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 uncertainty.
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 fixed-income fund.
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.
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 LatinFinance.
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 inventory.”
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 emerging world.
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 can control.”
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 says.
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 debt.
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 remains intact.
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 productivity.
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 fundamental.
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 accommodating.
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