With Mohamed El-Erian, Chair of President Obama’s Global Development Council, Chief Economic Adviser at Allianz, Author of The Only Game in Town: Central Banks, Instability, And Avoiding The Next Collapse
Mohamed El-Erian is chief economic adviser at Allianz (a multinational financial services company), the former CEO and co-chief investment officer at PIMCO, and author of The Only Game in Town: Central Banks, Instability, And Avoiding The Next Collapse. El-Erian serves as chair of President Obama’s Global Development Council and is a columnist for Bloomberg View, as well as contributing editor to the Financial Times and a member of their A List.
In 2009, Mohamed El-Erian and his colleagues at PIMCO predicted that economic growth would hit a slower “new normal” rate, which has largely come true and played itself out. He believes the “new normal” is coming to an end as the Federal Reserve maneuvers to extricate itself as the primary driver of economic growth— “the only game in town” as his book’s title says. So El-Erian sees the U.S. economy approaching what he calls a T junction, with some uncertainty ahead.
He also addresses the impact of negative interest rates in the Bank of Japan and added stimulus by the European Central Bank as a means to overcome structural head winds and force money into the economy, and thereby pushing investors into taking more risks and triggering the “wealth effect”. He likens this to being pushed into a marriage, which he says is more likely to meet with resistance than being pulled into a loving union. So he believes Japan’s move into negative interest rates may not yield expected results. Moreover, such moves have caused companies to deploy their cash towards non-growth initiatives such as buybacks, dividends, and defensive mergers.
El-Erian believes risk has migrated from the banking sector to institutions and households through the stock market. Since banks are highly capitalized and very cautious about lending, the risk now lies in the non-banking sector; so the Fed’s extricating itself from supporting the economy is causing higher volatility in the stock market. He also points to changing relationships between traditional asset classes. Oil and stocks now move in tandem. A drop in oil prices causes a sharp drop in stocks, making portfolio diversification all the more difficult. Looking ahead, he sees short-term volatility and urges investors to increase their cash positions to 25%-30% to weather a potential storm. In spite of that, El-Erian views U.S. stocks as a sound place to be invested in over the long-run.
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Steve Pomeranz: I’m really delighted to introduce my next guest. His name is Mohamed El-Erian. He’s chief economic advisor at Allianz and former CEO and co-chief investment officer at PIMCO; and at PIMCO, alongside of Bill Gross, he oversaw investment policies and strategies for all the company’s portfolio management activities. If you’re involved in the financial world, you know Mohamed’s name and the work that he has done. He’s very well respected. He serves as chair of President Obama’s Global Development Council. He’s a columnist for Bloomberg View as well as contributing editor to the Financial Times, and his new book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, was just released in January, and I welcome Mohamed. Welcome to “On the Money.”
Mohamed El-Erian: Thank you very much.
Steve Pomeranz: Your book has a very large scope to it, but let’s go back to 2009. You and your colleagues at PIMCO predicted that the economic growth for the coming 5 years, which is about as far ahead as anybody wants to talk about in the investment world, you predicted that the coming 5 years’ growth would be slower than normal, and you coined the term “new normal.” In fact, economic growth has been much slower than normal. It’s now 7 years since that proclamation. Are we still in the same new normal place?
Mohamed El-Erian: We are, but it’s getting increasingly exhausted, and it will soon yield to something else. Believe me, it’s very hard for me to say that, because having waited for so long for the new normal to go mainstream, and it has, now I suspect that it will no longer be as relevant to describe economic prospects as it has been.
Steve Pomeranz: Is it the old normal now? Is that what you’re saying?
Mohamed El-Erian: No. I’m saying that the new normal is part of what I call the T junction. Think of you’re on a road and you come into a crossroad, and what you know for sure is that the road you are on is going to end. We are seeing increasingly signs of this, but what comes next is not predestined. It depends on choices that we make. It’s a typical T junction. The new normal will end. We will no longer be able to secure the slow growth through experimental central bank policies, but what comes next is an open question.
Steve Pomeranz: When you say experimental policies, you’re referring to all the stimulus and the QEs and bond-buying and other things that the Federal Reserve has been doing since 2008?
Mohamed El-Erian: Correct. Think of the Fed having gone through 3 phases. Phase 1 was do whatever it takes, and that’s the phrase that the Fed used, also the phrase that the European Central Bank used, do whatever it takes to avoid a global depression.
Steve Pomeranz: Right.
Mohamed El-Erian: That required supporting the financial markets, the huge stimulus in combination with the federal government, and it succeeded. We avoided what would have been a very damaging global depression, and damaging not just for our generation but also for future generations. Phase 2 started in August 2010 when Chairman Bernanke and his colleagues realized that other policymaking entities were sidelined by political dysfunction. They took on massive economic responsibilities, recognizing that they didn’t have the right tools, so they had to experiment even more.
They told us from day one that it’s not just about benefits, but “It’s about benefits, costs, and risks,” and the longer we would remain with this excessive reliance on central banks, the greater the threat of collateral damage and unintended consequences, which takes us to the third phase we’re in now, which is that the Fed is trying to extricate itself very carefully from this prolonged reliance on policies that are having fewer benefits and higher cost and risks. We’ve gone through these 3 phases, and it all speaks to a simple reality. The Federal Reserve has been the only game in town, and our politicians have sidelined other policy-making entities with much better tools for what’s needed right now.
Steve Pomeranz: That’s a lot to digest, but it does explain the title of your new book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. Central bankers, though, in the United States are starting to extricate, to use your term, from the markets and from these experimental choices and strategies they’ve been using. Yet, we’re seeing overseas, we’re seeing central banks there still trying to stimulate like crazy to the point where interest rates are no longer just zero. They’re actually going negative, which seems very insane to me.
Mohamed El-Erian: Yes. This month alone, or this year alone, the Bank of Japan has followed the European Central Bank into negative territory, meaning negative interest rates, meaning that if you want to lend money, you actually pay for the privilege of lending money to somebody else. It’s absurd, but it is happening. In fact, about a third of outstanding government debt globally now trades at negative interest rates. We’ve also seen the European Central Bank press even harder on its stimulus, saying that it may even do more in terms of intervening in markets and buying securities and ballooning out its balance sheets.
Why? For a simple reason, multi-speed growth. We in the United States are lucky. Even though our growth rate is low, it is still pretty consistent, and we can rely on a much more flexible economy. Europe and Japan are overwhelmed by structural headwinds, including high unemployment, zombie companies, and, therefore, their central banks are not extricating themselves; they’re going in deeper.
Steve Pomeranz: I still don’t really understand how negative interest rates fosters growth. Are they forcing companies and individuals to take risk elsewhere because having your money sit at a bank safely earning interest, actually you have to pay the bank to hold your money, so they’re trying to force money into the economy?
Mohamed El-Erian: Yeah, it’s a little bit like being pushed into a marriage because you’re miserable being alone. What the central banks are telling us is, “You know what? If you want to stay in cash, I’m going to make it miserable for you, and I’m going to push you into taking more risk. I’m going to push you into buying stocks. I’m going to push you into buying corporate bonds.”
Why? Not because they see risk-taking as an end in itself, but they see risk-taking as boosting our natural markets so that when you and I open a 401 (k), we feel richer. If we feel richer, we go out and spend more. We trigger what the economists call the wealth effect. If we spend more, companies can invest more. Now that is the theory. The practice has been very different. Individuals have realized that being pushed into a marriage is not as good as being pulled into a marriage by love, so they haven’t been spending enough. Therefore, central banks, particularly in Europe and Japan, feel that they have to push more, but ultimately, it’s like pushing on a string.
Steve Pomeranz: Corporations which have amassed billions in their company because they were afraid of another 2008 where lines of credit were closed to them and they suffered quite a fear of economic contraction of their own businesses, they’ve been holding onto money, but they really haven’t been investing in new areas or new businesses. They’ve been buying back their own stock and really buying their competition to kind of bury their competition. Is that an unintended consequence?
Mohamed El-Erian: Yes, it is. In fact, it is striking that companies have cash earning zero. In some cases in Europe, they actually have to pay the bank to maintain their deposits. Yet, they are very hesitant to deploy it. When they’ve deployed it, they’ve deployed it in non-economic uses.
How? They have rolled back their stock. They’ve increased their dividends, or they’ve gone defensive and mergers and acquisitions. They’re not using it in a productive way. Why? Because of the uncertainty. They see great uncertainty ahead of them, and they want to maintain cash because cash gives you the optionality to make a mistake. If you’ve got cash, you’ve got resilience, so if you end up making a mistake, you can pay for it. Unfortunately, what makes sense for each individual company doesn’t make sense for the economy as a whole.
Steve Pomeranz: I think you would agree that U.S. Banks today are in terrific shape, and they have the money to meet probably the most serious financial challenges; but you quote Greg Ip in your book, and he says, “Squeezing risk out of the economy can be like pressing down on a waterbed, the risk often re-emerges elsewhere. So it goes with efforts to make our financial system safer since the financial crisis.” Where is the next risk that everybody I know, that I speak to, is so worried about, the next crisis coming up? You actually mention in your book avoiding the next collapse. If the banks are okay now, where is the next risk going to come from?
Mohamed El-Erian: You’re absolutely right and Greg Ip is absolutely right. Risk has both migrated and morphed and regulators are still playing catch-up with that. The first way it has morphed, it has morphed into being taken by institutions and by households to the stock market as opposed to being in the banking system. This is not 2008, and I think it’s important to stress that. This is not about the banks not trusting each other, about the payments and settlement system being paralyzed. The banks, as you say, are highly capitalized and are very cautious these days.
The risk now lies in the non-bank sectors. In particular, too many investors have taken too much risk, thinking that stock markets will always be supported by the central banks. I call it a BFF phenomenon, that too many investors believe that central banks are their best friends forever. Why? Because it has worked. There’s nothing more powerful than the stock market and a strategy that keeps on working.
Steve Pomeranz: Just buy the debts and you’ll be fine.
Mohamed El-Erian: Buy the debts because central bank’s got your back covered, but that is no longer as true. As we’ve talked about, one central bank in particular, and it happens to be the most important central bank, wants to get out of that business. As hard as the other central banks try to compensate, if the Fed is trying to get out of that business, there will be greater financial volatility and the higher the volatility, the more unsettled the investors and the less risk they’re going to be taking.
Steve Pomeranz: Now that’s an important takeaway for all of us, not to think that the Fed, especially in the U.S., is there to backstop us anymore. Expect the Fed to loosen the reins and expect more volatility, which isn’t necessarily the end of the world, but if you feel that investing is safe because it has been less volatile of late, get ready for more volatility. I think we’re already seeing that, right?
Mohamend El-Erian: Oh, we have. We have entered a period of much higher volatility, but also contagion, which is a fancy way of saying good companies get contaminated by bad companies. When the markets go down, everything goes down with it. Then when they bounce up, everything goes up with it.
Steve Pomeranz: Yes.
Mohamed El-Erian: We also are seeing something else that is unsettling. We’re seeing that the relationship between asset classes is changing, that oil and stocks have become codependent. We are seeing bonds, safe bonds, sometimes move with the equity market. The result of that is a diversified portfolio, which is what everybody should have, no longer provides you as much risk mitigation as it did in the past. That’s our new reality. We have been in a very artificial world where relationships have been distorted and now we’re seeing the consequences of that.
Steve Pomeranz: Okay. Looking at the average person who has been taught to take excess dollars, savings, especially that are long-term, put them into the equity markets. Over time, we’ve been rewarded by doing so. Now, we’re looking ahead and many are older now and concerned that if the old rules no longer apply, will this idea of stocks outperforming bonds and other investments over the long time, will that still be the case? Will that still take hold? What do I tell these people?
Mohamed El-Erian: There are 2 answers. There’s a long-term answer, and there’s critically the short-term answer. The longer term answer is over time, that relationship makes sense. Over time, American capitalism does prevail. Over time, a well-chosen portfolio of stocks will reward you. The short-term answer is as important, and it has to do with human behavior. We tend to do the worst things when volatility goes up. We tend to sell at the wrong time. There are 2 questions that every investor has to have clear in their mind. The first one is what is my starting position? In particular, have I taken on too much risk so that when I wake up and see the market down 15%, my instinct will be to sell? If the answer is yes, then reduce risk now. Take more of your money into cash. The second question that every investor should ask, and we don’t do that because it’s a very uncomfortable question, is if I make a mistake, can I afford that mistake? Because when the world has become unusually uncertain, to use Mr. Bernanke’s term, and when we’re heading towards a T junction, we are likely to make mistakes, not because we want to but because the world is so uncertain. It’s critical for us to be able to afford our mistake. If you put these 2 things together, I suspect that the average investor would want to have about 25% to 30% of their wealth right now in cash. It gives you resilience. It gives you optionality. It also gives you agility to respond when everybody else is rushing out of the market.
Steve Pomeranz: Okay. To hear more about this and to join the conversation, don’t forget to go to the website onthemoneyradio.org. Mohamed’s book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, is available in all sources. We’re going to continue our conversation with Mohamed in just a moment, so stay with us.