With Mohamed El-Erian, Bloomberg View columnist, Chief Economic Advisor at Allianz and is Chairman of President Obama’s Global Development Counsel, and Author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse
Making sense out of Great Britain’s decision to divorce itself from the European Union is a job for a highly-qualified expert. Mohamed El-Erian, author, Bloomberg View columnist, Chief Economic Advisor at Allianz, and Chairman of President Obama’s Global Development Counsel, is such an expert.
Mohamed foreshadowed the chaos caused by Brexit in his latest book The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, which was the subject of a compelling interview here at On The Money Radio last February. At the time, he spoke of the T-junction, that point in the road where you come to an intersection and must choose between following two dramatically different roads. Because of Brexit and other disruptive factors in our world economies and societies, Mohamed warns that we are now approaching that T junction, the end of the road, so to speak, and political choices will greatly affect the order of the world going forward.
How Brexit became the improbable that turned into a reality is best explained by going back to the beginning of Britain’s entry into the European Union. Unlike most of the other member countries who welcomed the opportunity to participate in a free trade zone and enjoy close economic, financial, social, and political ties, Great Britain viewed the EU mainly as a super free trade zone. Instead, they were held to regulations and requirements they found difficult to swallow, including those concerning immigration and open borders.
The political arena that ensued involved a Prime Minister, David Cameron, and his Conservative Party whose stability was threatened by the UKIP, the United Kingdom Independence Party, a fringe party much like the Tea Party branch of our Republican party, whose main goal was to exit from the EU. In order to win re-election, Cameron promised a referendum if he was unable to achieve certain concessions from his European partners. Apparently, the UKIP was not appeased, the referendum took place, and, to the surprise of even those who voted for it, Brexit ruled the day. And now what does remain is a mess.
Because this is such a singular world event, with no playbook to refer to, no one knows precisely what comes next. The ball is up in the air and how it all settles, Mohamed says, depends on the political choices made in the near future, not just in England or in the rest of Europe, but in the United States, as well.
Politics greatly affects the economy and the shock waves from something like Brexit create what Mohamed calls “unusual uncertainty”. Investment wise, so many factors are in play at one time that investors cannot differentiate between the good and the bad. With plenty of cash to invest, this could be a perfect time to pick up good names that are trading cheaply. Mohamed defines good names as those companies or countries with strong balance sheets, positive cash flow, and good management.
As for broad-based index funds or passive investments, the appeal is low fees, but part of the danger lies in passive funds being part of the index. Mohamed offers the example of Argentina which defaulted in 2001 and was 22% of the index. So caution is advised all the way around.
To say that we are in a pivotal moment in world history is not an over-statement. Much of the fallout from large events, such as Brexit, is beyond our control. But getting out of this situation, says Mohamed, requires “a recognition by the nation that unless we do something now, we will face something very nasty down the road.”
The way back to stability in unstable times is through the coming together of both sides of the political spectrum, no matter how divided, to a middle ground where compromise and reason prevail.
One hundred and fifty-eight years ago, Abraham Lincoln, running for the US Senate, delivered an impassioned speech at the Republican National Convention, the most memorable lines being:
“A house divided against itself cannot stand. I believe this government cannot endure, permanently, half slave and half free. I do not expect the Union to be dissolved — I do not expect the house to fall — but I do expect it will cease to be divided.”
Several years and many battles later, Lincoln’s wish for unity was achieved.
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Steve Pomeranz: Mohamed El-Erian graciously joins me now to help us understand and get some needed perspective about the implications of the Brexit referendum. Mohamed El-Erian is a Bloomberg View columnist, Chief Economic Advisor at Allianz and is Chairman of President Obama’s Global Development Counsel. In my previous interview, last February, Mohamed and I discussed his latest book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, which can be heard at onthemoneyradio.org. Welcome back to the show, Mohamed.
Mohamed El-Erian: Thank you. It’s a pleasure to be on.
Steve Pomeranz: Mohamed, can you take a moment to simply and succinctly explain British citizens’ vote to leave the EU and what it will entail in order to accomplish it.
Mohamed El-Erian: For 40 years, Britain has been a member of the European Union. They got free access to markets in Europe and 27 other countries, but, against that, it had to agree to implement regulations that were agreed to in Brussels. What the voters decided is they no longer liked that equation and a small majority of voters decided that what they would rather have is an exit from the European Union.
Steve Pomeranz: This equation you spoke about is a give and take. They get free access, and they have to then accept certain principles. One of those principles had to do with immigration, correct?
Mohamed El-Erian: Correct. Free access of people. Not just of goods and services, but also people. That issue ended up being the defining issue in the referendum. While they then assessed the case on a comprehensive basis, it was a single issue at the end of the day that was the decision maker.
Steve Pomeranz: These referendums are quite dangerous. From your writings, I understand that this was a political gambit by the current prime minister to try to appease some of the extreme members of his own party and without really understanding what risks were involved. What happened there?
Mohamed El-Erian: Going into the last general election, Prime Minister Cameron had the same situation as the Republican Party had in 2010, that is the emergence of a fringe party, the Tea Party here, but over there it was the UKIP, The United Kingdom Independence Party. They were seeking an exit from the European Union.
In order to secure his base, the Prime Minister said, “If you re-elect me and I stay in government, I will hold a referendum, but before I hold the referendum, I will get certain concessions from my European partners.” It was a gamble. It worked in the short-term, in that he was returned to office with a major majority but then the concession that he got did not seem enough to appease those who felt that Brexit should occur, and when the referendum was held, through a series of silly mistakes they found themselves playing defense and ended up losing the referendum. The Prime Minister, in fact, had to resign the day after the referendum.
Steve Pomeranz: It was a question of misunderstanding and underestimating the opposition and not taking it as seriously as needed. Is that a correct assessment?
Mohamed El-Erian: It was the same mistake as has been made repeatedly, including in this country, which is to underestimate the trust deficit between the majority of the people on the one hand and the political business-elite, as well as expert opinion.
Once again, just like happened with Donald Trump here, just like it has happened with non-traditional parties in Europe, the anti-establishment parties, expert opinion, and the elites underestimated the amount of anger there is. It’s not surprising because we have been in this new normal of very low growth and worsening inequality.
Steve Pomeranz: You’ve discussed that in your latest book, The Only Game in Town, and in that book you discussed three stages of central bank intervention. The first phase was “do whatever it takes”. The second phase was “experiment with new tools in order to get the economy expanding”, all the while letting the markets know that this is an experiment which has plenty of risks along with it. The third phase was to “try to extricate the central bank from the process”. Is Brexit one of these unforeseen risks you wrote about?
Mohamed El-Erian: Yes. Brexit is yet another improbable and unthinkable that has turned into reality. Others include, for example, negative interest rates on 30% of global government debt. Think about that. You lend your money to the government, and you pay them for the privilege of you lending your money to them. You and I know that that is absurd, but that is what happens when you experiment for a long time and when you do not promote economic growth. I think Brexit is another example, and we’re going to see lots of other “improbables” become reality if our politicians do not step up to their economic responsibilities.
Steve Pomeranz: Negative interest rates are so extreme, but not too long ago—really the other day—the 20-year yield on the German bond, you lending your money to Germany for 20 years, was zero. In what kind of a world would anybody lend money to an institution or person at zero rate?
Mohamed El-Erian: You and I find it very strange, and yet lots of people do it. I think there are three reasons why they do it. One, they have to. They have certain a regulation that forces them to hold safe government bonds. That’s certainly the case for insurance companies and for banks.
Two, they think that even though they’re going to earn zero, that’s much better than anywhere else. In particular, they’re worried about elevated asset prices elsewhere. They’d rather earn zero and secure their capital than lose their capital elsewhere. The third reason is that they believe that zero is not the end. They believe that it’s going to go more negative, and bonds have this feature that the more negative the interest rate goes, the higher the price. You have three types of forces that are sustaining a world that looks very strange and certainly was not something that anybody expected just 18 months ago.
Steve Pomeranz: What happens over the next few weeks and months?
Mohamed El-Erian: Over the next few weeks in Britain, we’re going to have political trauma. The Conservative Party is going to somehow have to reunite, elect a new leader. The Labor Party is putting enormous pressure on its own leader to exit. Scotland and Northern Ireland do not like the outcome of this referendum, so they are talking about perhaps independence from the rest of the United Kingdom.
It’s a very messy situation. In all this, somehow the UK has to negotiate a new arrangement. There’re some people who say maybe we can reverse Brexit. Maybe there’s some parliamentary way that we can reverse Brexit or even hold a second referendum. The bottom line is that it’s incredibly fluid, and we should expect lots of day-to-day developments because there is no script for this.
Steve Pomeranz: There was a recent article in the Wall Street Journal describing the similarities between today’s political upheaval and the 1930’s. The 1930’s was caused by the Great Depression. The situation was much more dire then and yet the political turmoil is so similar. Really, why do you think the level of discontent is so high? It’s not as if we’re in a deep depression worldwide.
Mohamed El-Erian: We discussed this back in February, when you kindly interviewed me on my book, and remember the thesis of the book is that we were on what the British called a T junction. Think of it as you’re driving down the road and you come to an intersection. What you know for sure is that the road you’re on is going to end, but there are two ways out that look dramatically different.
The road we’re on is ending. We cannot run sophisticated market democracies at very low-growth rates and worsening inequality without something breaking. What we’re seeing, negative interest rates, Brexit, anti-establishment movements, these are all signs that the path we’re on is ending. That is, I think, now more and more obvious to people.
The problem is, or the hope—depending on whether you’re an optimist or pessimist—is that that there’s nothing predestined about what comes next. It depends on political choices.
There is one scenario in which low growth gives way to high-inclusive growth, but there’s another scenario, and that is—if the political system doesn’t step up—where low growth becomes recession, artificial financial stability becomes instability, income inequality worsens even more, and political breakage accelerates.
We are heading towards that T junction and a lot will depend on the choices made in the next months and quarters.
Steve Pomeranz: Are these institutions flexible enough to change with actual real conditions on the ground?
Mohamed El-Erian: That’s a great question. Let me tell you, it’s not an engineering question. Most economists, in fact, the vast majority of economists, agree on the four things that need to happen for us to get out of this mediocre world of low growth. It’s not an engineering problem.
It is really a political will problem. It’s the ability to implement. You require what’s called a Sputnik moment. You require a recognition by the nation that unless we do something now, we will face something very nasty down the road.
It happened in the late 50s when the US woke up to the reality that the Soviet Union, the USSR, or what Ronald Reagan subsequently called the Evil Empire, had succeeded in sending a satellite into space and national security was threatened. The nation came together and responded in a very effective way. What we need today is an economic Sputnik moment.
Steve Pomeranz: The EU is an outgrowth of many Sputnik moments, based upon all of the turmoil, wars, poverty, and misery caused by two world wars and many wars in the 19th century and so on. It has really a positive side. The creation of the EU has created a stable, peaceful Europe for the first time in really a millennium, I suppose. I guess that’s just not enough at this point.
What do you think this Sputnik moment is going to turn out to be? Any ideas?
Mohamed El-Erian: The EU’s biggest problem was that there was an inconsistency from day one when the UK joined and that inconsistency never went away. The UK viewed the EU as a destination. It was a super free trade zone, and that’s why the UK was interested. The rest of Europe, particularly Germany and France, viewed the EU as a means to an end, that end is ever closer union—economic, financial, social, and political.
That was a fundamental difference in views. The hope had been that there would be convergence. As it turns out, there wasn’t sufficient convergence. There was an initial problem, an original sin, if you like, when the UK joined the EU that was never solved.
In terms of what you need, it’s not that hard. That’s what’s so frustrating, it’s not that hard. Basically, it requires coherent politics. It requires the courage by Congress, in particular, to take steps in which individual parties come together in the interest of the nation, recognizing that the base, either the more progressive side of the Democratic party or on the other side the Tea Party side of the Republican party, may reject. Ultimately, governing from the middle is what’s required right now in the United States.
Steve Pomeranz: Some brilliant “uniter” has to rise from the ashes, a Churchillian-like figure, in order to bring all of these together.
My guest is Mohamed El-Erian. He has graciously joined me today to discuss the Brexit referendum and its implications.
Mohamed, investment wise, all of these ideas we speak about are really not in our control as individual citizens. Let’s talk about some of the things that could be in our control. Investment wise, we know that this crisis will produce opportunities. What are some of the areas in the marketplace that we should be looking to tap into?
Mohamed El-Erian: A shock like Brexit, which changes the structure of trade and raises more questions than answers, is the equivalent of what markets call “unusual uncertainty”. It’s not just uncertainty, it’s unusual uncertainty. That means volatility goes up, and when volatility goes up you get what’s called contagient, which means good names and bad names behave the same for a while. Why? Because you’ve suddenly put so many things in play that investors cannot immediately differentiate. There are technical factors that lead to this.
If you happen to be an investor with dry powder, with cash, this is a wonderful time to pick up good names that are trading cheaply. The way you find good names, whether they are companies or whether they are countries, are three characteristics: Very strong balance sheets, positive cash flow, and good management. Those are the three characteristics.
Immediately after Brexit, you saw companies with these three characteristics being beaten up and offering opportunities for investors. I suspect that this is going to be a repeated pattern in the months to come.
Steve Pomeranz: Most investors over the last few years have been counseled, educated, to move much of their money into what are known as passive investments or broad-based index funds. Is that an idea that should still be considered the best idea, or, in the new world you’re describing, is it more important to be more discerning and try to separate out the good from the bad?
Mohamed El-Erian: It depends on where you’re investing. What do you get with passive funds? First, you get low fees, and in a world in which expected returns are low, if you can minimize your fees, that’s a good thing. Second, you don’t have to worry about manager selection. In order to do well in active management, you have to get the top 50% or preferably the top 25% of managers. Not everybody can be in the top 25%, that’s obvious. You have to be able to select managers well.
Passive funds get you out of this dilemma if you’re not confident about that. However, passive funds make you invest in names, not because they’re good, but because they’re part of the index. That is particularly dangerous in certain asset classes, in emerging markets, particularly.
Let me give you an example. If you are investing in the bonds issued by emerging markets, the weight in the index is based on how many bonds a country has issued. The more bonds a country issues, the more indebted it becomes. The more indebted it becomes, the higher the risk of default. You don’t want to be investing in a name simply because it’s acting irresponsibly in issuing more debt. As a reminder, on the eve of Argentina defaulting in 2001, it was 22% of the index. One has to be selective as to how they use passive and how they use active management.
Steve Pomeranz: Be selective is the message. Mohamed, we are out of time. Thank you so much for graciously joining our show to help educate and protect our investors from this quite uncertain world.
My guest Mohamed El-Erian,Chairman of President Obama’s Global Development Council and Economic Advisor at Allianz.
Mohamed, once again, thank you so much.
Mohamed El-Erian: My great pleasure. Thank you.