With Mohamed El-Erian, Chief Economic Advisor at Allianz SC, Chairman of President’s Global Development Council
Federal Reserve Normalizing in 2017?
Shifting gears to interest rates and the Federal Reserve, Steve raises the possibility that, in addition to its announcing two more rate hikes for 2017, the Fed is also signaling its readiness to unwind its balance sheet by selling some of the $1.7 trillion in mortgages and $2.5 trillion in Treasury securities that it purchased to stabilize the financial system in the aftermath of the global market crash in 2008. Steve wonders whether this action would bring the market and the economy “back to reality”? El-Erian thinks that the Fed wants to move away from being “the only game in town” in terms of supporting markets and that the relatively healthy state of the economy at the moment offers them “a window for it to start its normalization process.” This normalization includes easing measures to keep interest rates extremely low and getting out of the business of buying securities, upending policies which the Fed has been committed to for the past nearly nine years. El-Erian also remarks that he expects “at least” two more rate hikes this year, suggesting that he wouldn’t be surprised by further increases.
So what does this mean for markets? El-Erian says there will be less support in terms of cheap money (i.e.rates and liquidity) but that markets are reassured by the fact that the Fed wants to exit or normalize in a very orderly fashion. There’s no market panic yet because markets still believe that the Fed will have their back if needed. El-Erian expects higher market volatility for 2017/2018 as central banks in the US, Japan, and Europe withdraw support from buoyant markets. He contends that this situation relates back to his belief that the three elements of the “New Normal”—which have aided a muted growth/low volatility scenario—are at risk of breaking down. At this point, we’re either going to pivot to high or low growth, not stay on the same unsustainable course. One facet of this impending change is that politics in Europe are especially uncertain and this is already affecting economies in the form of BREXIT, with the possibility of further European Union defections to come.
Foreign Markets Outperform US Stocks in 2017
Steve points out that foreign markets have been performing better than domestic in the past couple of months and asks El-Erian why that is. He answers that it’s primarily because of rotation and lag: rotation meaning that investors are seeking other sectors that have not been as overbought as US equities and lag essentially being another way of saying the same thing—foreign markets were left behind in the initial run up in stock prices after the US election. Financials and industrials were the first to gain from the “Trump effect.” Other domestic sectors like tech followed and, soon after, so did foreign and emerging markets, which continue to be seen by many as underpriced even though they have risen sharply, while the US equities have gone flat. Emerging market sovereigns are also better prepared for a Fed interest rate hike than many US companies, thanks to reductions in their debt and increases in dollar reserves over the past several years. That said, it’s still important to look at countries individually. In El-Erian’s estimation, if you buy into the US stock market today, it’s because you expect Trump and Congress to deliver growth policies.
Steve observes that yields on longer-term Treasuries recently declined after a brief rise, indicating that buyers are still pouring in (demand for bonds raises their prices and lowers their yield). Short-term yields, meanwhile, have risen on the back of increases in the Fed Funds rate. This reduction in the spread between long-term and short-term yields is called a “flattening yield curve.” According to El-Erian, this is the result of capital “flows” leaving Japanese and European markets to buy US bonds, and what he calls “technicals,” which flushed out a lot of bond holders, leading them to close their positions. He believes this is a short-term situation and that a more normal, unflattened yield curve should return soon.
Are Stocks Cheap or Expensive? Economic Growth vs Interest Rates
Warren Buffet recently said that stocks are still cheap in the current low-interest rate environment. Steve asks whether it would be bad for stocks if further Fed rate increases caused stock returns and the “risk-free” rate (the 90-day Treasury bill rate) to converge. El-Erian describes the situation as “a race between normalizing interest rates and generating the higher income and the higher growth that this economy’s capable of.” Higher growth would be reflected in rising stock returns which offset and eclipse any simultaneous growth (i.e.”normalizing”) in rates. If growth wins the race, stocks will look inexpensive, but if interest rates rise faster than growth, stocks will be relatively costlier. Without higher growth, Steve notes, earnings and stocks could fall hard. Given the lack of growth policy successes for Trump thus far, this is a distinct possibility. El-Erian agrees, remarking that this is a good reason for investors to exercise more caution than normal. If they want more risk, look for it outside of high-flying US stocks in sectors that have lagged like emerging markets.
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Steve Pomeranz: I’m back with Mohamed El-Erian. Of course, he is very well-known and very well-respected. And we’re talking about interest rates; we’re talking about the stock market; we’re talking about the economy in this new age that we’re in. Welcome back to the segment, Mohamed.
Mohamed El-Erian: Thank you.
Steve Pomeranz: In the last segment, we were talking about high stock prices. And you mentioned that these prices have been decoupled from the underlying economy for quite some time. The Fed is starting to raise interest rates again, so I think that’s a sign that the central bank is starting to change its policy.
And they recently announced that they’re going to start selling off some of these mortgages that they bought up during the crisis in order to stabilize those markets and get them back out into the marketplace and into private hands. What is that gonna mean if, number one, if they’re going to do that, does that bring this decoupling idea, does that bring the stock market and the economy back into reality?
Mohamed El-Erian: Well, fundamentally, what we gain from the Fed is we wanna stop being the only game in town. We wanna get out of this experimental policy stance that has seen us keep interest rates extremely low and has seen us use a balance sheet to influence markets. And the Fed is seeing a window for it to start its normalization process.
So, it’s already started raising interest rates. And I think we’re gonna get at least, and I stress at least, two more hikes this year. And it’s now talking about also getting out of the business of buying securities in the marketplace. It’s talking about stopping from reinvesting proceeds from its asset purchase program. And that’s an important change.
Steve Pomeranz: Yeah.
Mohamed El-Erian: What does it mean for markets? Less support, but markets also realize that the Fed wants to exit or normalize in a very orderly fashion. So, there’s no market panic yet because markets still believe that the Fed will have their back covered.
Steve Pomeranz: Like that “put” that many people talk about—that things go really bad, the fed will come in and kind of save the day. But do you think this is gonna add to a pickup in volatility for late 2017, 2018?
Mohamed El-Erian: I do. I think that the three elements that we talked about which were part of this new normal where growth was muted, but financial volatility was low. I think all three are at risk.
Steve Pomeranz: Mm-hm.
Mohamed El-Erian: One, we are either gonna pivot depending on whether the pro-growth or this stagflationist re-protectionist policies dominate here in Europe. We’re either gonna pivot on the growth to higher or lower, but we’re not gonna stay where we are. Second, led by the Fed, but also gradually the ECB and the Bank of Japan, central banks are gonna be less supportive when it comes to repressing financial volatility.
Third, I think the politics, especially in Europe, is starting to influence the economics. And you see this in Brexit. Brexit was the outcome of an anti-establishment movement that is now gonna change the UK’s trading relations with its most important partner. And that involves a lot of uncertainty.
Steve Pomeranz: I’m glad you brought that up because, from my vantage point as an investment advisor and manager, I’ve noticed that foreign markets, the returns, dollar-based of developed countries and even emerging markets have outperformed the US stock market this year.
What do you account for that?
Mohamed El-Erian: Catch up and rotation, so they lagged in the initial stages of the Trump rally. So, the day after the election, until about mid-December, two sectors took off based on the Trump victory—financials and industrials. And the other sectors, particularly foreign markets and technology, lagged.
And then the marketplace at the end of December and January said, “well, wait a minute. If the outlook is gonna be that much better, does it make sense to have such a discrepancy?” And the answer is no. So, what you got is a rotation where financial and industrials haven’t gone anywhere, but overseas markets, including emerging markets and tech, have had a very good three months.
So what I think you’re seeing is simply a catch-up phase, Steve, whereby the difference between the segments had gotten too much for what actually was taking place.
Steve Pomeranz: So, not necessarily the underlying financials of the corporations that make up those markets, but just more of a rotation to more attractive price assets.
Is that accurate?
Mohamed El-Erian: Correct, this so far is a movement led by markets discounting the potential impact of a better economy and more money coming into the marketplace because of repatriation of capital based on policy announcements. It’s not yet based on policy implementation. And that’s a very important distinction that investors should realize.
If you buy in the market here, it’s because you have high confidence that Congress and the Trump Administration will deliver pro-growth measures.
Steve Pomeranz: So emerging markets have also exceeded even developed markets. Is there anything else going on in emerging markets that’s different than developed economies like the US and Europe?
Mohamed El-Erian: A couple of things, one is that they lagged even more. In their case, the lag was not just a few months but was a few years. And what you’re seeing is, again, a catch-up. But there’s a second element, is that people are realizing that most emerging markets are much better prepared for a Fed interest rate cycle.
Mohamed El-Erian: They have ample reserves. They have lowered the dollar denomination of their debt, and, importantly, they have reduced their overall indebtedness relative to GDP. So, from a sovereign perspective, people realize that emerging markets are better prepared for an interest rate hike.
Steve Pomeranz: So, in a sense, they’re safer financially to invest in than they were years ago when they had much higher debt, more dollar reserves, and dollar movement could hurt them. They’re in a better position financially.
Mohamed El-Erian: Correct, now that is true as an average. I think one also has to be careful in terms of specifics. So, if you look at a Mexico, it’s much better off. But if you look at a Venezuela, it’s much worse off.
So, investors have to be careful in terms of differentiating between different countries when they go into emerging markets. Much more so that in the past.
Steve Pomeranz: My guest is Mohamed El-Erian, and we’re talking about the markets. We’re talking about world economies.
Mohamed, interest rates have been very, I think, unusual this year with, on the one hand, very short-term interest rates which are controlled by the Fed have been rising because the Fed is raising rates and, as you mentioned, you think they’re going to continue to raise rates two more times. The part of the interest rate market which is not controlled by the government, which would be longer-term bonds, like the 10-year Treasury and the 30-year Treasury, instead of going up in yield to anticipate what could be higher growth, while they initially went up in yield, they’ve actually come back down quite a bit.
So you got this flattening of the yield curve, which is a technical term meaning that short-term rates are rising, long-term rates are falling. And that has some implications for financial companies and for other businesses that use interest rates in order to fund economic growth. What’s going on there?
Mohamed El-Erian: Two things are going on, Steve. First, it’s the influence of the rest of the world. When our rates started going up after the Trump [INAUDIBLE] lent the view that inflation, higher growth, and high inflation, was likely, money got pulled in from Europe and Japan. And that money tends to go to segments of the yield curve that are not controlled by Fed policies.
So beyond five years, so that had a depressing effect on interest rates as short-term rates went up.
Steve Pomeranz: Mm-hm.
Mohamed El-Erian: The second element is what market participants call technicals, which is a fancy word for how the market is positioned. And the market was positioned for yields to go higher.
So when yields started going lower, certain market participants started losing money. And when they lose money, they close their positions, which accelerates the dampening effect on longer-dated yields. I think that both effects are running their course and, that within the next few weeks and months, we’re gonna see a return to a more normal yield curve than what we’ve had in the last few weeks.
Steve Pomeranz: So you don’t think that the lower interest rates on the longer-term bonds is a vote, let’s say, by the bond market that we’re gonna be back to this low growth, low inflation scenario?
Mohamed El-Erian: I do not, I think it’s more the influence of technical and foreign flows.
If they were right, in terms of level—because remember, you have a ten-year at 2.30, that’s very low—so if they were right on terms of levels, then the Fed is making a big policy mistake. I don’t think that’s the case.
Steve Pomeranz: Okay, one final question, we only have about a minute left.
Warren Buffet has been quoted as saying that stock prices are high, but we’re not in a bubble because of low-interest rates and the level of the cost of risk-free money. What would happen if, as interest rates go up and the cost of money gets more expensive, and the comparatives between stock market and risk-free rates narrow, is that negative for the stock market?
Mohamed El-Erian: It is if the rates are not reflecting a better economy, so think of it as a race. A race between normalizing interest rates and generating the higher income and the higher growth that this economy’s capable of. And depending on who wins that race, the stock market is either fair to somewhat cheap if growth wins, to being expensive if interest rates win the race.
Steve Pomeranz: It’s like a rocket trying to leave the Earth. It’s gotta hit acceleration escape velocity or otherwise, it’s gonna fall back down to Earth because gravity will pull it back down. It sounds kind of a similar thing. We better get that higher growth or else it’s gonna kinda collapse on itself.
Not to use the word collapse, but it’s probably not gonna bode well for earnings in the economies in the future. Final word?
Mohamed El-Erian: You’re absolutely correct. And investors, therefore, should be a little bit more cautious. And to the extent that they wanna take more risk, they should take it in sectors that have lagged rather than sectors that have led the recent routing.
Steve Pomeranz: Buy low, sell high.
Steve Pomeranz: My guest, Mohamed El-Erian, of course, well-known. He’s the Chief Economic Advisor for Allianz and a friend of the show. Thank you, once again, for joining us, Mohammad.
Mohamed El-Erian: Thank you so much.
Steve Pomeranz: And to join this conversation again, don’t forget to go to stevepomeranz.com, where we list this audio segment plus transcripts plus a summary of what we discussed here today.
Thank you, once again, Mohamed.
Mohamed El-Erian: Thank you.