Mohamed El-Erian has been an important voice through many market cycles, including the Great Financial Crisis, the trade wars, and throughout this pandemic. Very few people can synthesize what is happening in the macro economy and make it matter for individual investors. I sat down with El-Erian, the President of Queens College Cambridge, and an adviser at Allianz and Gramercy for an interview that aired on The Investopedia Express podcast this week.
Here is the full interview:
Silver: What concerns you most as a social scientist right now? You've seen many cycles, but this is very unique. What has you worried?
El-Erian: What makes me most concerned are the longer term effects, and the longer term effects not just on the economy and finance, but on people. What we call scarring. The fact that people will come out of this different. And I'm not just talking about economic insecurity, which I think is considerable, but also mental health. I think we've got to be very conscious that this is putting people under considerable strain. It’s keeping them out of their comfort zone for a long time. It is a major disruption to how they behave and therefore how they think about the future.
Silver: We've seen it obviously in children who can't be at school or are going to school part-time, but you also see it in the workforce, especially those folks that can't work from home. We've also seen it in our shopping habits. Long-term, I don't think we've seen anything like this in several decades. How does it play out in terms of the way we spend? In terms of the way we will interact?
El-Erian: So the greatest concern is that this is a very unequal shock, and you're not just gonna pick it up in the inequality of income and wealth, but we're gonna pick it up in the inequality of opportunity. The minute you bring opportunity into play, it's about multiple generations. So the biggest concern is opportunity, and that's one thing we've got to be very careful of. That is a supply side shock, the economist will tell you. That you are taking away the ability of people to be productive and it adds to other negative productivity effects. Two in particular: The stronger getting stronger, the weaker getting weaker - that's true for companies as well, and definitely we see increased concentration, which is not good for competitiveness. And then we're seeing deglobalization. We're seeing a reordering of supply chains and that in the short term is a negative productivity shock.
So the first thing to be careful about is on the supply side. Then there's the demand side. You know me well. I like simple examples. The Orange County Food Bank saw very new people come asking for assistance. One of them was a long-term 15-year baggage handler at the local airport. They had a very secure job and they were very good at it. Because they had a secure job, they lived from paycheck to paycheck. They never saved. Suddenly that secure job became joblessness. That person will go back to work, but I'm willing to bet that that person will save. So what we're going to see is a demand shock as well as the supply shock.
Silver: Right, because they don't want to be left empty handed the next time this happens.
El-Erian: Correct. You know what? When you suffer a tail event, a low probability huge impact event, you change behavior. The most simple example: How many people buy flood insurance after a flood even though the price of flood insurance has gone up, right? That's the sort of behavior you get when you we react to what's called a tail event.
Risks of a K-Shaped Recovery
Silver: We talked a little bit about the K shaped recovery - the strong getting stronger. Those that have income, those that have capital, those that have equity and own homes are in very good shape here. Some people are actually going to wind up better on the other side of this. But there's a very large subset of low-income earners in the services economy who are not. Is it too late to stop the K-shaped recovery, or to fix it at this stage in the game? We potentially have a new administration coming in Washington. We've known that that's something that they wanted to address. Is it too late?
El-Erian: So it's not too late to address it, and we need to fix it. I don't think people quite realize that the consequences go beyond those suffering. The phrase, “You can't be a good house in a challenged neighborhood” is really applicable, and to understand why, think of distributions. We normally live on the what are called bell shaped distribution, normal distribution. It looks like a bell. These are very comforting because it's anchored by the middle, high probability outcomes, and the tails exist but are thin. Now what happens to a distribution when you hollow out the middle? When you hollow out the middle and you increase the tails, it becomes unstable. It is no longer anchored. We over the last few years have rendered one distribution after another unstable. The middle class got eroded.
Now, why do people care about the middle class? Because it stabilizes social interaction. We have seen the rich get richer, the poor suffer more. That is the income distribution getting hollowed out in the middle. Middle-income people have been hit very hard. And we are seeing the same thing happen in companies where the small boutique players continue, the big companies get bigger, and the middle gets squeezed out. So every distribution we're looking at gets hollowed out.
The new administration has to realize this is a multi-year phenomenon that needs a multi- year response, and what's at stake is much more than economic social wellbeing. It is of stability.
Advice for the Biden Administration
Silver: So let's put your advisor hat on for a second. Assuming the Biden administration ultimately prevails and they take office on January 20th of next year, what should be the first three things it should do to get the recovery, particularly the labor market and particularly these low-income people left out of the recovery, back into gear?
El-Erian: First, manage the period of living with COVID better. We are going to continue living with COVID. I am as excited as everybody else is about the vaccine news, but it will take time. It takes time to distribute it. It takes time for full adoption. We're not going to get the herd immunity for another nine to 12 months. So we need to live better during COVID. The government has a critical role to play here. It's about enhancing testing and tracing. It's about encouraging certain behaviors. So t That's number one.
Number two: enable people. Recognize that people are being hit hard and we're going to need a renewed focus on a few things: Re-training and re-tooling. It can be done with private-public partnerships. Infrastructure modernization. That's absolutely key.That includes getting wifi to children in public schools. When COVID hit and people went online, the LA school district, the second largest in the country, lost touch with 30% of its students. 30%! Think of what that means in terms of their future. Why did they lose touch? Yes, some didn't want to stay in touch. But that's not the real reason. Some didn’t have wifi. Some didn’t have computers. Some didn't have the place to work. So the second element is going to be enabling. Empowering people to make sure that marginalization and alienation stops.
And then the third is household insecurity. We've got to recognize that our safety nets are not strong enough for the sort of world we live in.
Markets vs. The Economy
Silver: Let's switch gears and put your investor hat on for a second. Are you surprised by the way capital markets have recovered and how they are behaving?
El-Erian: No, because I remember the question that would be asked repeatedly when considering a new investment. When I was at PIMCO and we would look at a new investment, we would, of course, assess it on the base of the fundamentals, and then ask the question, who’s going to buy after us? Who is the next buyer? And when you ask the question, who is the next buyer, if the next buyer happens to be a central bank with a printing press in the basement and ample willingness to use it, it is incredibly comforting. So it comes as no surprise to me at all that asset prices have been decoupled from the real economy because central banks are so powerful when it comes to the asset channel - not the economy channel - the asset channel.
Silver: Which is why the Federal Reserve Chair Jerome Powell has been voting Congress to pass another stimulus bill. They have done what they can in terms of tracking the capital markets, putting the safety net under the bond market and even the equity market. But they can't distribute money to individuals directly. Where should the stimulus package be aimed? Should it be any different from the last one?
El-Erian: Yes. And it's important that it happens because central banks desperately need to hand off. It cannot continue being the only game in town. They need to hand off that responsibility. And if they don't hand it off, then the famous equation that Ben Bernanke has set out in 2010 when he used unconventional policy, not to normalize financial markets, but to target economic outcome, he said, quote, “It's about benefit costs and risks.” Now we are in the zone where the costs and risks are starting to exceed the benefits. So that handoff has to be partly to fiscal policy, partly to structural reforms. It has to be both. As to how different the fiscal package needs to be? It needs to be more forward-looking, more pro-work, and more aimed at not just relief, but also enabling the future. I think that's really important, and we have to start early because these things take time to gain traction.
The Next Round of Stimulus
Silver: Do you favor giving direct stimulus payments to families, to households, to pay their bills, to spend? A more directed a stimulus package, checks really, two to households, even those that may be working?
El-Erian: No. I think we have to target the resources. What I favor is to support those who need relief. Focus on those. I understand why in the first phase of the crisis we sent checks out to almost everybody below a certain income level. I understand why because I worked 15 years at the IMF, OK? You cannot wait for perfection in a crisis because the best becomes the enemy of the good. What you do is you respond, you recognize that you may be making mistakes, but then you correct those mistakes as you learn more.
So for me, yes, that first round should have been completely overwhelming, throw everything at it, whatever it takes, all in, all these lovely phrases we’ve heard. But we've learned a lot. So the second round has got to be informed and influenced by our experience. Our experience was that we were too generous in some areas, and not generous enough in others. So we've got to target this better. I think this element of redistribution is going to become more and more important because of how much of an unequal disruption COVID has been.
The Path Toward Deglobalization
Silver: We've talked frequently in the last few years and we've been on this path towards deglobalization, certainly in the Trump era that was a very big theme. Is there a chance that reverses in a Biden administration, assuming he's inaugurated on January 20, or is that just the new paradigm and we're moving in that direction anyway and we'll find other ways to play well on the global scale in terms of the United States?
El-Erian: It's not going to reverse, it's going to slow. So we are going to continue the deglobalizing, but at a slower rate. And you have to understand why. There are three drivers of de-globalization and they all have come together. There's the 2010 driver, which is the sense of certain segments of the population are left behind. That's not going to go away. There's a second driver, which is the sense that not everybody's playing according to the rules. And you know what? We gave countries the opportunity to live up to their global responsibility. They didn't. So now we have to use not just a carrot, but also a stick. That's not going to go away anywhere soon, especially on technology.
Then there's a third element, which is resilience. Company after company is trying to look at its supply chains. And the most typical conversation I'm having is we’ve over focused on efficiency, we over-focused on just-in-time delivery. These very cost-effective cross border supply chains. Now we’re looking to reshore or localize our supply chains. That in the short term is the de-globalization effect.
So you put these three things together, they will continue. But what is different is I think under a Biden administration engagement with the rest of the world will be different. The US is critically needed to inform, influence, and sometimes even impose outcomes on multilateral discussions. It is the only country that can do that. When the US steps away from its leadership role, multilateralism basically stops.
Advice for Individual Investors
Silver: Let's bring it a little bit back to individual investors. We have a lot who listen to this program who are not looking for tactical advice. What would you tell an individual investor or a 401k contributor or a pre-retiree trying to make it to that magic number, trying to make it to that maybe it's 10 years out, maybe it's five years out, maybe they have a number in their head, but they're looking at this. At the same time, the capital markets have roared back, and if they sat on the sidelines or got out when things got scary, now they're even in a worse place. What would you tell the individual investor just trying to make some sense out of this and allocate responsibly?
El-Erian: I would say, you know what? Our greatest strength can become our greatest weakness. So what you've got to make sure is that doesn't happen. Our greatest strength has been basically that correlations go down. Through 2019 and even most of this year, if you ignore what happened in March, you've made money on virtually everything you own. Ironically, you've made money, both on risk assets and also on risk free assets compared to a year and a half ago. You've made money on both. That is wonderful, but that's not normal. We have to realize that. When you realize that's not normal, you start thinking about your mindset.
Now the biggest debate is out there is, is the 60-40 portfolio still valid or not? Basically what that is telling you is that it's not easy to mitigate risk. That's the biggest challenge for investors. When someone tells you, you can't mitigate risk, they’re basically telling you there's a chance you're going to make a mistake. Now, most mistakes in investment are recoverable over time, but some are not. What are non-recoverable mistakes? Capital impairments, bankruptcies, fundamental restructurings. So what I tell people is, don't think you have to go in cash completely. Don't think you have to abandon everything you've learned but take a bottom-up look at your portfolio and ask the following questions. Do you own names that are predominantly resilient? Do they have a strong balance sheet, agile means that they can respond to different global environments and have a certain amount of cognitive diversity - that you've seen them think outside the box.
If you have at least two of these things, especially resilience and agility, then you can sleep well at night. Does it mean that you'll have no volatility? No, you would have it. But it means that whatever short term mistakes your portfolio ends up making, they will be recoverable over time.
Biggest Surprises in 2020
Silver: What surprised you most throughout this pandemic? Whether it's a social behavior or market behavior. What has just shocked you?
El-Erian: So what shocked me and what's not being talked about enough is what my dad used to call the upside of adversity, the silver linings. You know, we are going to come out damaged. Yes. But there's also a bunch of silver linings that if we can bottle them up, we are going to be better.
It starts on the medical side. We have seen an incredible amount of leapfrogging in medical innovation and invention. That's what happened when they threw aton of money at something, you end up getting a lot of positive side effects. So these innovations are going to help. We've seen so much collaboration among scientists. We've seen better public-private partnerships. We've seen better awareness of tail events. That's really important because there were people denying climate change. They thought at best, it's a very remote tail risk. Well, we've seen what a very remote tail risk looks like. So let's do something.
Finally we've seen amazing acts of kindness, we really have. We now respect much more on nurses, our doctors, our healthcare professionals, our first responders. If we can bottle all that up. So what has surprised me is all the silver linings and my great hope is that we can turn these silver linings into long-term benefits.