Mohamed El-Erian, chief economic adviser at Allianz, expects a fundamental shift in the global economy that will either result in a powerful economic boom or in renewed tremors at the financial markets.
In the world finance, there are few people as highly respected as Mohamed El-Erian. Not only is the chief economic adviser at Allianz well versed when it comes to navigating the global financial markets, he’s also brilliant at explaining complex developments in a comprehensible way. The most prominent example is the concept of the «New Normal» which he and his colleagues developed in early 2009 when he was at the helm of Pimco together with Bill Gross. Today, this concept of a new economic reality, defined by slow growth and super low interest rates, is widely accepted. However, Mr. El-Erian predicts that the New Normal won’t continue much longer. He sees significant changes ahead that will either lead to a powerful economic boom or to a recession with renewed tremors in the financial markets.
Dr. El-Erian, the phrase New Normal has become a broadly accepted concept for today’s dull economic environment with slow growth and historically low interest rates. Will we ever be able to leave the New Normal behind?
The New Normal was based on the notion that the financial crisis wasn’t just a flesh wound but that it was something deeper, that it was structural rather than just cyclical. At the time, this concept was resisted by conventional wisdom and it was very difficult to get it accepted because the advanced economies had lived mostly in the cyclical space. It was the developing countries that lived in the structural space. So the mindset in the advanced economies was all about cyclical and the focus was all on temporary, targeted and transient measures.
Why didn’t those policy measures help?
What my colleagues and I at Pimco were trying to suggest was that the recovery wouldn’t be in the shape of a V. It would more look like an L or U because the West had the wrong growth model. It was based on finance as opposed to genuine growth drivers. Therefore, it would take time to develop genuine growth drivers.
How much longer will this take? Since, the financial crisis almost ten years have passed.
Today, the notion of the New Normal has become conventional wisdom and it acquired two other names: Secular Stagnation or, as the IMF calls it, the New Mediocre. A lot of people are extrapolating forward the New Normal, but I can’t. The reason why is because the New Normal has sown the seeds of its own destruction. When a sophisticated market economy like the one we have in advanced countries grows for a very long time at a slow pace and that growth is also not very inclusive, things start to break. They break economically, they break socially, they break politically, and they break financially. In order to say that the New Normal will last another five years, you have to say that these breakages won’t matter, but they do matter.
Then again, we’re also seeing some encouraging signs for a global synchronized recovery.
I think this uplift is real because we have four important engines of global growth all kicking into a higher gear: The US is growing at 3.3%, Europe is looking at a 2 to 2.5% growth rate for the first time in a very long time and you have Japan and China which has stabilized at a new growth rate of around 5 to 6%. This does bode well for the first half of 2018.
And beyond that?
What’s more uncertain is how durable this recovery is. Part of it reflects healing, part of it reflects temporary factors.
What does that mean for the outlook on the global economy and on the financial markets?
Rather than seeing the New Normal continuing I think the world is nearing a tipping point. We are heading toward a T-junction which has three fundamental implications: One is, that the road we’re on is going to end. The second message is that what comes afterwards is very different from what we’ve had. And the third message is that it can be one of two things. So it’s a bimodal distribution with two modes: really good or really bad. We either tip into high and inclusive growth or we tip into recession with renewed financial instability.
When will we get to that tipping point?
I think within the next two years we are going to tip one way or the other. The probabilities are pretty equal and that’s what makes it very hard for decision making.
What will define the direction in which we are going to tip?
The major difference will be what the politicians do. It’s not an economic question, it’s a political question. When you grow an economy slowly and in a non-inclusive way, the politics of anger take over and you get improbable outcomes like Brexit, the election of President Trump in the US or the difficulties chancellor Merkel is having in coming up with a new coalition. The list is long. Sometimes the politics of anger result in growth reform candidates likes President Macron in France, sometimes they result in a very disruptive outcome like Brexit. But the politics of anger starts dominating which means that the political establishment becomes less secure.
Nevertheless, some fears didn’t come true. A year ago, the financial markets were deeply worried about the elections in France, in the Netherlands and in Austria. But none of these countries elected the populist candidate of the far right. Isn’t this fear of a populist wave overdone?
I don’t call it populist, I call it anti-establishment. There’s a big difference: In France, the anti-establishment candidate won. President Macron ran on the formation of a new party called «En March». Not only did he win the election, but his party swept the national assembly and the establishment parties got hit very hard. Brexit was an anti-establishment vote, as well and President Trump was an anti-establishment candidate. So it’s not populist, it’s anti-establishment.
What are the consequences of these anti-establishment movements?
The anti-establishment-movement is like a technological disruption: It shakes the system to a better or to a worse equilibrium. In the case of Macron, what you see is a shake to a better equilibrium. In the case of President Trump, we are starting to see congress take on measures that it hasn’t been able to take on for a very long time. That’s why Brexit is going to be very important.
What’s so important about Brexit?
Brexit can be used by both, the EU and Britain, to get things done. The EU needs to move on a lot of things and Brexit has been like a wake-up call. Britain was never in on the EU like in a full marriage. Britain viewed the EU as a big free trade zone. Germany on the other hand, views the EU as an ever-closer union; economically, socially and politically. These are two very different visions and there are going to be continuous clashes between these two visions. So now, once you navigate the short-term difficulties, there’s an opportunity to actually work on new visions that are compatible with Britain outside the EU.
What will it take to seize this opportunity?
For Europe, there are four critical elements: The implementation of pro-growth structural reforms, balancing fiscal policy within Europe, acknowledging that in certain cases like Greece there is too much debt and regional as well as global policy coordination. The Eurozone is supposed to be like a chair with four legs. But instead it’s a chair with a leg and a half. The complete leg is the monetary union and that works well. The half leg is the banking union and that must be completed. But then there are two other legs where you need political decisions on: fiscal integration and better political integration. There are regional and global policy coordination issues that have to be addressed.
What are the chances that this gets done?
One good outcome of Brexit and the anti-establishment vote in France is that it’s focusing people’s minds on what Europe needs to do. Now, you have the possibility of a Merkel-Macron leadership in Europe. Germany has the ability to be the leader of Europe but doesn’t have the willingness. It’s more hesitant. On the other side, France has the willingness to lead but doesn’t really have the ability because its economy is weaker. Put them together and you have both: willingness and ability. So there is a significant window that has opened up in order to get things done.
And what about the US? How are the tax cuts going to impact the American economy?
I think it’s important that we are getting a tax bill. The corporate tax changes are important, and they can generate growth. The key question is what will companies do: Will they react positively and not give back the windfall to shareholders via stock buybacks and via dividends or via mergers and acquisitions? Will they invest in new plants, in new equipment and in people training? So the focus is going to shift on companies and I’m actually quite optimistic that you can get a growth response.
Like in 2017, investors will be watching carefully what happens in the political world in 2018. What’s your take on the financial markets after an exceptionally good year?
Markets have been conditioned to buy every dip, regardless of how elevated asset prices are and regardless of how decoupled asset prices are from fundamentals. That can continue for a while. It takes a lot to derail this market because that strategy to keep buying the dips is very simple and it has been very profitable repeatedly – and there is nothing that markets like more than a simple strategy that is repeatedly profitable. But when it stops, there’s an air pocket that comes afterwards.
What could cause such an accident?
The question is what it takes to change the conditioning of investors: the belief that every dip is a buying opportunity. This conditioning is so deep that you need not just a shock but a major shock to shake people. One possible source for that could be a big geopolitical shock. We have a very unusual geopolitical situation. North Korea is unpredictable and it’s very difficult for markets to price in North Korea. Also, you have the changes going on in Saudi Arabia that are very important. So you have a whole host of geopolitical factors that we have to monitor.
What else could cause such a major shock?
A policy accident. Most economists would agree that today they understand less about three important things than they ever have in their careers: Productivity, wage determination and inflation which outgoing Fed Chair Janet Yellen called a «mystery». These three things which are critical to the economy and to policy making are very uncertain. So when you have this high degree of uncertainty the risk of a policy mistake goes up.
Where do you spot the biggest risk of a policy mistake?
Because the engines of growth in the advanced world are not very strong, no country or region is willing or able to live with an appreciated currency for a long time. Switzerland feels this more than anybody else. When a currency appreciates and stays strong for a while it’s like a hot potato: you want to throw it to somebody else. You saw this in 2017 again: The dollar appreciated and come January, President Trump complained about the currency being too strong. So the hot potato was thrown to the ECB. Then, the Euro appreciated, and you heard the ECB saying the currency was too strong. So the hot potato keeps being thrown around and that’s because the genuine growth engines are not strong enough.
What’s more, for the first time since the financial crisis central banks are getting serious with respect to policy normalization. Will this go well?
In the advanced world, we have three categories of central banks: One is the Fed which has raised interest rates for a fifth time in December. It also has stopped buying securities and it has started a plan to reduce its balance sheet. Borrowing a phrase from Ray Dalio in another concept, all this has been what I call a «beautiful normalization». That means the Fed has been able to do all this without disrupting the financial markets and without derailing economic growth. That’s a big achievement and my view is that this can continue.
What about the other categories of central banks?
The other extreme is the Bank of England. If you think of the Olympics with degrees of difficulties, the Bank of England is facing a very high degree of difficulty. It has the worst winds for any central bank and that’s stagflation: inflation going up and growth being stagnant. That puts a central bank in a very difficult policy position.
And who’s in the middle of this spectrum?
In the middle category you have three systemically important central banks: The ECB, the Bank of Japan and the People’s Bank of China. All three are starting to feel more confident about normalizing policies but they have a lot more challenges than the Fed. So the key question for the global economy and for the financial markets in 2018 is what happens if not just the Fed but up to four systemically important central banks try to normalize monetary policy at the same time. If it’s just the Fed, chances are pretty good that it can accomplish a beautiful normalization. But if it’s four central banks that are systemically important it raises a lot more challenges for the global economy and for the financial markets.
Additionally, there are important changes in leadership. In February, Jerome Powell will take over at the Federal Reserve and soon rumors will start swirling about the succession of ECB chief Mario Draghi whose term ends in 2019.
Add to that the People’s Bank of China and the New York Fed. So you have a whole change in leadership in systemically important central banks. At the end, it comes down to your view of institutions and there are two views: The first is that when you change people you change institutions and therefore every single change becomes very important. The second view is that institutions influence people: No matter who you are, when you step into the ECB, into the Federal Reserve, into the New York Fed or into the People’s Bank of China there is a whole institution with a large staff and research team and processes that influence you. So you get a lot more continuity than you would have otherwise. I think that second characterization is the correct one. Where it is challenged is when we hit a crisis. In a crisis, individuals matter a great deal because they have to make quick decisions.
How do you experience these discussions personally? Rumor has it that the White House is considering you for vice chair at the Federal Reserve.
I’m going to be disappointing and I apologize. Let me just say that when I read the news that I was among several candidates, I was very honored to be on that list. That’s all I’m going to say.
Let’s switch subjects then. How should investors prepare themselves for that upcoming T-junction you described at the beginning of our conversation?
Going back to this bimodal distribution we talked about at the beginning, investors have to be able to navigate both outcomes until we have better indications as to which way we are going to tip. So you have to cope not just with uncertainty but with unusual uncertainty or radical uncertainty, as Mervyn King, the former governor of the Bank of England calls it. In such cases, behavioral sciences can help a lot and there are three types of mistakes when it comes to decision making: denial, reframing and something called active inertia.
What do you mean by that?
The best example of active inertia is IBM. On the eve of the PC revolution, IBM had identified that the PC is going to be extremely disruptive to their business model. They understood that they were facing a bimodal distribution and that they no longer could operate in the same way. So they came to the conclusion that they needed to occupy the PC space and that they needed to take their mainframe upstream. This strategy was correctly identified. Also, IBM was the leading brand in technology, had massive research and development budgets and was very profitable. And yet, IBM almost went bankrupt. Why? Because when they tried to implement this strategy they got pulled back into the existing processes. The result of that was that IBM got eaten alive, first by Compaq and then by HP. Had they not completely reinvented themselves they wouldn’t exist today.
What can investors learn from that?
You need a lot of scenario analysis and you need to ask difficult questions. That is not just «what can go right?» We love asking that question. We’re also good at asking «What kind of mistake can I make?» But the question we never ask is: «What mistake can I not afford to make?» This is a very difficult question to ask because you are identifying massive failure and we find that very hard.
So how can we avoid a massive failure when it comes to the composition of a portfolio?
You have to have this combination of resilience and agility. It’s called a barbell portfolio. So as public markets become more and more expensive, you take some of that money and put it into cash and cash equivalents. This is your resilience part.
And what’s with the other side of the barbell?
The other distribution requires great resilience: You want to stay in the game because the longer you are in the game the more opportunities you have. 2008/09 was a perfect example of that. If you could stay in the game which means not being forced into doing bad things at the wrong time you had massive opportunities. Today, you have these opportunities in investments that other people cannot access as easily. Examples would be the mortgage markets in developing countries or venture funds that invest in infrastructure. But most people find this difficult to do because such investments are not easily accessible. That’s why they get pulled back, like IBM in the early 80s, into doing more of what they have been doing.