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Former PIMCO CEO Mohamed El Erian on Global Markets and India

Hari Viswanath BL Research Bureau | Updated on May 23, 2021

The international economist and markets expert speaks with BusinessLine in an exclusive interview

Few have the depth of experience to understand the dynamics of markets as Mohamed A. El-Erian, currently the President of Queens’ College, Cambridge University, and Advisor to Allianz and Gramercy. El-Erian is widely sought after and followed by policy makers, asset managers, and analysts for his expert views and insights on equities and macros. In his earlier role as CEO/co-CIO of PIMCO (2007-2014), he was responsible for managing around $2 trillion in AUM across asset classes and geographies, together with the legendary founder of PIMCO, Bill Gross (referred to as the ‘Bond King’).

El-Erian shares his perspectives on US economy and markets and where India stands, in an exclusive interview with BusinessLine. Excerpts:

There is a point of view that the recent US inflation data, which has come in above estimates, is driven by base effect and hence is transitory. Others believe this may be persistent and hence, it is time to start considering plans for gradual withdrawal of monetary stimulus. Which side are you on?

I believe we must have an open mind. I do not disagree with two transitory factors — base effect and temporary mismatch between demand and supply. However, there is increasing evidence from the ground — from companies reporting that there is a fundamental shift going on in the structure of supply and demand. That is why it is important to keep an open mind.

Right now, the most important institution that holds on to this conviction that it is transitory is the Federal Reserve. And this matters because it is the most powerful central bank in the world; So, how it acts has an impact well beyond the US.

It is very unlikely they may withdraw their accommodative stance even though the evidence is getting more and more compelling. We have just had a whole season of earnings releases where company after company have pointed out to higher input prices, more difficulty in hiring labour. The reason why they are unlikely to act is because they (Fed) changed their framework in 2019 from forecast-based to outcome-based approach (referring to Fed inflation targeting/ new monetary framework). They are hostage to the outcome-based approach, which is now a bit problematic.

That means if it turns out inflation is not transitory, they will end up being very late. There is a journey and a destination. In the journey, there is a risk that the markets will start getting worried. When the markets start getting worried about inflation, it results in tightening of financial conditions ahead of the Fed. The concern at the destination is, if it proves the inflation is not transitory, then the Fed is going to have to hit the brakes. And history suggests when the Fed hits the brakes, the US ends up in a recession.

When bond investors worry about inflation and exit the market, which is the asset class that benefits from this outflow?

First of all, they are not selling. They are not selling because they are respecting the Fed. Even if you disagree with the Fed, you must respect the fact that every month the Fed is buying $120 billion of market securities. So even if you have a different view from the Fed, when it comes to how you react in the bond market, you will respect the fact that the Fed has the printing press in their basement and has this enormous willingness to use it. That is the reason the bond market seems very calm about this although other indicators suggest there is growing concern.

Now, you have raised a really interesting issue, which is where do people go if they exit bonds on inflation concerns. Well, bonds offer investors, historically, risk mitigation. So if you are worried about bonds, it is not clear where you go. So, people have gone to many places — some have gone to crypto currencies, some to gold and some to cash. But the important thing is the major migration out of bonds has not happened yet. Thus, the move in US 10-year treasury yields from around 1 per cent at the beginning of the year to around 1.65 per cent now is not because people have started exiting bonds, but more due to lack of demand.

The Indian stock markets have been driven by foreign flows from a zero interest regime which find the market earnings yield of around 4 per cent attractive. What would you recommend to Indian investors for whom the risk-free (g-sec) yield is at 6 per cent?

There is the famous story of someone who comes and proudly tells his family — “I just bought a dog for $20,000”, and the family is shocked and says, “You did what?” And that person replies, “Yes, I bought a dog for $20,000 and that’s a great deal because the cat was selling for $30,000.”

Developing countries and emerging markets like India have benefited from the fact that the (foreign) investor mindset has been a relative investor mindset. But as we know, there is a difference between tourist dollars and resident dollars. Resident dollars tend to stay; Tourist dollars tend to turn around at the first sign of something going wrong and the history of emerging markets is that of feast and famine. Everybody that I know right now is in a tactical mindset. Not strategic or secular, but short-term. One famous investor (referring to Leon Cooperman of Omega Advisors) has said that he is a fully invested bear. Now that is a very interesting concept, how can you be a bear and be fully invested? It’s because you are opportunistic in nature. You realise the massive liquidity wave, and what you are doing is benefiting from the liquidity wave; But you know that wave is going to break at some point.

It’s been a great run over the last year for commodities. Are we going to see another super cycle?

Right now, commodities are benefiting from two things — one, demand exceeding supply which is causing physical shortages; and two is the very high investment demand for commodities. People are looking to diversify their portfolio. However, we do know commodities are not homogeneous, so for certain commodities, the supply side will respond very quickly. I find it hard to talk of a super cycle because a super cycle implies there is going to be a persistent demand-supply imbalance for everybody and there will be a persistence of the liquidity-induced financial demand. I think both of those things are unlikely. I think higher prices may continue for some commodities, but not for all.

There is a lot of talk that the dollar will weaken due to the monetary and fiscal measures. Why should it, when literally every developed country besides the US — the UK, Euro Zone, Japan — is aggressively printing money?

When people think about dollar weakness, they really think about the dollar weakness vs the Euro and vs the Chinese currency. Versus the Euro, there are two things — the thinkable and unthinkable. The thinkable is that Europe is now getting its act together on vaccines and the economic outlook is improving very rapidly. The European Commission has just significantly revised upwards its growth projections. So the US is no longer expected to outpace Europe economically, as was expected a few months ago.

People now believe there is a higher probability that the ECB may start lifting its foot off the stimulus before the Fed. And that was unthinkable, not so long ago. That is why you are seeing the euro strengthen relative to the dollar.

So the dollar weakness bodes well for emerging markets?

Logically the dollar weakness bodes well for emerging markets,but what one does not want is sharp movements either way. If you are a developing country, and you are naturally importing the financial conditions of the advanced economies, what you want is the dollar to weaken slightly, interest rates to remain low, markets to continue functioning well.

Can you explain how the money printed by Fed moves into equities?

Fed comes in and buys treasuries, mortgages and corporate bonds. When the Fed buys, it puts liquidity into the system. People who receive that liquidity have two choices — to stay in cash or invest elsewhere. Typically, what you get is cascading movements down the risk spectrum. For example, the people who had their investment grade bond bought by the Fed will normally replenish their investment with high-yield bonds. People who feel they are not getting paid enough will go to other places like equities, including those in emerging markets.

Markets seem to have become completely decoupled from fundamentals. Incidents such as Gamestop and Archegos caused near accidents in the financial system but markets brushed them off. In India, the markets are at historically high valuations and are just around 2 per cent below all-time highs, when the country is going through its worst crisis ever due to the Covid second wave...

Markets have embraced a liquidity paradigm. The idea of having someone buy after you is very powerful, because that next purchaser does two things. First they push the price up, so your investment is worth more. Secondly, they provide liquidity, which means if you want to change your mind, you can get out. Imagine again if the buyer after you is a central bank and is a non-commercial buyer and is price insensitive. They are not looking to make money, they are looking to fulfil economic objectives. If you have in the system a very large non-commercial buyer, other people will have the confidence to buy.

And that is why every sell-off has been a buying opportunity. That’s why now there are three mantras in the market place all related to the backstop that central banks have provided — the so-called ‘central bank put’ (or Fed put or Powell put).; the The mantras being — one, there is no alternative to risk assets; two, buy the dip; three, FOMO. When you have a market that has been conditioned to that extent, it will ignore all sorts of other things as long as it is confident in the liquidity backstop.

The world has had its worst crisis post World War II in the last year, central banks acted quick, recovery has been swift and investors have got rich. It is almost giving a message that every few years when growth is slowing down, governments should undertake such measures. This does not appear logical. Either someone is already paying the price for this, or somebody will pay the price in future...

Future generations will pay for this. We have run a finance-dependent economy and what such an economy does is that, it borrows growth and financial returns from the future. That is fine if at the same time you are investing in infrastructure, in human resources, and in productivity-enhancing activities. Phase one of crisis management is you borrow growth from the future; Phase two is you contribute to growth in the future. I call it winning the war and winning the peace. Unfortunately, coming out of the global financial crisis of 2008, while we won the war, we failed to secure the peace.

Given risks exist for the long-term as we remain a finance-dependent economy, is there one asset class that you feel is the safest or best option for investors?

I don’t have an answer because every asset class I have liked has been bid higher in price. It has literally been an everything rally. What remains now unfortunately is not accessible easily to the small investors — the private market. Public market investors need to realise that they are like surfers surfing a big wave. Every smart surfer keeps an eye on when this wave is going to break.

I am really glad that I am no longer managing other people’s money. If I were, I would do something counter to how I am wired. I am wired to be a fundamentally-based investor who tries to take advantage of long-term opportunities. And this market is for short-term, opportunistic, very tactical investors.

The rally over the last year has seen huge retail participation and in an era of mobile trading apps, many are hooked to trading. Do you have any advice for them?

For people who are buying things simply because everything is going up, I keep sharing a very simple lesson I learnt from Bill Gross, who was the founder of PIMCO and a brilliant investor. He used to say investing is like sitting at a table and playing a game of cards. If you don’t know why it is that you have an edge over everybody else, you are going to lose. So don’t buy things without knowing why it is that you are smarter than everybody else. Do you have better gut instinct, do you have better information, do you have better analysis? What makes you think you are better than the crowd? And if you can’t answer that question, understand that you are not buying a stock, but buying a lottery ticket.

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)

Published on May 22, 2021

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