary to avoid the “something much worse” case. El-Erian concedes that a Trump and GOP-led boom is one possible scenario. He adds that this political moment (Trump’s and the GOP’s control of government) has arrived due a disruption in the normal political dynamics, one fueled by anger over the slow, unequally distributed economic growth. In the case of the US, as well as of other countries (particularly Europe (think BREXIT), this kind of political disruption is followed by a choice to pursue either high-growth policies or nationalistic, protectionist, growth-killing ones.
In El-Erian’s opinion, Trump so far has emphasized growth, despite all his talk in the campaign about abandoning free trade agreements and punishing foreign imports with tariffs. That said, in terms of concrete actions, Trump has been slow so far to roll out the detailed designs to promote growth, thanks in part to the complexity of policy making. The details are key, El-Erian argues, because tax reforms could actually end up being either good or bad, and likewise with deregulation and infrastructure programs.
After creating a package of new and detailed policies that can pass the House and Senate and become law, sustained implementation becomes the next serious challenge. Even though Trump has only been in office a few months, US markets have stalled because of a lack of details involving design and implementation of his pro-growth platform. Healthcare reform stumbled because the issues involved were too complex for a new administration to overcome. Whether it ought to be blamed more on poor timing and execution than a failure of policy, this setback has been interpreted as a bad signal for the rest of Trump’s agenda because GOP control of Congress couldn’t pass new healthcare legislation.
Markets and Economy Uncoupled
Steve mentions that many investors are worried that the stock market is too expensive because earnings are not accelerating enough to keep pace with rising stock prices. El-Erian says that markets are decoupled from fundamentals because of two anomalies: one is the gap between soft data (described as household and corporate sentiment) which is “off the charts” positive and hard economic data like production, wages, and employment, which is lagging. The second anomaly is the fact that financial risk taking is strong while economic risk taking is weak. Economic risk taking refers to businesses investing in “capital goods” to build their capacity. This is a longer-term growth strategy, one undertaken when businesses are optimistic about the future of the broader economy. Based on the market’s bullish run in the past few months, El-Erian believes that it appears to be betting on “good soft data becoming good hard data” and that economic risk taking will follow in the footsteps of greater financial risk-taking.
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Steve Pomeranz: Mohamed El-Erian is well known and very well respected. He’s the Chief Economic Advisor at Allianz SC, Chairman of the President’s Global Development Council, and he was Chief Executive and Co-Chief Investment Officer of PIMCO. His books include The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, which we’ve discussed with him on the show before.
And I’d like to welcome him back to discuss the current market conditions and the economy. Welcome back, Mohamed.
Mohamed El-Erian: Thank you, it’s a huge pleasure and an honor to be back with you.
Steve Pomeranz: Thank you so much. For years, people have been talking about the new normal. We’ve heard that over and over again from pundits and from economists alike, what is the new normal?
Mohamed El-Erian: The new normal evolves into having three major characteristics. The first is that economic growth would be unusually low for a very long time. Meaning that the economy wouldn’t bounce back in a cyclical manner from the global financial crisis, but rather growth would be weak and people would be surprised repeatedly by how weak growth would be.
The second element is that central banks will take on enormous policy responsibility. And that will be good news for markets because they would decouple markets from the underlying weakness in the economy. And the third element has to do with politics that make it messy but wouldn’t fundamentally alter the growth and market equation.
Steve Pomeranz: Yeah, so there’s a lot there. So, normally when economies go under recession, it kind of corrects a lot of the imbalances. And you get this kind of “V” —this bounce to a higher, stronger economy after that happens, but the new normal was that was muted. There was an economic muted response, we had slow growth.
And then the central bank stepped in and kinda stabilized the economy and put liquidity into the economic systems. So, stock markets did really well, which decoupled the returns on the stock markets. It didn’t really reflect what was going on in the real economy, and then the other aspect was politics.
So now you recently wrote an article and said that the new normal is over, so what does that mean?
Mohamed El-Erian: Yeah, I said that the new normal is feeding the elements of its own destruction. And that within the next two years, we would have to pivot either to much higher growth or to something much worse.
And that has to do with the contradictions that are fueled by growing complex economic systems at low speed and having the benefits of that growth go to a small segment of the population. You just simply get too many economic, financial, political, and institutional contradictions.
Steve Pomeranz: So, one of those drivers of this pivot from low growth to much higher growth has been the promises of the new administration.
This idea of lowering taxes and lowering regulation and infrastructure spending. So, do you think a lot of this pivot banks on the success of that?
Mohamed El-Erian: And that’s one scenario, yes, the reason why we’re even talking about it is because we’ve had an internal political disruption. And that’s because people get angry when the economy grows in a slow and non-inclusive manner.
So you’ve had the disruption here in terms of the election of Donald Trump as president. You’ve had it in the UK with Brexit, you have it in other parts of Europe with the growth of the anti-establishment movements. So, the first element is you get an internal political disruption. The second element is you get a choice, either to pivot towards pro-growth policies or to slip into nationalism and protectionism.
What we’ve seen so far from the Trump administration is more of the former, in terms of announcements, than the latter. We’ve had both, but the former has dominated the latter. And that’s why the market initially embraced the Trump rally and took stocks significantly higher.
Steve Pomeranz: Wow, okay, well, the Trump administration also has played the nationalist card quite strongly as well. But their main focus and the market’s main reaction has been with the agenda of, as I mentioned, lower taxes, regulation, and infrastructure spending. In your view, how’s that going?
Mohamed El-Erian: Slowly, we’ve seen and we’ve heard, I should say more accurately, the announcements, but we’re lacking two things. One is detailed designs, and policy making is complicated.
So, it’s really important to see what the details look like, because, remember, you could have good tax reform or bad tax reform. You could have good deregulation, you could have bad deregulation, certainly, with infrastructure, so detailed design matters. And then the next step after that is sustained implementation.
And the reason why the markets paused after the initial enthusiasm is because announcements haven’t been followed as yet with detailed design and with implementation.
Steve Pomeranz: Yeah, so the first major legislation that came out of the chute was the healthcare legislation, and we know what happened with that. And then there is concern that the taxes are next, and that’s going to be, perhaps, a difficult strategy to accomplish.
What are your thoughts, I mean, do you think that—you know, it’s really early in the Trump administration—I mean, it hasn’t even been 100 days yet. And so many people are forecasting the death knell of this and that, but what do you think?
Mohamed El-Erian: Yeah, I think it’s early days, and one has to be careful not to extrapolate too much.
Having said that, healthcare signals two things, one is that the sequencing was wrong. Healthcare is inherently complicated, it has a very long history. Going with something complicated first meant it was a higher risk strategy. The second element of the healthcare issue is that it showed that you can’t go from Republican majorities to clear sailing for legislation.
That that doesn’t follow automatically. And that, for the market, was a bit of a surprise, because the market assumed that with the Republicans now having a majority in both houses of Congress that gridlock was behind us. And we got a reminder that politics is a lot more complicated than what simple numbers tell you.
Steve Pomeranz: A lot of people are talking about the current high levels of the stock market. People sense that we saw this big run, but we really haven’t seen the earnings accelerating yet to justify this large increase since the election. Many are quoting Shiller’s CAPE Index, which shows it as being at the highest level since ‘08 or ‘07, and 1999, which were these big tops of the market which were followed by some pretty significant declines.
What is your thinking about the current level of the US stock market relative to earnings?
Mohamed El-Erian: It remains decoupled from fundamentals, and that’s what the Shiller Index and other measures pick up, and that’s because of two anomalies. The first anomaly is the difference between what economists call soft data and hard data.
Soft data is sentiment, and household sentiment and corporate sentiment is off the charts, but it’s yet to be reflected in the hard data. The hard data is actual production, wages, employment. So, the first big distinction is between soft data and hard data. The second big distinction is between financial risk taking and economic risk taking.
Financial risk taking is again very high, and you see this in the stock market. Economic risk taking, which is, are companies willing to invest in new facilities, in new equipment? It hasn’t yet picked up, and there’s a reason for that. Financial investors believe that they can change their mind and change their portfolios.
Steve Pomeranz: Yeah.
Mohamed El-Erian: Companies know that their decisions are much longer termed. So when you put these two things together, the market is really betting on, first, good soft data becoming good hard data. And second, economic risk taking picking up to be more like financial risk-taking.
Steve Pomeranz: Stay with us, I’m gonna be back with Mohamed El-Erian in a moment.
We’re gonna continue to discuss the stock market. We’re gonna talk about interest rates and also the prospect for a pivot or the pickup in the economy going through 2017 through 2018.