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.
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.
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.”