Economist Mohamed El-Erian: Central Banks Don’t Realize Extent Of Irresponsible Risk, Reaching Dangerous Levels
With central banks printing money to infinity and beyond, the bull market in stocks continues. The growing expectation of inflation and higher bond yields could endanger the stability of financial markets, according to Mohamed A. El-Erian, chief economic adviser at Allianz, the Munich, Germany-based corporate parent of investment management firm PIMCO.
El-Erian discussed what he calls unhealthy codependences between central banks and investors, debt issuers (governments and companies) and politicians, during an interview with The Market NZZ, a financial media platform in Switzerland.
“It’s like a bad marriage,” El-Erian said. “They’ve ended up relying on each other, and they just don’t know how to get out of it. Every time the central banks have tried to get out of it, the markets were at risk of becoming disorderly.”
The president of Queens’ College at the University of Cambridge in England, El-Erian served as chairman of President Barack Obama’s Global Development Council. He’s a senior adviser at emerging-markets investment manager Gramercy and part-time professor at the Wharton School, University of Pennsylvania.
“I don’t think central banks quite realize how much irresponsible risk taking is going on,” El-Erian told The Market.
Central banks, especially the U.S. Federal Reserve and the European Central Bank, “are going to provide ample and predictable injections of liquidity, and that they are going to be continuous buyers with no limit to how much they can buy and at what price,” El-Erian predicted. “That is the reason why we’ve seen prices going from one record high to another despite completely changing narratives.”
El-Erian described all the different narratives that have been used to justify market price action in the past year.
“Before the pandemic, the narrative was that Trump was going to win, that we are going to have continuous tax cuts, and that companies are going to benefit from more deregulation,” he said. “Then, that political narrative gave way to: We’re going to have a divided government, and that’s good for markets because it keeps the government out of the way. Next, the narrative changed again to: We’re going to have a blue wave and massive stimulus. Now, it’s all about the big reopening trade. When so many narratives are being used to justify price action, it tells you that the price action reflects something else completely.”
There’s irresponsible risk-taking going on — more than central banks quite realize, he said. When it comes to costs and benefits for the economy, the beneficial economic implications are low, he said. “The costs include irresponsible risk taking, higher inequality, distortion of financial markets such as negative interest rates and misallocation of resources. There is abundant evidence, but no one knows how to exit.”
Does that mean investors can’t actually do anything wrong, because central banks will always bail them out if the worst comes to the worst? the Market asked.
“There are certain things that central banks clearly buy: investment-grade paper and government debt,” El-Erian said. “In the case of the Fed … they even buy high-yield … All these assets are under a strong central bank umbrella. You can stay under that umbrella, and you are fine. But investors tend to be greedy … the further you go away from the umbrella, the higher the default risk — the one risk central banks cannot protect you against. It’s reasonable to continue betting on central banks. Yet, valuations are leading you to be less and less cautious and that’s going to be the big balancing act in 2021.”
El-Erian identified the U.S. yield curve as “one of the most under covered stories.”
It’s moving up consistently and that puts the Fed in a very difficult position, he said, “because if it allows the curve to continue to steepen it can undermine financial stability. If the Fed wants the yield curve to stop steeping, it has to implement yield curve control, or what they like to call yield curve targeting. But yield curve targeting is a huge step in policy. It would distort the U.S. Treasury market completely. So keep an eye on this, because this is starting to get to dangerous levels.”
When El-Erian was asked what he’s doing now when it comes to putting his money to work, he said he thinks of three levels of investment: secular, structural and tactical or opportunistic.
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The secular position is investments that he said he believes will work out over time. “For me, technology was a secular position, and emerging markets as well. These are now fully valued. Therefore, my allocation to them has become much smaller.
“The second layer is what I call structural: Certain areas in the investment world that are attractive because of some market imperfection. There used to be many of these — inflation-protected bonds for example — because many people did not understand them. Now, they are gone as well.”
On the third level, El-Erian said he’s become much more opportunistic but also very cautious. “Think of me as an uncomfortable investor. I don’t buy treasuries for my risk management. I stay in cash, because in treasuries, once you go beyond three- or four-year maturities, you face the potential of higher yields and lower prices.”