El-Erian Warns: “My Main Worry Is Europe”

Authored by Christoph Gisiger via The Market,

Mohamed El-Erian, Chief Economic Advisor at Allianz, warns of more struggles ahead for the European economy. He points out that negative interest rates are causing more harm than good and cautions of over-promised liquidity in the financial markets.

Can it get any better than this? That’s the question investors are asking themselves after an exceptional year. Despite a slowdown in the global economy and increasing trade tensions, almost every asset class is up for the past twelve months.

Mohamed El-Erian is convinced that the world is nearing a tipping point. According to the internationally renowned economist who coined the term «New Normal», the faith of the global economy depends on a successful hand-off from monetary to fiscal policy and structural reforms. Otherwise, the world will sink into a mire of financial volatility and political collapse, he fears.

«As good as the ‹New Normal› was for the last ten years, I don’t think it will continue during the next ten years», says Mr. El-Erian in an extended interview with The Market.

In his view, Europe is getting much closer to a fateful junction. If the European economy hits stall speed, chances of a recession are increasing, Mr. El-Erian argues. Furthermore, he cautions that the U.S.-China deal will be a short-term truce since trade is no longer just about economics but also about national security.

Mr. El-Erian, investors are looking back at an amazing year with many turns and twists. What’s ahead for the financial markets in 2020?

There’s a tendency to what I call a «one issue market», meaning the market embraces a single issue and is influenced by that issue most of the time. For a long time, this issue used to be Central Banks, then it has evolved into trade. Trade will continue to be an important issue, even with the recent short-term truce. We have pressed the pause button on globalization. Now, the big question is if we press the play button again and continue to globalize as the market is assuming or if we step towards pressing the rewind button on globalization and deglobalize. That uncertainty is not going to go away. It’s going to be with us for the whole of 2020 because trade is no longer just about economics. It’s also about national security.

What do you mean by that? More restrictions against China when it comes to technology like the ban against Huawei?

Technology is at the forefront of that, because technology focuses on the issue of national security. But it’s just an illustration of a much bigger evolution: Because the trade dispute has lasted for so long, it has expanded to include things beyond economics.

What’s the endgame in this evolution?

I don’t know. I worry that we have entered a period of deglobalization and that’s concerning because neither the global economy nor the financial markets are wired for deglobalization. So I’m not as optimistic as others that the mini-deal between China and the U.S. will lead to a long-term resolution. We have weaponized the economic tools, and the minute you do that, it’s very hard to step back.

Why is it so hard to step back?

If you talk to people in Washington two things strike you: Number one, both parties agree on addressing long-term grievances they hold about how China practices certain elements of trade. These are grievances Europe has as well, namely intellectual property theft, forced transfer of technology and joint venture requirements. China has been slow in dismantling them. This is not an issue of President Trump, it’s something that unites Republicans and Democrats. Where they differ is on the method. Most people think that the US should have pursued a unified approach with Europe. The second thing that strikes you is this phrase «If not now, then when?» There’s a real possession that this is the time to press not just free trade, but a fairer trade system.

What does this mean for the economic outlook?

Around the end of 2017, almost everybody had bought into what was called a globally synchronized recovery. I was warning against that because it was just individual factors that contributed to a better outlook in the short-term. The fundamental structural integrity of the global economy was still weak and what was needed was pro-growth policies. Then, we got this global growth scare and a lot of people started predicting a U.S. recession. I dispute this view, because the consumer and the household sector are too strong to get a recession in the U.S. So what we’re going to continue to see is weak growth and divergence: The U.S. will continue to do ok, but my main worry about the global prospect is Europe.

Why?

Many people are saying that European economic data is bottoming out and we’re going to get a V-shaped recovery. But there’s a risk we’re going to see an L-shaped course, and that the Eurozone gets stuck with growth rates of 1% or less. That’s not fast enough, given the structural and financial vulnerabilities. Ironically, Europe is now recognizing that monetary policy is not the solution. People agree that more negative interest rates are likely to cause more harm than good. Also, people have identified policies for a hand-off from an excessive reliance on Central Banks to a more comprehensive growth strategy. But the problem in Europe is politics: They don’t allow for a quick implementation of these sorts of measures.

There is a lot of talk that Germany could implement a major fiscal stimulus program. What are the odds of such a «big-bang» approach?

I think that’s very hard to do. Not only is the political situation complicated, but one part of the German economy is just fine: the domestic sector. There’s a strong view that a broad-based fiscal stimulus would be problematic because the domestic sector is going to do well, and the issues in the manufacturing sector are due to the trade war and specific challenges facing the auto sector, neither of which is addressed by fiscal stimulus. So the argument that we are going to get a major German fiscal stimulus is going to prove too optimistic. I do think we’re going to get a small, environmentally oriented, green infrastructure program. But Germany needs something more on infrastructure – and the political system is not ready for that yet.

And what about China? China’s economy is slowing down and we’re seeing a rising wave of bond defaults.

People underestimate the extent to which China needs the global economy to navigate what is a very tricky development transition. It’s called the middle-income transition: going from a high growth to a moderate to low growth environment. It’s one of the most complicated transitions because when you are in a high growth environment, you do a lot of things that make less sense in a low growth environment. Already, we’re seeing some pockets of vulnerability come up. I don’t underestimate the difficulties that China faces, but compared to Europe, China politically has more policy flexibility. Over and over again, the Chinese have shown their political ability to correct course quickly.

Still, China is a state-controlled economy and history shows that central planning usually doesn’t end well.

To be clear: I wouldn’t give up the liberal democracies of Europe. They are a huge asset to Europe. The problem is that when the voters get angry the political system is delayed in reacting with reform policies. Structural reforms are good over the long-term, but they can involve short-term costs. So what happens politically in Europe is really the politics of anger, whether you look at Brexit, the difficulty of government formation in Spain or Italy, or the protests in the streets. It’s not just Europe, it’s also happening in countries like Chile and Columbia – well managed countries having similar issues because the electorate wants more, not just in terms of higher growth but more inclusive growth.

In the aftermath of the financial crisis, you introduced the term «New Normal». More than a decade later, this concept of a new economic reality, defined by slow growth and super low interest rates is still widely accepted. Are we ever going to escape the “New Normal”?

I remember exactly where I was at that time. It was in January 2009 and I was at a business meeting. People said: “This is not normal; this is not normal”. So I thought in my mind: “Yes, this is not normal, so it’s a new normal”. The idea was to warn against a cyclical mindset. People in the industrial world are used to live in what’s called a cyclical space. But this is not a business cycle.

What is really going on?

What’s going on in the advanced world is structural. It’s about productivity and growth potential. If you run complex liberal democracies at low growth for a long time, things start to break. So as good as the «New Normal» was for the last ten years, I don’t think it will expand the next ten years. We’re going to see a tip, and in Europe we’re getting much closer to it: If Europe hits stall speed in 2020, which is a growth rate of below 1%, the chances of a recession are increasing. Yet, with better policies, Europe can also bounce back quite quickly. So Europe is really heading for this tipping point or T-junction. The same is true for China and the US. But Europe is most advanced in that process.

In which direction do you think Europe is going to go?

The good news is that there is now an awareness that we cannot rely on negative interest rates. People understand that, at some point, negative interest rates become counterproductive: Savers save more rather than less because they’re not getting paid on their savings. You encourage too much risk taking in the financial world. You depress productivity because you allow for zombie companies to continue. And, you encourage inequality of wealth. So there is an awareness that we can no longer rely simply on the ECB. Also, most European economists agree on what’s needed. But it’s all an issue of implementation. What many of my European friends are most afraid of is that we don’t get implementation until things get a lot worse, until Europe actually goes into a deep recession.

Yet, investors are celebrating easy monetary policy once again. In the US, the Federal Reserve has cut interest rates three times this year and is injecting a ton of liquidity into the financial system.

It’s amazing: Today a year ago, the Fed raised interest rates once more and indicated continuing raising them in 2019. It also indicated that quantitative tightening was on autopilot. Now, they’ve lowered interest rates three times this year, and they started QE again, whether they call it QE or not. Interestingly, it’s not the economy that caused this turn. What changed was this very dramatic market dislocation in the fourth quarter of 2018. I call it a dislocation and not a sell-off because what Central Banks worry about is the functioning of the financial system. And, behind the 20% drop in the S&P 500 a year ago was an indication that certain segments of the financial markets will become illiquid. So what the Fed’s U-turn shows you is that the system has become addicted to continuous liquidity injection.

What does this mean for monetary policy going forward?

Central Banks increasingly are in a lose-lose-lose situation: They cannot step back and normalize policy, because the system is too addicted to liquidity. And, if they try to step back, they risk market dislocation. That’s the first loss. On the other hand, by doing more, they risk being counterproductive. So even though they’re forced to do more, they’re really uncomfortable about it. That’s the second loss. And finally, where they are now, they’re subject to attack. So they lose by going back, they lose by going forward and they lose by staying in an uncomfortable position. That’s why this hand-off to fiscal policy and structural reforms is so important.

What is the Fed going to do in this kind of pickle?

I don’t think we’re going to see a hike in 2020. The most likely outcome is that the Fed stays on hold for the whole year. If there is a change, it will be lower interest rates.

Speaking of liquidity issues: How concerning are the ongoing strains in the repo market?

The repo market is one of the most sophisticated markets as it deals with wholesale funding. That’s why everybody assumed that this market was in good shape. But then, we had two surprises:

• First, to the surprise not only of the public but also of the New York Fed – which is totally focusing on that market – interest rates spiked to 10%. That was a massive dislocation.

• Second, it has taken a very long time to calm the repo market. Even today, the New York Fed continues to inject massive liquidity to keep the repo rate down.

So we’re learning that after so many years of very big liquidity injections by Central Banks, the system has over-promised liquidity: You get these episodes of illiquidity in the midst of liquidity.

The turmoil in the short-term funding markets raises bad memories about the darkest hours of the financial crisis. Could we encounter a similar melt-down of the money markets today?

Today, we have the tools to deal with dislocations in the US banking system. I don’t worry about that. But for two reasons I worry about the promise of liquidity to non-banks.

The first reason is a structural change: Before 2008, the intermediaries were big and the end-users were small. So when the end-users collectively changed their mind, they could get balance sheet from the intermediaries. Now, because of a combination of regulation and market pressure, the intermediaries have shrunk, and the end-users have gotten bigger. So whenever there is a collective change of view, like in the fourth quarter of 2018, the intermediaries cannot absorb that through their balance sheet, and we get market dislocations.

And what’s the second reason?

In certain segments, particularly in the ETF market, there’s over-promised liquidity. An ETF is an implicit promise of instantaneous liquidity at reasonable bid/offer prices. That’s why it makes sense to offer ETFs on liquid markets. But it doesn’t make sense to offer ETFs on segments of the high yield market or on segments of emerging markets. They may be liquid today, but their underlying liquidity is fragile.

Nevertheless, 2019 turned out to be one of the best years ever for investing. What kind of performance can we expect in 2020?

I’ve been calling it «living the dream» because we’ve had three things that are almost impossible to get together:

• One, you’ve had almost a 30% increase in US stock market indices.

• Two, on the whole, volatility was very low.

• And three, you’ve also made money on your risk-free assets.

So the correlations have broken down, everything has worked for investors. The reason is liquidity: The relaxation of monetary policy by the Federal Reserve and the ECB boosts all asset prices. They’re buying the risk-free assets which pushes investors to buy the risky assets, so everything goes up.

How long can this «dream» go on?

Going forward three or four years, this cannot continue. So this is a very good time to go up in quality: favor strong balance sheets and reduce exposure to illiquid asset classes that could get disrupted, like certain segments of the high yield market and emerging markets corporates. For example, two years ago, Argentina issued a hundred-year bond at 7,9% which was massively oversubscribed. Then, suddenly Argentina went into troubles and that bond came down quickly to trading at 30 Cents on the Dollar because no one is making the market as the price goes down. That’s because there are two types of investors in these assets: The dedicated investor who understands how these markets function, and «tourist investors» who come in because they’re attracted by the higher yield. The latter don’t understand the higher yield very well but it’s much better than what they get elsewhere. So when a problem occurs, they want to get out at any cost – and that’s why you get this massive gap in prices.

What should a prudent investor do in this kind of market environment?

If you’re like me and expect volatility, you want to have some cash to pick up good opportunities at cheap prices. So as you get rallies, you sell companies with weaker fundamentals and you do two things: You allocate some of that money to attractive opportunities and you build up your cash. People forget that cash performs multiple functions in a portfolio: First, it performs as a risk mitigation. Especially when yields are so low, it’s important to have cash as a risk mitigator. Second, cash gives you agility. The fourth quarter of 2018 was the perfect example. You could have picked up the big technology firms like Microsoft at very cheap prices. These firms are attractive when they sell-off big because they have very solid balance sheets, they are massive cash generators and they’re in a growing business.

Where else would you watch out for opportunities?

Markets overshoot on the way up and on the way down. That means sell-offs offer opportunities to take advantage of distressed situations trading at bargain prices. For instance, as much as Argentina is distressed, when that Argentine bond was trading at 30 Cents, the market had overshot. Here’s another example: There are Turkish multinational companies with assets outside of Turkey that are very reliant on Turkish banks. Since Turkish banks are lending less, you can lend to these companies with collateral outside of Turkey at double digit interest rates. And then, there is the issue of getting closer to the real economy: We are seeing more and more people co-investing in direct lending vehicles where you can find value as well. So it’s all about slowly re-orienting your portfolio because very short-term I’m constructive.