Mr. El-Erian, the outbreak of the corona pandemic has dashed all expectations for 2020. How do you perceive the global economy and capital markets in this new world after the big lockdown?
MOHAMED EL-ERIAN: The new world looks even more insecure than the old world – and it was pretty insecure. We now have square uncertainty. It is unprecedented that individual developed economies experience such a sudden economic standstill, and especially the entire global economy. This is something that actually only happens in fragile or failed states or when a natural disaster strikes a community.
The world will be more indebted and less globalized – even if we defeat the virus. What are the consequences?
From today’s perspective, three things are pretty clear that will result in low productivity and less growth. First, we will actually get out of the crisis with higher levels of debt at all levels, that is, governments, businesses and households. Second, productivity will be lower due to the change in delivery routes and because companies are partially returning production to their home countries – the corona pandemic is the third significant blow to globalization. The first blow from 2010 was the social protest against too many people being marginalized and not benefiting from globalization. The second blow was the US-China trade war. Now the third blow is coming in ten years, and I think a process of deglobalization is accelerating.
And what – thirdly – can be seen as a corona episode?
There is an increasing state influence. We will end up with business and the public sector intertwined in the economy like a bowl of spaghetti. We certainly experience that in the USA, but also in Germany. Just think of Lufthansa. And we will see the formation of another spaghetti bowl between the central banks and the public sector. All of this will weaken productivity.
We survive the crisis, but we distort the markets even more through expansionary monetary policy. Can this be reversed?
One of the risks along the way is that we are not just getting more out of it
will have so-called zombie companies – companies that would have long since disappeared from the market without low interest rates. We’ll also have more zombie markets. Let’s see what happens in the US financial markets. People think they are in a win-win situation with an investment in US stocks. It is extremely dangerous.
Why do these investors believe that they will always win? And why is it so dangerous?
They believe that either there will soon be a solution to the acute health problem and the economy will recover quickly – or else the US Federal Reserve will intervene in the stock market. The Fed entered the high yield market, allowing less robust companies to borrow money cheaply. The next step, namely going into the stock market, doesn’t seem to be that big anymore.
Will the Fed buy stocks?
I also didn’t expect it to go into the high yield market. And then it happens right at the beginning of the crisis. The Fed’s behavior is difficult to predict if it intervenes in the market these days. Should it really go into the stock market, which I would strongly advise against, it risks destroying the price signals of the market. Second, there is a risk of undermining efficient capital allocation, which is a basic function of markets. Both of these would squeeze productivity. However, we need higher productivity because the debt will have increased very sharply.
So that you can grow out of debt?
Exactly. People often forget that the sustainability of debt is a fraction: the numerator is debt, the denominator is economic growth. And if you move both in the wrong direction – that is, towards more debt and less growth – then you get a more serious problem with the sustainability of the debt.
Hasn’t the Fed itself long contributed to investors always expecting it to bail it out?
The Fed follows the motto “We’re all in” (for example: “We play with full commitment” – ed.) And, like the European Central Bank, is in a “whatever it takes” mode. Let us remember where the expression “all in” comes from.
In poker, “all in” means: you put everything you have in this one game. In terms of game theory – and I don’t mean that the crisis is a game, but that this idea opens up interesting insights – “all in” is a one-round game in which the player expects to win. However, there is currently the possibility of a game over several rounds. Not all problems can be identified at the beginning of a crisis. If that is the case, much of what we are doing at the moment will appear ill-considered in the future.
If you put everything on the table at once, there will be no instruments left for future crises. What options do we still have?
We have experienced an external shock to an extent that I would never have expected. We have to do more than just act as a crisis manager and take care of basic issues. Otherwise the system will become more and more vulnerable.
We met in Frankfurt last November. Back then, you described stocks and bonds as too expensive. Does that still apply?
Let me just tell you what I did. I went into the crisis with a cautious stance, which meant keeping mostly cash. In January and February I repeatedly warned against buying into the first price drops induced by coronavirus in anticipation of further drops. When I saw the massive contortions in mid-late March, I considered a few criteria as to how I would like to participate in a recovery.
Which are they?
There are four criteria: strong balance sheets, i.e. large cash holdings, secondly a positive cash flow as part of a solid balance sheet, thirdly good management and fourthly that the companies can develop well not only in the recovery phase but after the crisis. Companies that meet these criteria include Microsoft, Alphabet, and Netflix. If you invest in the US stock market, they are a good chance of price gains. I bought it as a tactical investment at the end of March and sold it at the end of April, beginning of May, when I felt that the market upswing could go beyond itself.
Why that – don’t you believe in companies anymore?
I think these are great companies, but given the uncertainty about the health and economic aspects, I could never have imagined that there would be such a striking and quick recovery. If you invested in the S&P 500, you would have lost twelve percent by early May this year, and even 17 percent in the Dow Jones. But whoever holds Microsoft, for example, has won eleven percent this year and just lost two percent with Alphabet. If there is a price correction again, you can very selectively buy the companies that will do well.
Until then, do you stay in cash?
Yes. The government bond market is so distorted that it is almost impossible to predict.
There is a debate about whether higher government debt will raise interest rates. Could you then invest in bonds again?
The increased debt will, and so far has hardly been discussed, lead to more defaults in weak countries, especially in the developing world. The market has not yet realized that many countries do not have the resilience of Germany. The West can do whatever it takes, the less developing countries can’t.
Let’s come back to Corona. What does the pandemic mean for social discussion in the United States?
We have been in crisis in the US for just over two months now – it is similar in Europe – and the debate between Main Street and Wall Street is already coming back. Wall Street is saved, although there is little responsibility, while Main Street, ordinary people, suffers more. This debate is fueled by two things: first, the memory of the 2008/2009 crisis, when the feeling arose that Wall Street would be saved, but Main Street would not. Added to this is the divergence between economic data, especially labor market data, and the rapid recovery of the stock market. We got 30 million new unemployed in six weeks.
What does that mean for the upcoming presidential election?
The development reinforces the differences between rich and poor, between companies and people, between present and future generations. We see a wave of reactions from the political spectrum. If the real economy does not recover quickly, this debate gains a lot of momentum.
The article was published in Personal-Financial.com 6/2020. interested in Personal-Financial.com? Click here for the Subscription shopwhere you can order the print edition. Our digital edition is available at iTunes and GooglePlay