Lunches with Legends: Mohamed El-Erian on Making Sense of the Economy
Mohamed El-Erian believes four factors explain 80% of where we find ourselves in the global economy today. Using this “reduced form equation” is more actionable than attempting to understand all the factors (and struggling with the last 20%).
In this hour-long conversation, Mohamed walked us through the four factors, the policies necessary to emerge from the COVID crisis, and several easy-to-understand analogies addressing what is happening in the markets today. And, finally, even though he is no longer a capital allocator, he shared a valuable framework for making allocation decisions with those of us who are.
Four factors explaining 80% of “Where are we in the global economy?”
- Dispersion – Different countries are in different places. Mohamed believes that whether you are running a country or a business, as a leader right now, you need to solve for (1) public health, (2) normalizing economic/social interactions as quickly as possible, and (3) individual freedom. Many countries have sacrificed one of these three on their road to recovery. China, which does not care about individual freedom, sacrificed that. The US sacrificed public health. This dispersion will result in different types of recoveries. China will have a ‘V’ -shaped’ recovery, Europe a ‘W’, and the US will see a ‘√’.
- COVID is the great unequalizer. The initial narrative was that COVID was the great equalizer; anyone could get it. It has turned out that COVID is an unequalizer – creating higher income and wealth disparities and risking a generation. Mohamed pointed out that in the Los Angeles school district – the second largest in the United States – 30% of students are no longer in touch with their school.
- Scarring – Mohamed knows we will emerge from this, but we will be different.
- The great disconnect – Wall Street is completely disconnected from what’s happening in the real world.
Regarding the right policies as we emerge from the COVID crisis, Mohamed believes we need less monetary policy, smarter fiscal policy, a lot more productivity-enhancing structural reform, and more public engagement with the private sector.
He believes that monetary policy is counterproductive at this point and refers to Ben Bernanke’s equation of ‘benefits, costs and risks’. He points out that the longer we engage in this degree of monetary policy, the lower the benefits and the higher the costs and risks. Mohamed believes monetary policy has been pursued for too long and now has a distortive effect on markets. “We are well beyond where we should be.”
So how do we take our foot off the monetary accelerator? Mohamed recommends doing it carefully and gradually and pressing harder (much harder) on a different type of fiscal policy, one that is pro-growth, pro-productivity, and favors public/private partnerships that will help address inequality. He believes we have the answers and that it is not a design issue but a political implementation issue.
He referred to his time at the IMF and said the first thing you learn there is that they “are not in the business of creating crises, they are in the business of avoiding crises”. He likens central banks to doctors who never walk away from their patients. Even if it may not lead to the best long-term outcome, they often continue to administer whatever medication they can. He cites the IMF’s continued lending to Argentina as evidence of this.
He also believes that markets are underestimating three primary risks: liquidity and that central banks will always be there to provide it (not likely); a significant steepening of the yield curve (which he expects); and inflation expectations (currently too low in his view). He compared investors who might not pay attention to these risks to a surfer riding a wave. Does the surfer know the wave is eventually going to break? Yes. But is the surfer going to get off the wave early? No, because it is so enjoyable.
And how do we wean ourselves from Fed and financial market co-dependency and the corresponding notion of a “Fed Put” (1)? Mohamed compares this to taking candy from a toddler. The candy may make the toddler feel good in the short term, but we know limiting its candy intake is the right thing to do as the aftereffects are not pleasant.
Finally, even though Mohamed no longer makes capital allocation decisions, he offered a three-pronged approach for making these decisions over the long term:
- What themes am I buying? So think about buying artificial intelligence, big data, green technology - not just continued liquidity from the Fed.
- Be honest with yourself – at some point, you will make a mistake – know which mistakes you can afford to make.
- What resilience do you have? You would want to have resilience, optionality, and agility in a perfect world.
Investing is tricky right now. At current price levels, Mohamed feels it is hard to imagine that real (after inflation) returns will be 7-8% over the next ten years. Paying attention to market dynamics is particularly important right now. If you told him he could have an option to get into the market at any point in the next 12 months, he would pay a lot for that as he believes there will be better entry points than where we are right now.
Mohamed certainly covered a lot of ground in our session: the four primary factors explaining where we find ourselves, the fiscal and structural medicine required to deal with them, key risks we face, and thoughts on how to make better investment decisions in the midst of it all. And not without touching on surfing and infant sugar rushes. No small feat!
Head to our YouTube channel to watch the full recording!
- A “Fed Put” is the idea that the US Federal Reserve will always come to the rescue in times of market stress – as it has in recent market crises.