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We recently had the chance to sit with Dr. Mohamed A. El-Erian, the chief economic advisor to Allianz (ALV.DE), the corporate parent of PIMCO where he formerly served as chief executive and co-chief investment officer. He chairs President Obama's Global Development Council and is a columnist for Bloomberg View and a contributing editor at the Financial Times.

El-Erian has written two insightful and highly recommended books: When Markets Collide: Investment Strategies for the Age of Global Economic Change (McGraw-Hill, May 2008) and The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, January 2016). El-Erian’s conversation with Investopedia offered insights investors should take to heart in trying to navigate a market environment likely to stay volatile well beyond the current turmoil resulting from the U.K.’s unexpected June 23, 2016, Brexit vote.

In line with the thesis of The Only Game in Town, El-Erian holds that monetary policy has gone as far as it can in supporting the global economy. While central banks have performed heroically in bringing the world back from the financial collapse that stemmed from the September 2008 failure of investment bank Lehman Brothers and insurer AIG, successive waves of quantitative easing and regulatory mandates on financial institutions have, in El-Erian’s view, resulted in a number of dysfunctional conditions.

The most significant of these is that globally more than 30% of government debt and 16% of investment grade corporate debt now carry negative yields. Over the long term, the spread of widespread negative interest rates will be increasingly untenable, as it fundamentally undermines the ability of financial institutions to sustain an economic business model. For example, with negative interest rates, it becomes difficult to insure risks as insurers are unable to earn sufficient return on premium income. Over time, negative interest rates will erode the infrastructure of financial firms necessary to support the economy, something that should concern central bankers and politicians alike.

With El-Erian is expecting the present regime of overreliance on monetary policy as economic stimulus to last at most two to three years, higher cash balances are necessary unless fiscal policy stimulus occurs on a coordinated global basis. This is a policy option that the present fiscal austerity and anti-establishment popular political sentiments would appear to block, absent a substantial crisis. In El-Erian’s view, the global economy is heading quickly towards a “T” intersection requiring a sharp turn in either direction, but no forward path.

Relative to central banks specifically, El-Erian indicates that investors wishing to understand the long-term negative consequences of a low-growth, excessive central bank involvement scenario should study Japan: The Bank of Japan has worked its way into a position where it has the choice between two options – either to be ineffective or to be counterproductive. It can no longer be effective. El-Erian warns that if we’re not careful, that is where the ECB and the Federal Reserve will similarly end up. In Japan, negative interest rates have prompted a soaring demand for home safes, as account holders have opted to withdraw cash from a financial system that, with negative interest rates, charges them to hold funds.

The impact of protracted reliance solely on monetary stimulus to support the global economy has been to materially alter the behavior of financial-market participants. In El-Erian’s view, investors have three concerns: the expected portfolio return, the volatility of their portfolio, and the correlation among the portfolio holdings. Successive waves of quantitative easing have brought forward expected returns, artificially repressed volatility and completely changed correlation. The risk for investors is forgetting that sustained central bank intervention leads to a substantially distorted market in which future returns may be flat at best.

Given that many long-term institutional investors have actuarial rate of return assumptions of 7% to 8%, El-Erian offers the following advice in terms of portfolio management: The idea of being able to rely on a long-term “buy and hold” approach to meet 7% to 8% investment objectives has now been undermined. Consequently, investors need to become more tactical in their investment approach, to be prepared to trade to take advantage of short-term market volatility and to hold higher cash balances as a matter of prudent portfolio construction.

For El-Erian, investors have to consider two major factors in the present financial environment: 1) can they afford the mistake that can happen, and 2) correlations among asset classes have changed to such an extent that diversification is no longer a good risk mitigator. Investors have to be less aggressive in the way capital is allocated and find, against conventional wisdom, that cash belongs in the strategic allocation; it is no longer just a tactical allocation decision.

Apart from the fiscal policy uncertainties, El-Erian highlights structural changes unfolding in sectors such as housing and automotive that historically carried significant multiplier effects, as they are being disrupted by the likes of AirBnb and Uber. For El-Erian, disruption is a powerful phenomenon that is not sufficiently understood. The expected impact will likely be reduced demand as the sharing economy improves utilization of existing resources rather than the purchase of new goods – something that will depress GDP growth while perhaps serving to improve long-term efficiency. From disruption, El-Erian expects policy discussions to develop around the possible implementation of a universal basic income to protect workers who are being disrupted and to maintain aggregate demand.

Clearly, the challenges for investors to consider are more than just the coming end of monetary policy as an economic growth driver. Mohamed El-Erian’s conversation with Investopedia provides both deeper questions and new answers. 

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