Three Big Risks
Regardless of which new paradigm becomes reality, El-Erian predicted that investors can expect more volatility in markets in 2018 than was seen during the unusually tranquil period of 2017.
One risk investors should watch out for is geopolitics. “Geopolitics matter,” said El-Erian. “Markets cannot price in geopolitical shocks easily. If you get a shock, you could get a shift in markets that could be quite violent.”
He said the biggest hot spots to keep an eye on are North Korea and the Middle East, where Iran and Saudi Arabia are waging a proxy war.
Another risk to consider is how successful central banks are at normalizing their unconventional monetary policies. El-Erian is confident the Fed can continue to normalize policy successfully. However, it remains to be seen whether the Fed, the European Central Bank, the Bank of Japan and the People’s Bank of China can all do it at the same time.
The third risk that El-Erian pointed out is the potential for a market accident, particularly from index funds and ETFs.
A small proportion of these funds “have inadvertently overpromised liquidity to the users” and “the users have assumed much more liquidity than the underlying asset class can serve,” he said.
El-Erian suggested areas such as emerging markets and high-yield bonds could be faced with a liquidity crunch in the future. “What happens if certain sectors have overpromised liquidity; do you get contagion or not?” he asked.
Paradigm Shift
Despite the three risks he outlined, El-Erian ended his talk on a hopeful note: “For the first time in a very long time, there’s reason to be optimistic about fundamentals gaining enough traction to validate asset prices,” he said.
Investors just have to expect a bumpier ride this year than last: “The world I’m describing is a world in which even the long-term investor has to have a tactical layer on top of the structural and secular layer.”
“We are coming out of one paradigm and going into another paradigm,” El-Erian added. “There’s more probability of success than failure, but it’s not overwhelming.”
