In the coming year, U.S. investors will have to shift tracks as they adjust to a different set of risks and opportunities. Many of the concerns relating to the trade war with China and uncertainty over Brexit have diminished, but new ones have surfaced. Globalization is no longer about just economics, but also about national security and human rights — and it could take a 180-degree turn, potentially hurting emerging economies. Investors have in recent years experienced buoyant stock markets, especially in the U.S., as central banks persisted with expanding liquidity. But the liquidity spigot could be turned off as central banks step back, increasing volatility and making stock-picking more challenging. Investors would then gravitate away from passive, index investing to more actively manage their portfolios.
Mohamed El-Erian, chief economic adviser at Allianz, listed those and other factors as the key imponderables for investors in the year ahead in a discussion with Wharton finance professor Jeremy Siegel on Wharton Business Radio’s Behind the Markets show on Sirius XM. El-Erian was recently named a senior global fellow at the Joseph H. Lauder Institute of Management and International Studies and is also a part-time professor of practice at Wharton. Siegel was joined by his co-host on the show, Jeremy Schwartz, director of research at WisdomTree, a New York City-based investment advisory services firm.
A Strengthening Economy
Latest economic indicators have lifted expectations for U.S. economic growth in the near term. Both the Dow and the S&P 500 began the new year on a high, continuing their trend from 2019, a year in which they they rose 22% and 29%, respectively. Stock prices could continue that uptrend this year as well, according to an analysis by Instinet cited by The Wall Street Journal. U.S. manufacturing seems to have stabilized after a soft patch last summer, and home prices ticked up encouragingly in the second half of last year. Economists surveyed by the WSJ expected the U.S. to continue its economic expansion in 2020, the 12th year after the last recession, citing a “healthy labor market,” among other factors. However, fears of a recession and uncertainty over the U.S. trade war with China persist. To be sure, unanticipated events could rock the markets, such as last Thursday’s oil price surge after U.S. forces killed Iran’s top general.
Siegel, too, cited the strong employment report for November 2019, which continued the trend from October. “There are not usually two wows in a row,” he said during his conversation with El-Erian, which took place in December. He pointed also to “a strong start to the Christmas season and a good consumer sentiment report” as harbingers of GDP growth above 2%. He predicted that corporate earnings would increase 5% in 2020, adding that “a lot depends on the U.S. economy and foreign economies, but also exchange rates between the dollar and the euro and other currencies.”
“The U.S. economy is fine,” said El-Erian. “You cannot get a recession with the household sector so strong. The U.S. market on a stand-alone basis is in a good place,” he added. “The problem is the rest of the world.
“I have been against the view that investors should fade [from] the U.S. markets in favor of the rest of the world,” El-Erian continued. “I’ve been saying, ‘Stick with the U.S. Stick with the U.S.’ But at some point over the medium term, the uncertainties from the rest of the world, I fear, are going to have an impact for the market — less for the economy, and more for the market.”
“The U.S. economy is fine…. The problem is the rest of the world.” –Mohamed El-Erian
Why Europe Lags
El-Erian pointed to the latest sign of trouble in Europe: reports that Germany’s industrial output saw a 5.3% year-over-year drop in October to log its biggest downturn since 2009. The divergence between the U.S. and Europe in economic growth is related mainly – and not entirely – to three factors, he noted. “One is that the U.S. has had some pro-growth policies, whether you agree that they were efficient and fair.” Most economists agree that deregulation and the tax cuts that took effect last year in the U.S. have produced a short-term growth boost, he noted. “Europe has done very little, if anything, to promote economic growth policy-wise, and that relates to politics.”
Secondly, the U.S. economy is doing better because “it is less open than Europe,” El-Erian continued. “So, [the U.S.] has been less vulnerable to the spillover from the U.S.-China trade war. Europe is very open to trade and has taken the hit hard.” Thirdly, “the U.S. is just inherently more dynamic in terms of economic activities,” he said. “Put these three things together, and the U.S. continues to outperform the rest of the world, both for internal reasons and because it’s less exposed to external vulnerabilities.”
Is a Rebound in Sight?
Siegel pointed to buzz that a turnaround might be underway in some stock markets elsewhere in the world. For instance, “European stocks have done well recently, [although] they don’t have the record of U.S. stocks,” he added. There have been “some tentative signs that maybe [the downturn in] Germany had bottomed,” he added.
At the same time, as concerns persisted over Brexit, he wondered if the so-called recovery was “a little false turnaround,” and if Europe would continue to see a deepening slump. (A few days after the Wharton Business Daily interview, Boris Johnson led the Conservative Party to a landslide win in the U.K., with a promise to “get Brexit done” and lowering some of the concerns around it.)
El-Erian read the early signs of an uptick in Europe as the beginning of an L-shaped recovery instead of the V-shaped recovery that some experts have visualized. “[With a growth rate of] 1% or below being stall speed (the slowest speed a plane can fly to maintain level flight), you’re not going fast enough to overcome a lot of the structural and debt weaknesses that are embedded in different countries in the Eurozone,” he said. He worried that an L-shaped recovery might make “the likelihood of a recession in Europe higher.”
Europe’s Growth Challenges
Schwartz wondered if the European Commercial Bank’s policy of negative interest rates could stimulate the economy. The ECB’s negative interest rate policy requires financial institutions to pay interest for parking excess reserves with the central bank, which should prompt them to boost lending to businesses and consumers, as a Reuters article noted.
“The ECB is in a lose-lose-lose situation,” said El-Erian. “We have crossed a line between negative interest rates having a beneficial impact, and now we talk about collateral damage and unintended consequences. These negative rates undermine economic activity in several ways.”
“The major reason for the big decline in interest rates — even negative interest rates — is really not central bank policy, but fundamental demographic factors.” –Jeremy Siegel
One outcome of the negative rates is an increase in German savings, said El-Erian. “Rather than stimulate consumption, what’s happening is very cautious German savers, who are targeting a certain terminal income level, are simply saving more because they’re not getting paid on their savings.”
Two, he saw “excessive risk-taking” in some sectors of the financial system. Three, “we’re seeing zombie companies continue to operate,” he said, noting that they are pressuring down productivity growth. Zombie companies typically exit a competitive market, are typically connected to weak banks, congest markets and constrain the growth of more productive firms, according to an ECB research paper. “Four, I worry that we’re going to find that there has been a misallocation of resources. Market-based economies don’t function well in a prolonged period of negative rates. I think that the Eurozone is discovering this.”
El-Erian explained why he called it a lose-lose-lose case for the ECB. “Getting out is not an option, because if they were to raise interest rates right now, it would cause financial market disruptions, and that in itself could spill back. Doing more is not going to help, either.”
So what are the options? “What we need is a policy hand-off from excessive reliance on unconventional policies by central banks to a more comprehensive, pro-growth policy approach,” said El-Erian. “It’s a political implementation issue. And the politics in Germany right now suggest that we are just going to continue hoping for a policy response, but it’s not going to happen.”
Meanwhile, Europe’s reliance on negative interest rates may be coming to an end, if it takes a cue from Sweden. On December 18, Sweden’s central bank Riksbank dropped its policy of negative interest rates and raised its key rate to zero from minus 0.25%. El-Erian said in a tweet that other central banks should follow the lead set by Riksbank. Among the “positive signals” the Riksbank cited were the election outcome in the U.K., which has eliminated of the risk that the U.K. might exit the EU without a deal; and signs of a thawing in U.S.-China trade relations.
“The major reason for the big decline in interest rates — even negative interest rates — is really not the central bank policy, but fundamental demographic factors,” said Siegel. He pointed to the continued intervention of central banks with quantitative easing, which spurred demand for high-quality assets, which in turn depressed interest rates to zero. “All of us are falling into the low interest rate world,” he said, noting that it is difficult “get out of it,” unless it results in sufficient economic growth.
“The risk is that you succeed in promoting asset prices, and you don’t succeed in promoting economic activity to the same extent,” said El-Erian. The result of that scenario is the likelihood of volatility. “Unless fundamentals improve quickly in the rest of the world to validate where asset prices are today, we are going to have more liquidity-induced volatility.”
U.S. investors have done well in recent years with passive index investing, but may now switch to more active investing, El-Erian noted. “This is living the dream for investors – high returns, no volatility and correlations that favor you – even though it doesn’t make sense that both risk-free and risky assets go up,” he said. “That is the period we’ve come from, and it has been a very good period for passive index investing. I’m not sure we can extrapolate that for the next five years.”
“Unless fundamentals improve quickly in the rest of the world to validate where asset prices are today, we are going to have more liquidity-induced volatility.” –Mohamed El-Erian
Navigating Uncertainties Ahead
El-Erian pointed to “major uncertainties” facing investors in the year ahead. One is over the pace of globalization. “I don’t know whether we have just pressed the pause button on globalization and that we’re simply going to press play again and the world will continue to globalize economically and financially on better footing,” he said. “And, by ‘better footing’ I mean not just a fair trade, but a fairer trade that remains free.” Another view out there is that the world might “de-globalize, because it’s not just about economics anymore, it’s also about national security,” he added.
El-Erian said he has been “very pro-American markets” and cautioned investors against re-allocating their funds away from the U.S. towards emerging markets generally. “Picking certain spots in emerging markets – that I’m OK with,” he said. “But general exposure to emerging markets vis-a-vis the U.S., I say, ‘Not yet.’” He pointed to one big danger: “If we press pause on globalization, emerging markets are the most vulnerable segment of the marketplace. The risk of de-globalization is a major headwind for emerging markets; it can actually derail the more vulnerable of them.”
Trade issues with China continue to be a big factor, and a durable solution” to the trade conflict is harder to achieve, especially because the issues are not just economic, but also involve national security and human rights. The U.S. has “weaponized tariffs” as a means of getting to a fairer trade system, El-Erian noted, and wondered if more countries might resort to similar actions.
Any country, a company or even a household needs three attributes to navigate uncertainties, El-Erian said. “You need resilience…. You need the options to be able to update your information set and your probabilities of potential outcomes using scenario analyses. And then you need agility, and the ability to move quickly.”
For companies, those attributes translate into “a solid balance-sheet position, cash generation, a solid business model and good management,” said El-Erian, adding that those are the most likely to reward investors. The volatility he expected in the markets would allow investors to find pick those stocks cheaply.
His advice for investors: “Maintain your structural and secular inclinations, and positions in the portfolio. But you have somewhat more of a tactical or opportunistic side to it, and you slowly evolve your portfolio from what has worked very well – which is general market exposure – to making it somewhat more focused and more targeted as the opportunities arise.” He said those opportunities could be found in not just “value stocks” (which trade at lower prices relative to their fundamentals such as earnings and dividends), but also elsewhere.
