Wall Street guru Mohamed El-Erian believes that the global economy is in the midst of what he calls ‘unusual uncertainty’ that poses risks to sound decision-making. More than a decade after the financial crisis, global economic growth is on unstable ground, with the U.S. as the only nation enjoying strong growth among the major economies. This is also a time when age-old correlations, such as between stocks and bonds, become less predictable, carrying implications for risk management.
“Get used to more unthinkables and unlikely events becoming reality,” El-Erian warned at a recent Wharton event hosted by the Joshua J. Harris Alternative Investments Program. “The underlying system is becoming less predictable.” He shared his perspective on the global economy as the chief economic adviser of Allianz, a German financial services giant. Previously, he served as the CEO of PIMCO, the world’s largest bond fund manager, working alongside legendary co-founder Bill Gross.
As an example of global instability, El-Erian pointed to the headlines coming out of the World Economic Forum in Davos, Switzerland last year. They reported that global economies were growing in sync. But “one year later, consensus among leaders of both the private and public sector does a 180 [degree turn],” he said. The headlines now warned about a coming synchronized global economic slowdown. “That is a massive shift. … For the global economy to go from the hope of a synchronized global pickup to that of a global slowdown when nothing really has changed that much is quite [remarkable].”
So what happened?
The first mistake was initially thinking that global growth was synchronized. Instead, they were merely correlated, El-Erian said. In January 2018, business and government representatives went to Davos feeling that they were better off but for very different reasons: The U.S. economy was going strong after deregulation and pro-growth policies; Europe was no longer in intensive care, but finally walking although not yet running. India was recovering from demonetization, Russia was rebounding from low oil prices. “The fact that we, consensus opinion, confused correlation with synchronization was the first big mistake,” El-Erian said.
“Get used to more unthinkables and unlikely events becoming reality.”
The second mistake occurred around mid-2018, when the trends started shifting. “The hope was that the U.S. would continue [to do well]” as it was driven by policy changes instead of factors outside its control, El-Erian said. “But then the U.S. decided to have two significant self-inflicted wounds that slowed activity down.” These were the partial government shutdown and the “major Fed miscommunication that disrupted financial markets,” he added. The view was that the U.S., the leader of the pack, could not even sustain itself.
Another misstep was thinking the economy was going through a typical cyclical downturn instead of a deeper and longer-lasting structural change. After the global financial crisis, countries had two priorities: normalize the system and buy time for a cyclical recovery to pick up. “The assumption coming out of the financial crisis is we had had a really bad cyclical downturn but that’s OK because the upturn would be even stronger,” he said, comparing it to a stretched rubber band that would revert to normal. “But that proved to be the completely wrong understanding of what had happened. What 2018 was, was a structural shock.”
El-Erian said society had over-invested in finance and underinvested in other sources of growth. Cities started competing to be a financial center. “There was very little done, with the exception of Germany, in terms of investing in actual growth. So there was a structural missed hole and coming out, very important, time was lost in terms of fixing this.” Why? The mindset was the global economy was in a cyclical change, which was incorrect. “So the foundation of growth remains very weak.”
Meanwhile, major economies have exhausted their cache of “spare tires” to rescue a faltering economic engine, such as by lowering interest rates, El-Erian said. “Central banks were already at very low interest rates, and Europe had negative interest rates.” That means investors in bonds effectively pay folks to borrow money instead of getting paid interest. In Germany, bonds up to nine years of maturity are trading at a negative yield. “Can you really take interest rates much lower from there?” he asked. Add to the mix the uncertain result of central banks’ unprecedented quantitative easing of buying toxic assets to stabilize the financial system.
U.S. vs. Europe and China
The good news is that the U.S. economy is in good shape. “Fundamentally, the U.S. is OK. We have one of the strongest labor markets. We continue to create jobs at two to three times what would be normally expected for this stage of the cycle. Wage growth is 3% and the labor participation rate is going up,” El-Erian said. And its self-inflicted wounds are healing. “We’ve opened the government again. The Fed has tried to correct its miscommunication by going the other way,” he said. Stocks have rebounded. “The selloff has been followed by an incredible recovery. The Dow is now 4% away from its October high,” he said. Also, company profits are “at historically high levels.”
“The problem in the global economy is not the U.S.; the problem is what’s happening in Europe and China.”
The picture in Europe and China is not as rosy. “The problem in the global economy is not the U.S.; the problem is what’s happening in Europe and China,” he said. “Europe is now having the consequences of underinvestment ––and the political situation in Europe doesn’t allow for pro-growth forces.” El-Erian then compared the five largest European economies to a sports team where the top five players are all having problems. “Your five most powerful players that make a difference in the team are playing well below capacity,” he posited. Moreover, “the team is not playing as a team at all. There’s no teamwork going on. Would you bet on the team? You wouldn’t.”
El-Erian said that “if you look at the five major economies that move the needle in the European context, they are all unlikely to do anything pro-growth.” Here are his assessments of the five:
- United Kingdom: “The U.K. is in the midst of a Brexit saga. And what does Brexit do? It consumes all the oxygen in the room. You can’t talk about anything else in Britain but Brexit. So if you try to have a pro-growth, competitive initiative” it’s not likely to go through. (El-Erian added that while Brexit is a big deal for the U.K., for others the impact is much less. “Once you look at the global economy, it’s just a small irritant.”)
- Germany: “It’s in the midst of a major political transition. Mrs. Merkel is on her way out. … It’s clear who’s going to replace her in the party, but it’s not clear whether AKK [Annegret Kramp-Karrenbauer, Merkel’s successor] will be a chancellor. That’s not an environment for pro-growth policies.”
- France: “France did try pro-growth policies, but they triggered quite a reaction in the ‘yellow vest’ movement. And now, that has been put on pause.”
- Spain: “Spain had a weak government and is now facing snap elections. So forget anything out of Spain.”
- Italy: “You have two extremes … parties whose first decision was to get into a fight with Brussels,” the seat of the European Union.
On top of these issues, the EU as a whole is “trying to figure out what does life after Brexit look like — and you [also] have issues in Central and Eastern Europe,” El-Erian said. As a result, he doesn’t think the EU will hit its GDP growth forecast of 2% this year but rather will come in at 1%, at best. “What happens at 1% and below is to risk a stall speed. Would you get on a plane that only goes forward 50 miles an hour? No, you wouldn’t, because you lose altitude quite quickly. Europe not only faces the prospect of lower growth, but stall speed with nothing being done.”
As for China, it is a country “in the midst of a really exciting transition that needed the tailwind from the global economy to make meaningful changes in the domestic economies,” he said. “It’s not a question of leadership. It’s a question of having the time to navigate the most difficult transition in development economics called the ‘middle-income transition’.” In the last 17 years, only five countries have managed to do it, but none are as big and complex as China, El-Erian said. They include Taiwan, Singapore and South Korea. The big nations, such as Brazil and Argentina, have not succeeded. “So China needed the tailwind of the global economy to facilitate it and that tailwind has turned into a major headwind,” he added. “So they are facing issues.”
“The trouble with a system that’s supposed to run in a correlated fashion, not a divergent fashion, is it starts getting unstable.”
The bottom line is that the world is not going through a synchronized global slowdown, El-Erian said, but rather one of divergent growth, “which is very unusual.” This growth is not enough to offset the “underlying insecurities but enough to keep us out of a synchronized global slowdown.” In the past, he said, divergent growth looked like this: The U.S. markets outperformed while other countries’ stayed steady or went down. U.S. interest rates went up but other countries remained low or went negative.
So what if economies have divergent growth? “The trouble with a system that’s supposed to run in a correlated fashion, not a divergent fashion, is it starts getting unstable,” El-Erian said. “It imposes enormous pressure on market relationships.” For example, the traditional inverse relationship between stocks and bonds break down. When stocks fall, investors may go to bonds to protect their returns because these securities typically go up. But that relationship now breaks down.
“If you’re hoping that somehow your bond exposure is going to compensate for your stock exposure, it doesn’t happen,” he said. “That is why active managers had such a tough time last year and why the hedge fund community as a whole had a tough time … because correlations broke down in a very meaningful way.” As such, there is the possibility of a “market exodus” and it also makes risk management much more complicated, he explained.
Trade Wars, Brexit and Central Banks
Unlike what the headlines warn about the U.S. trade wars, El-Erian thinks they are the “least important problem we face.” Trade between countries is inherently a “cooperative gig,” which has kept the system more or less free of protectionism in the form of tariffs. However, it “had the disadvantage of not solving the issues that were accumulating,” he said.
These are non-tariff barriers such as rules imposed on foreign investors to restrict their market access, like requiring foreign companies to set up a joint venture with a local firm before they can do business. “You’re always a minority [owner]. You don’t have decision-making power, but give me all the technology,” El-Erian said. “Over the years, non-tariff barriers have accumulated and everybody has acknowledged they are a problem, but we have not been able to solve it.”
Then the Trump administration comes along and decides “for political reasons this cooperative approach … doesn’t work,” El-Erian said. Trump threatened to impose tariffs and the initial reaction among other trading partners is to do the same. The markets saw this and reacted negatively. But look deeper. “This is a very uneven game. The U.S. is a much bigger economy, the U.S. is a less open economy and the U.S. is a relatively entrepreneurial economy,” he said. “If U.S. leadership is willing to incur damage to its own economy, the damage it will impose on another economy is a massive magnitude more than that.”
“If you want to talk about risks to the global economy, it is central bank policy mistakes.”
That is why South Korea, Mexico and Canada all realized that the way to play the trade game “is not to play it uncooperatively. The way to play this game is to diffuse tensions and make concessions,” El-Erian said. “So we have a new NAFTA, we have a new agreement with Korea and in my view, it’s only a matter of time before we’ll have a deal with China.”
However, the one big danger of the Trump approach is the U.S. is now seen as “less predictable and less reliable,” El-Erian said. That’s troubling because the U.S. is “at the center of the global system and it supplies the reserve currency [held by central banks]. It manages other people’s savings, it has veto power in the multilateral institutions. Against those privileges comes an expectation of responsible management.”
El-Erian is also worried about errant monetary policies. “If you want to talk about risks to the global economy, it’s central bank policy mistakes. And central banks have been way ahead of everybody else since the financial crisis in taking on more and more responsibilities for delivering economic outcomes,” he said. “We think we know that one systemically important central bank can normalize policy. We’re not sure that more than one systemically important central bank can do it at the same time. And what do you do if you’re the European Central Bank and your growth is slowing? Do you even want to normalize in this environment? Can you take interest rates further negative?”
How to Navigate Uncertainty
When faced with uncertainty, it is easy for people to fall into certain traps. One is to have a blind spot. “What happens when someone takes you out of your comfort zone? You don’t see it. You deny it,” he said. “There’s part of us that won’t even see what’s happening. … When these signals reach critical mass, we have a complete blind spot.” Another trap is to reframe the situation to one that more easily conforms to what one is used to seeing, and miss what’s really going on. The third is ‘active inertia’ — there is action but the pull from the status quo is so strong that it doesn’t adequately move the needle.
El-Erian encouraged companies to engage in scenario planning, which greatly helped PIMCO during the uncertainty of the financial crisis. In the critical 2008 weekend when Lehman Bros. was on the cusp of failing, he said PIMCO sketched out three possible scenarios. They set an 80% probability that Lehman would replay the Bear Stearns case, where JPMorgan Chase took over its weak balance sheet to the relief of Wall Street. “We knew that Lehman was in discussions with Barclays and possibly another bank. So we thought that was going to be the outcome.”
PIMCO gave a 15% probability that Lehman would fail, but do so in an orderly fashion. That means its demise would be carefully orchestrated to have the least impact. “No policy maker in their right mind would let Lehman fail in a disorderly fashion,” El-Erian said. “You put the payments and settlements system [at risk. This] is the most critical element of any economy. If you don’t trust the payments and settlements system, nothing gets done.”
“The world in which you’re living in is fluid, unpredictable, less stable.”
Think of the system as a drive-through fast-food chain where the customer orders at one window, pays at another and picks up the food at a third, El-Erian said. The customer hears that a rival fast-food chain went under and starts getting anxious that this chain would fail as well. He worries that after paying for food in the second window, he might not get his order in the third. So he goes to the second window and insists on paying and getting his food at the same time. “But the system cannot deliver instantaneous payment and settlement,” he said. “What do you do? You walk away hungry even though you have the ability to pay. [The fast-food chain] throws away the meal even though they’ve cooked it for you. So activity comes to a standstill.”
That Lehman would fail in a disorderly way was so unlikely in PIMCO’s estimation that the probability was set as “almost de minimus,” he said. “Guess what happened? Lehman failed in a disorderly fashion. We did not predict the financial crisis. We got it completely wrong. But for every scenario, we had developed an action plan — who would do what in the firm. Things as simple as which lawyer would deliver the notice of failure on our swaps so we could reestablish our swaps and protect our clients.” PIMCO put its plan into action and stayed a step ahead of competitors. “That’s the power of scenario planning.”
Rumble in the Jungle
El-Erian named three characteristics that are important in navigating uncertainty: resilience, developing options and acting quickly. “At the end of the day … you want resilience to be able to survive your mistakes. You want optionality to change your mind once more information comes in, and you need to act quickly once you know [your path]. That is probably the most powerful combination [to have] when you’re facing unusual uncertainty — and has huge implications about how you think about the world.”
He ended the lecture with the example of the 1974 ‘Rumble in the Jungle’ heavyweight boxing fight in Zaire between George Foreman and Muhammad Ali. All the commentators were sure Foreman would win. He was young and had never lost. Ali was an aging and overweight boxer. For sure, Ali would be knocked out. The only question was how badly would he be hurt? But El-Erian said Ali’s camp used the three characteristics of resilience, optionality and quick action to pull off a surprising upset.
The traditional strategy for Ali would have been to put him on a fitness regimen, position him in the middle of the boxing ring and hope he lasts 15 rounds — perhaps he can win by technical points. But Ali’s camp innovated. Instead of focusing on fitness, they built resilience. His training consisted of standing in the middle of a boxing ring while ex-convicts they hired hit him for three hours in the morning and three hours in the afternoon.
“Three characteristics that are important in navigating uncertainty: resilience, developing options and acting quickly.”
The second was to position Ali on the ropes during the fight, not the center of the ring. The typical view is not to get trapped against the ropes because then the boxer would be a sitting duck, El-Erian said. “Instead, Ali comes out and goes to the ropes … and puts his hands up,” he said.
Ali added to his option of standing in the middle of the ring hoping to survive. “For seven rounds, he relied on his resilience and maintained his optionality,” El-Erian said. That strategy is now known in boxing as ‘rope-a-dope.’ When the eighth round came, “Foreman got tired and Ali had the one window to knock him out.” Despite the overwhelming odds, Ali pulled one of biggest upsets in boxing history.
“So where does this leave us?” El-Erian posited in his lecture to Wharton students. “The world in which you’re living in is fluid, unpredictable, less stable. … The dramatic shift in the global growth consensus is part of a bigger reality that speaks to continuing fluidity, more unthinkables becoming reality, and trickier decision-making challenges.” He advocated having an open mindset and not letting “the best be the enemy of the good.” That means not letting a perfectionist pursuit of excellence be the only goal. “If you can optimize on the good [do it.] It’s very hard to come up with the best in this sort of environment.”