Are we in a bubble? That’s the question Mohamed El-Erian asked the audience to answer at the start of his closing keynote address at the Inside ETFs conference on Monday. Using their mobile phones, two-thirds of those in attendance selected “no,” while one-third selected “yes.”
As for El-Erian himself, he never explicitly answered his own question. Rather, in his typical nuanced style, the chief economic advisor at Allianz offered the various scenarios that could transpire in what he called a critical transition period for global economies and financial markets.
The short version is that El-Erian believes we probably aren’t in a bubble. For the long version, read on.
Convergence Will Happen
El-Erian kicked off this talk with a rundown of just how extraordinary 2017 was for financial markets. Last year featured six of the seven lowest readings for the VIX on record; the smallest peak-to-trough drawdown for the S&P 500 in any year; and strong returns for both stocks and bonds.
Stocks, in particular, did much better than the fundamentals did. In turn, the wedge between fundamentals and valuations grew bigger.
“The wedge can last years at a time, but ultimately, the convergence will happen,” noted El-Erian. “The question is, will it happen from above or below?”
If the convergence happens from above, it would entail a massive price correction that could overshoot to the downside (the bursting of the bubble). If it happens from below, it means that fundamentals would eventually catch up with valuations.
Chance To Break Out
Laying out the case for the more optimistic view, El-Erian said the global economy finally has a chance to break out after years of subpar growth. He pointed out that economic growth is synchronized (every engine of growth is kicking into high gear at the same time) and real (it’s not about leverage or debt, but consumption, investment and trade).
According to El-Erian, the reason for this improving backdrop is there is more focus on pro-growth policies, especially in the U.S., where there’s been deregulation, tax reform and the potential for increased infrastructure spending.
Meanwhile, in Europe, there’s been “a natural healing process that is getting to critical mass,” he said, while adding that “the emerging world is also kicking into higher gear.”
“It’s not the old type of growth that we had 15 years ago that was finance driven. Its not about leverage or central banks; this is much more genuine,” El-Erian added.
In addition to the positive things that have transpired, El-Erian pointed to some things that didn’t happen that are also proving to be a boon for global economies.
For example, there was no central bank policy mistake; there were no major disruptions to international trade; there was no surge in inflation; there was no surge in yields; there was no dollar appreciation; and there was no geopolitical shock to speak of.
Despite the plethora of constructive signs for the economy, El-Erian said that most economists and analysts don’t believe they will lead to a sustained uptick in growth. “The consensus is that we will get better growth, but not fundamentally better―I think that’s wrong,” he said.
In his view, one of two things will happen. Either the paradigm of subpar growth will end and “we’ll turn into a much better place that validates asset prices,” or, “we’ll take the wrong turn and end up in a much worse place where you’re worried about recessions,” El-Erian explained.
What will determine which scenario comes to pass is policies. If pro-growth policies continue―including infrastructure spending, education and labor market reform, and more balanced fiscal and monetary policies―good things will happen: faster economic growth, a validation of asset prices and less complicated politics.
If those policies don’t continue, “then low growth will become recession; artificial stability will become disorderly financial markets; and politics will get a lot more complicated,” he warned.