By Taimur Ahmad
Global financial markets will be marked by one principal
feature in the years ahead: heightened volatility, as investors
re-price risk in a world weighed down by macro and policy
That’s the view of Mohamed El Erian, chief
executive and co-chief investment officer at Newport Beach,
California-based Pimco, the world’s biggest
Fear gripped global markets in the early weeks of the summer
after US Federal Reserve chairman Ben Bernanke made it clear
the central bank intended to wind down its bond-buying program
by year-end. What followed was a widespread re-pricing of risk
– and an almost indiscriminate sell-off across credit
Markets stabilized in the weeks that followed, but El Erian
says heightened volatility is now an inevitable feature of a
new landscape: investors will continue to realign credit risk
amid lingering uncertainty over US monetary policy and
continued global economic weakness.
"I see a lot of financial volatility ahead because people
like us will be re-pricing the liquidity paradigm," he tells
Emerging market turmoil
The prospect of tightening global liquidity proved
especially violent for emerging markets. A sell-off intensified
to levels not seen since the collapse of Lehman Brothers in
2008, leading many analysts to proclaim the end of the road for
the asset class. Returns for the year as a whole are likely to
be negative for the first time in five years. And the asset
class has abruptly fallen out of favor with investors.
But El Erian – who returned in 2007 to run the $2
trillion asset manager after two years overseeing the Harvard
Management Company, where he managed its $30 billion endowment
– says the turmoil represented a "severe technical
adjustment" that is likely to have run its course.
He puts much of the adjustment across global emerging
markets down to a retreat by crossover investors. "What happens
still in Latin America is the minute you have a technical
dislocation in the global markets crossover investors look to
get out. At that point liquidity evaporates and you get a
massive technical sell-off."
That has led to investment opportunities, especially in
local currency and interest rate markets. "That sell-off makes
the less informed people think these are the bad old days. But
the more informed people see this is a great thing, a time for
differentiation, and they see this as opportunity."
While he "wouldn’t go out and buy the [EM]
index," emerging markets have become "a very differentiated
story," he says.
"History tells you that unless bad technicals lead to bad
fundamentals this technical phase is often temporary and
reversible," he says, citing Mexican local-currency interest
rates as being of particular appeal.
Asset markets will nevertheless remain "much bumpier than
the real economy because you’re going to shake out
crossover investors," El Erian says.
Much of this follows an artificial rise in global asset
markets in recent years following what he describes as
"aggressive, experimental and unconventional policies" by
developed nation central banks.
"Everything has been overvalued. We’ve had
artificial pricing everywhere, starting from the US Treasury
market all the way out: whatever risk factor you want to look
at, be it credit, liquidity, equity, everything was overvalued.
And what you’ve had is an adjustment."
Emerging market debt was hit especially hard by this
year’s market turmoil, says El Erian, because of
the pullout of crossover investors.
"Emerging debt suffered more than it should have because of
the phenomenon of the 'tourist’ dollars and the
lack of a big enough dedicated investor base," he says. "People
exited simply because they didn’t want to be
caught with off-benchmark exposures and there was very little
appetite among the broker-dealer community to take down
Emerging markets continue to suffer the fallout out of
unorthodox monetary policies by developed world central banks
– a fact that has complicated policymaking across the
The effects of Western central bank policy "have put many of
these emerging economies in a lose-lose situation," he says.
"You lose by trying to resist the negative externalities and
you lose by internalizing the negative externalities. It is
impossible not to come up with some policy incoherence."
But despite the challenges, the era of emerging market
crises is long past, El Erian says. "We will continue to have
these bouts of volatility. It means that there will be some
policy incoherence. It means that the full potential of certain
countries will not be exploited. But it does not lead us to the
old crisis world."
What’s changed, in El Erian’s
view, is that emerging markets have now achieved financial
self-determination, thanks to improved governance and
fundamentals. "Countries have taken control of their destiny.
It doesn’t mean that they’re not
buffeted by what’s happening outside –
there are always risks that you can’t control
– but they are in much better control of the risks you
The result is that "it’s much harder for
technical dislocation to tip the average Latin American country
into the bad old multiple equilibria, where one bad outcome
would increase the probability of another worse outcome," he
says. "That is a fundamental difference."
The new Latin America "is somewhat better at avoiding own
goals, so they score few own goals. And it has built much more
resilience to external shocks. That doesn’t mean
that it can avoid the cold; it cannot. But it can avoid the
cold from developing into something worse."
But nevertheless, weak points remain. El Erian says
today’s global economic weakness poses the gravest
risk in Latin America to Argentina. "In this environment, there
are certain countries that will tip. Argentina will tip," he
This is not his first bearish call on Argentina. In 1999, as
manager of Pimco’s emerging markets bond fund, he
sold $2 billion of Argentine debt, convinced that the
country’s economic dynamics looked bad –
even though the sovereign at the time represented 20% of the JP
Morgan benchmark index. That call was famously vindicated two
years later when Argentina defaulted on its $100 billion
In contrast, in October 2002, as anxiety gripped Wall Street
over the possible election in Brazil of leftist candidate Luiz
Inácio Lula da Silva, El Erian would fly in the face of
mainstream logic and bulk up on Brazilian dollar debt
– just as Lula’s poll lead widened and
the nation’s currency and bonds slid. Pimco dug in
its heels, adding to its portfolio of roughly $1 billion in
Brazilian dollar debt.
At the time, El Erian insisted that a default was not on the
cards. "Brazil has the willingness and ability to make its debt
payments," he said then. "Those who are betting on a Brazil
default are likely to lose. We’re bullish on
Brazil because it is a good buy at these levels." That bet not
only paid off for the firm – but cemented El
Erian’s status as an investor.
Today, El Erian says Brazil faces the risk of "policy
incoherence" in the face of slowing growth and a global
re-pricing of risk. "I would put Brazil nearer to Mexico than
Argentina, but it’s not Mexico. Mexico has
benefitted from the institutional anchor that Brazil is still
developing. In the absence of institutional anchors people will
go back to old bad habits," he says.
Not so stable
Anxiety over an early end to the $85 billion monthly bond
purchases still weighs heavy on the financial markets. But the
problem, as El Erian sees it, is that the markets are
conflating a winding down of unorthodox policies with a
normalizing of the interest rate cycle.
The latter is unlikely to happen soon, he says, because
growth in the advanced economies will remain weak for
foreseeable future. Central banks, including the US Federal
Reserve, will therefore be hard pressed to tighten policy.
"There simply isn’t enough strength in the
underlying economy allowing central banks to exit, but they
will start adjusting because of the costs and risks and the net
impact will be bumpiness," he says.
Markets are similarly overestimating the capacity of
developed economies, principally the US, to return to
meaningful growth in the short to medium term, he says. "I
don’t see growth in the advanced world taking off
nor do I see it collapsing," he says. "People are
overestimating the extent to which the undeniable healing in
the US economy will lead to higher growth. It’s
hard. We torture our models and it’s hard to get
to the 3%-3.5% GDP growth."
"My best guess is you don’t get enough growth
to allow the central banks to disengage. Remember, they are
supporting markets through three different mechanisms: the
balance sheet operations, the forward guidance, and the
negative real policy rate."
El Erian, who popularized the term "new normal" in 2009 to
describe an era of slow economic growth, high unemployment, and
government debt problems in the West, says the world economy is
now entering a period of "stable disequilibrium" –
that could end in financial turmoil, greater social tensions
and protectionist policies.
"There’s superficial stability but when you dig
there are elements of disequilibrium that makes the predictions
quite hard," he says.
Developed and emerging economies are approaching a
crossroads "where the current road eventually ends, giving way
to one of two contrasting outcomes" – a fast,
sustainable expansion or a slowing world economy with countries
"competing for a smaller pie". This includes China, the
world’s second largest economy, which either
completes its "middle-income transition and grows robustly at
4%- 5% a year, or it fails – and then
they’re going to grow slower," El Erian says.
The next five years, while world growth slows and the global
monetary policy cycle normalizes, will remain turbulent across
developed and emerging markets, he says. But over the longer
term, the investment case for the emerging markets nevertheless
He insists that in five years’ time the term
'emerging market’ will no longer be useful. The
traditional thesis – whereby emerging markets were
characterized by credit risk and default risk, while developed
markets were defined by interest rate risk – has
already broken down, he says. "Already in terms of investment,
we have default risk in the advanced economies and interest
rate risk in emerging markets.
"The term was useful shorthand for a particular historical
period. But that period has come to an end by virtue of what is
happening on both sides." LF
Mohamed El Erian: In his own words
I’m not a buyer of the complete decoupling
argument for emerging markets. The short-term picture is bumpy
– very bumpy.
But over the longer-term, there is significant growth
potential in these markets. If you’re a long-term
investor, now is an opportunity. I see four main factors
supporting the investment case for emerging markets.
First, there is still technology catch up. This becomes much
more powerful given the source of innovation that is occurring.
This allows economies to leapfrog in terms of
Second, entrepreneurship, both of individuals and small and
medium-sized companies, is just beginning to take off. This is
because the enabling environment in emerging economies has
become much more accommodating.
Third, emerging markets have not yet exploited their linkages
with one another. If you look at their patterns of trade, they
are still heavily historically influenced, that is,
south-north. But we’re starting to see much more
south-south trade, which is a win-win for the countries
involved. I’m not talking about labor costs,
I’m talking about something much more
Fourth, for investors, these are markets that have yet to be
completed. For example, there is an irony that exists in many
countries where there is a stock of housing and a growing
middle class – a demand for housing and supply of
housing – but the two are not connected properly. This
happens because the market lacks collateral rules, for example.
So there are lots of places where investors can complete
markets, because the enabling environment is much more
Take Latin America. It’s been an amazing
transformation over the last 25 years.
For an investor today, the region is not just about external
sovereign dollar-denominated debt. It’s about
sovereigns and corporates; it’s about local debt
and external debt; it’s about foreign currency,
it’s about completing markets; it’s
about private equity; the list goes on. Investors now have a
much broader set of risks and opportunities and many more
markets in which to invest.
This has come with a significant development of local
financial markets, a decline in external vulnerability and with
much better governance in many countries Countries have taken
control of their destiny. It doesn’t mean that
they’re not buffeted by what’s
happening outside – there are always risks that you
can’t control – but they are in much
better control of the risks you can control.
— Interviewed by Taimur Ahmad