El-Erian: «The Fed will be in a lose-lose situation»

Mohamed El-Erian, chief economic adviser at Allianz, warns of market accidents due to high liquidity risk.

When Mohamed El-Erian speaks, investors listen. The chief economic advisor at Allianz (ALV 198.38 +0.55%) is well versed when it comes to navigating the global financial markets and explaining complex developments in a comprehensible way. In 2009, the internationally renowned economist coined the term «New Normal»: an economic environment with weak growth and historically low interest rates. Central banks today face a different challenge: the threat of higher inflation. Challenging are the circumstances for investors too. Because of the increased liquidity risk, there is the danger of a market accident, we came close to one during the GameStock franzy. And now interest rates are rising too.

Dr. El-Erian, do the rising yields spell trouble for the stock market?
They are bearable as long as the yields don’t go up too quickly. The two periods of nervousness were when the yields moved up too quickly.

About Mohamed El-Erian

Mohamed El-Erian is chief economic adviser at Allianz. Before that, he chaired President Barack Obama’s Global Development Council (2012 – 2017), headed the operational business of US bond giant Pimco, was Co-CIO with Pimco-founder Bill Gross (2007 – 2014), was president and CEO of Harvard Management Company, the entity that manages Harvard’s endowment, was managing director at Salomon Smith Barney/Citigroup (C 62.76 -1.65%) in London and spent 15 years with the International Monetary Fund in Washington. He received his doctorate in economics from Oxford University and has written several New York Times bestsellers. His last book was published in 2016: «The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse».

What do rising yields mean for the stock market?
We are currently seeing a yield-driven rotation: Out of technology and into banks. As of the beginning of this week, bank ETF had outperformed the Nasdaq by 15% this year.

Are higher yields putting a limit to the stock market rally?
Yes. They are limiting the rally because the very strong buy signals that come from models based on discounted cash flow are getting weaker. The higher the yields go, the weaker these signals are. They are also limiting because of market conditioning. Markets have been driven by the notion that there is no alternative to stocks because yield levels are so low. Now with the yield level moving up and with stocks having gone to elevated levels, the more the yields go up the more there will be an alternative to stocks.

Rising yields can be a drag on the bond portfolio due to duration risk.
There are three different risks that one needs to think about when talking about higher yield: duration risk or interest rate risk, credit risk, and liquidity risk. The most dangerous right now is liquidity risk. The second most dangerous is duration risk and the third is credit risk.

Credit risk is nothing to worry about?
I put credit risk third because markets anticipate being flooded with liquidity. That liquidity means that for companies that can access the capital market, that access will remain available. Credit risk on its own is not going up. Add to that that we are feeling better about the economic reopening and I think the peak of risk to the credit market is behind us.

Why is duration risk less dangerous than liquidity risk?
I put duration risk in second place because you have a very segmented investor base. For investors that look for a total return, interest rate risk or duration risk is a big issue. But there are also liability matching investors. And for them, it’s less of an issue.

Where do you see liquidity risk?
People have ventured very far in taking risks and looking for higher returns. You can see it in the massive inflows into the credit market, the amount of debt issuance in high-yield, the rally in CCC-credit. Then there is the explosion in Special Purpose Acquisition Companies (SPAC).

How could this liquidity risk play out?
There could be a market accident because too much risk has been taken in one segment of the market. Besides interest rates rising too fast, which could put the Federal Reserve in a lose-lose situation, I see this as the biggest risk to rising markets and investors’ increasingly excessive risk appetite.

«When people know that there is a distressed seller out there, they will try to get ahead of it.»

How likely is a market accident?
We came close to a market accident during the GameStop (GME 172.39 -5.05%) mania. It was avoided – thankfully – but it indicated how stretched the underlying situation was. Although the phenomenon was relatively small, because only a few stocks were targeted, over two days it had led to a 5% decline in the S&P 500.

Why would a small event have this broad effect?
It contributed to the degrossing of balance sheets. Certain hedge funds had to reduce both their longs and their shorts simultaneously. That put pressure on the market. It doesn’t take much to move the prices of stocks like GameStop. There isn’t a lot of liquidity.

Is this a problem for the broader market?
It destabilizes the broader market because everybody has taken on a lot of risk. There aren’t many people who have sat out this rally because it has proven so resistant. When people know that there is a distressed seller out there, they will try to get ahead of it.

There is also a lot of speculation in bitcoin. Nevertheless, Tesla (TSLA 1'014.97 -6.42%) will accept it as a form of payment.
There’s a massive tug of war going on in bitcoin. On the one hand – and the Tesla example is really important – there is a greater private sector adoption of bitcoin both as a form of payment and as a monetary asset. The announcement of Tesla was remarkable. It said that it had put 1,5 bn $ into bitcoin and that it would start accepting bitcoin as a form of payment. Those are the two characteristics of money: medium of exchange and store of value. Tesla CEO Elon Musk is way ahead of everyone else, but there’s a general tendency towards private sector adoption of bitcoin.

Who is on the other side?
There’s a growing public sector discomfort.  United States treasury secretary Janet Yellen was critical of bitcoin only a couple of days ago. Prior to that, there were warnings from the Bank of England and the European Central Bank.

Who will prevail?
I don’t know. At the end of the day, if the public sector insists it will prevail.

Will other companies accept bitcoin as a method of payment?
Yes, absolutely. It will spread. But it’s a little bit strange to have a form of payment that can move so much.

Is the rally in bitcoin a reason why gold hasn’t performed better over the last weeks?
There is a lot of debate on Twitter (TWTR 42.07 -1.36%) about whether bitcoin is the new gold.

Is it?
In the old days, you had simple choices to mitigate the risk in your portfolio. The simple answer was to buy government bonds. That choice today is not a good one, because you get paid very little and you can lose a lot of money. The less simple answer was to buy gold. But gold has the disadvantage of not paying you anything.

And today?
What we have seen is a search for new risk-mitigating instruments. But there is no perfect risk-mitigation instrument. There just isn’t. Until government bond yields normalize, there won’t be. The fact that investors are diversifying their approach to risk mitigation makes sense, but we are living in the world of third and fourth-best alternatives.

«We are going to see that the supply side is less responsive. We’ve already seen this in the rising commodity prices.»

How big is the risk that inflation will pick up?
I see the likelihood of a price increase. I’m making a distinction between inflation and the change in price levels. The change in price level this year will be well above what the Fed expects, which is around 2%.

Why are you expecting a higher level?
We have massive injections of liquidity. We are probably looking at 20 to 25 % of GDP. This is from fiscal and monetary policy as well as private sector savings that haven’t been spent. That’s a lot of money. We are going to see that the supply side is less responsive. We’ve already seen this in the rising commodity prices.

Will this increase be transient?
I’m not sure about whether it’s an inflationary process or a one-time price increase. I suspect that within a few months, economists are going to have a massive debate as to whether this is inflation or just a one-time price adjustment. The Federal Reserve is going to be arguing that it is a one-time price adjustment and the markets are going to behave as if it is inflation.

How will this play out?
There will be a further steepening of the yield curve, that will put the Fed in a lose-lose situation. Either it stands by and accepts the risk that the steeper yield curve will disrupt the equity market and could hurt the economy – or it feels compelled to intervene.

What could the Fed do?
It could apply more yield curve control and distort markets even more. Whichever way it goes it’s not in a good position. The problem isn’t new. The longer we stay in this policy regime where we depend only on central banks, the more difficult it will be to exit. The same holds true for the ECB as well.

What are your expectations for the economy?
We are going to see very different growth rates around the world. We’ve already seen it last year. While the UK’s economy contracted by 9,9%, China grew 2,3%.

Will China show the fastest growth?
China will lead again, the US will be in second place and Europe will be in third place. How fast they go is a function of the pandemic, the infection rates, the vaccination effort as well as new strains becoming prevalent. But we are only out of the woods once we are all safe.

What do you mean?
The progress among the countries is very different. Let’s take the UK as an example. They are further ahead in vaccinating their population compared to mainland Europe. Let’s assume there’s a new strain outside of the UK. This will lead to a bunker mentality in the UK, where it wants to protect itself from the strains from the rest of the world. If we don’t solve this problem in the majority of countries, we’re not going to go back to normal. We’re not saved until we’re all safe.

Are there other risks for the economy?
We are going to continue seeing increasing debt. This will be a problem for some countries in the developing world. There is also a disconnect between markets and the economy as well as a higher inequality. It’s not just that the inequality of income and wealth has gone up, it’s also that inequality of opportunity has gone up. There is a risk of a lost generation.