In 2000, it was technology stocks. In 2007, it was real-estate prices. Among today’s overvalued asset classes, which one will crash most spectacularly when the bubble bursts?
Mohamed El-Erian, the chief economic advisor at Allianz, says it is “liquidity.”
El-Erian was the keynote speaker on February 3 at the Boston Security Analyst Society’s annual market dinner. Prior to his current position, El-Erian was the CEO and co-chief investment offer (along with Bill Gross) at PIMCO. PIMCO is a subsidiary of Allianz.
“I don’t think we realize – even though we’ve been warned a few times – how little liquidity is actually available if there is a need for major repositioning,” he said.
We’ll look at why El-Erian is concerned about liquidity, but first let’s review his forecast for the U.S. economy, emerging markets, the asset-management industry and the country he said faces the greatest geopolitical risk.
Getting to escape velocity
Since 2009, El-Erian has consistently addressed whether the U.S. economy has reached “escape velocity” and fully emerged and delivered from the depths of the financial crisis.
Despite 5.6% unemployment (he spoke before Friday’s figures were released), a budget deficit less than 3% of GDP and almost three million new jobs created last year, El-Erian said it was “questionable whether the U.S. can actually get to escape velocity.” The economy, he said, may not be able re-attain the growth path that it was on before the crisis.
The U.S., however, is the only global economy that is strengthening, he said. He credited entrepreneurship and a lower exposure to geopolitical risks for the relative strength of the U.S. economy.
Europe, he said, only implemented a serious banking system stress test in 2014, something the U.S. had done in 2009. He described the European Union as an economic system that is supposed to have four legs, but operates on only one and a half. The EU has a monetary union and half a banking union but lacks fiscal and political integration.
Getting to escape velocity, El-Erian said, “drags back potential growth. It becomes an issue for our kinds.”
According to El-Erian, three factors are holding back U.S. growth: ineffective fiscal policy (insufficient investment in infrastructure, labor market incentives and tax reform), a lack of willingness on the part of the government to spend aggressively and some sectors of the economy that remain overleveraged.
He claimed that economists might only disagree with him as to the relative contributions of each.
These issues, he noted, cannot be addressed by the Fed or other central banks. “What central banks can and have been doing is buying time for the system to heal and buying time for the politicians to hopefully make the right decisions,” he said.
“We should thank them for avoiding a global depression. But we should not expect them to be able to deliver good outcomes. They simply don’t have good instruments for that,” he stated.
According to El-Erian, slow growth will lead to political instability. Evidence can be seen in Europe, where extreme political parties are gaining popularity in Germany, France and Spain. In Greece, he said, an extreme party has already seized power.
“When you get stuck in a global equilibrium and the system is perceived not to deliver solutions, then people start looking for alternatives,” he said. “Greece is systemic in terms of how political environments will destabilize.”
Instability is also evident in central bank policies, according to El-Erian. He said that three central banks – Switzerland, Singapore and Denmark – whose brands “spoke to predictability and stability” did “strange things” very recently. Switzerland removed its peg to the euro on January 15, Singapore unexpectedly eased on January 28 and Denmark cut interest three times in the second half of January.
El-Erian worries most about Russia because it faces the greatest systemic risk. Cold-war political fears – rooted in the spread and potential use of nuclear weapons – are no longer relevant, he stated. “The advantage of nation states is that you can bring them to the negotiating table,” El-Erian said. The major fears have shifted to non-state actors, such as those who are engaged in the uprising in the Ukraine.
“We’ve learned that we are in a lose-lose situation, certainly for Ukraine,” he said. “It is also lose for Russia. Russia right now is imploding.”
Sanctions could escalate. El-Erian said that “the West is at risk of being on the receiving end of counter sanctions from Russia.” This could reduce the supply of energy to Europe. Europe gets approximately 33% of its oil and 39% of its natural gas from Russia, as of 2007.
“It’s not clear to me how you get out of this situation,” he said. “I don’t know it is all priced in to the market, and I don’t even know how you price it in.”
The future of the asset-management industry
“We live in a world in which correlations have become unstable and unpredictable,” El-Erian said. “Products no longer deliver what they used to deliver and therefore, so solutions become something that clients need.”
He said that the investment industry is already moving from a product- to a solution-focused approach. Asset allocation will gain in importance. He said that asset managers will also need to adapt to evolving customer needs, including a greater frequency of updates and altering client-service models as clients age.
Active management still has a future, he stated, but firms will need to target specific asset classes “as opposed to trying to be active in every single space.”
“There is going to be a tremendous alpha opportunities – positive and negative – in a world that is evolving and structurally changing. I don’t think it’s passive that’s going to win,” he said. “I think it’s getting the right mix and being able to concentrate your process on your high-conviction bets and not get involved in trying to do too much with too little.”
Medium-sized firms are threatened, he said, because they lack the economies of scale of larger firms and the agility and flexibility of smaller firms. He predicted consolidation among asset managers as a result.
The U.S. equity market rally is in “extra innings,” El-Erian said, “but the game can go on for quite a while.”
Investors should gird themselves for higher volatility, he advised, adding that three quarters of the days since the end of the year have had triple-digit moves in the Dow average.
El-Erian would reduce his U.S. equity allocation relative to other developed markets, but would keep an exposure to emerging markets. Valuations there are attractive, but emerging economies will be unstable because central-bank policy changes in the developed world will trigger unpredictable capital inflows and outflows.
Outcomes – not just for investments but in a broader sense – are no longer normally distributed, according to El-Erian. Human beings have trouble dealing with the alternative, which are outcomes that are bifurcated, with “fatter tails” and a higher likelihood of extreme events.
He predicted that people will react in one of four ways when faced with a bimodal distribution: they will have a “complete blind spot” and fail to recognize the distribution; they will average out the extremes; they will succumb to inertia and rely on recent history of events; or they will recognize that they have to do things completely differently.
The first three groups will get things completely wrong, he said, and only the fourth group has a chance of success. El-Erian said the best example came from boxing when Mohammed Ali faced Foreman. George Foreman in the “Rumble in the Jungle” in 1974.
Ali was past the prime of his career and was an underdog. But, according to El-Erian, his team recognized that he was facing a bimodal distribution; he could win by a “miracle,” or would lose and face a high probability of injury. Ali changed his training to ensure that he could defend himself early in the fight against Foreman’s blows, in part by positioning himself against the ropes.
This worked, and by the eight round Foreman had become tired, enabling Ali to knock him out. “That is one of the best examples of people realizing you can face an increasing probability of bimodal outcomes,” El-Erian said, “but you have to have the resilience and agility to adapt.”
To illustrate his contention that the most mispriced risk premium in the market is liquidity, El-Erian reminded the audience of the events in May 2013. Ben Bernanke warned that Fed might taper its quantitative easing policies. The word “taper” was new to the investment vocabulary, he said, and it caused “major market dysfunctions,” particularly among less liquid asset classes like emerging markets.
“We don’t realize how little liquidity is available if there is a need for a repositioning,” he said.
Changing market dynamics have increased liquidity risk, he said. The prevalence of regulators and risk controls mean that investors no longer view positioning themselves counter-cyclically as a good thing, he said, and are more inclined to be pro-cyclical. In the “old days,” El-Erian said that end users were very small and intermediaries very large; now their sizes have converged. So the pipeline – market liquidity – has to serve more people, he explained, “but it’s much smaller.”
“What happens? It gets clogged,” he said.
Doubters should look at the Russian corporate market where trades are extremely difficult to execute. “Try to find someone willing to take that risk,” he said.
El-Erian is undoubtedly accurate about the underestimation of liquidity risk. That is not peculiar to the current market, however. Under any conditions, the least liquid asset classes will face the greatest stresses in a severe market downturn. That is especially true among asset classes widely held by retail investors who can demand daily redemptions, as with ETFs and mutual funds.
Liquidity risk may be heightened because of elevated market valuations and a higher probability of a market downturn, but that should not be a surprise to anyone.
Read more articles by Robert Huebscher