FEG Bridge Insight with Dr. Mohamed El-Erian

apple

 

spotify

 

google-podcast

 

listen on YouTube

 

From his start with the International Monetary Fund to his current roles as president of Queens College, chair of Gramercy Funds, and chief economic advisor to Allianz, Mohamed El-Erian has a host of experience dealing with global macro issues and assisting policymakers across the globe with difficult economic situations.

On this episode of the FEG Insight Bridge, Mohamed talks about his deep respect for central banks (and his disappointment with the Fed), and the intricacies of policymaking, which must account for political, social, and economic issues. He also discusses the seemingly conflicting signals from the stock and fixed income markets and how institutional investors should be repositioning their portfolios in response to market volatility. This is one episode you do not want to miss!

Chapters

00:00:00 Intro

00:00:30 Episode overview

00:01:31 How Mohamed’s international background informs his investment perspective

00:04:00 On being a die-hard Jets and Mets fan

00:05:40 Discussing Mohamed’s book The Only Game in Town: Central Banks, Instability and Avoiding the Next Market Collapse

00:09:19 The Fed’s (lack of) credibility

00:14:42 Managing volatility as an investor         

00:19:31 Comparing the signals of the stock market and the fixed income market

00:23:31 What institutions should be looking to change in their investment portfolios right now

00:25:20 Are emerging and frontier markets currently investable?

00:33:18 Currency volatility in international developed markets

00:36:31 Mohamed’s advice for the Biden administration

00:38:38 Reading recommendations

 

SPEAKERS

Dr. Mohamed El-Erian

Economist

Dr. El-Erian is a global economist and leader in emerging markets investment and research, having previously held senior roles in investment management and international policymaking. He was on Foreign Policy’s list of Top 100 Global Thinkers for four years in a row and writes regularly for Bloomberg and the Financial Times. As Chair of Gramercy Funds Management, Dr. El-Erian actively contributes in the following areas: (i) providing the investment team with global, regional and country perspectives on economic, market and geopolitical developments; (ii) offering insights on a range of investment-related matters (in particular, global investment trends and their immediate and longer-term impacts on emerging markets asset classes); (iii) helping to decode economic and policy developments, focusing on their potential emerging markets effects; (iv) macro themes that inform and influence individual trades and; and (v) advising on specific investment issues, including multi-asset allocations.

Host

Greg Dowling, CFA, CAIA

Chief Investment Officer, Head of Research, FEG

Greg Dowling is Chief Investment Officer and Head of Research at FEG. Greg joined FEG in 2004 and focuses on managing the day-to-day activities of the Research department. Greg chairs the Firm’s Investment Policy Committee, which approves all manager recommendations and provides oversight on strategic asset allocations and capital market assumptions. He also is a member of the firm’s Leadership Team and Risk Committee.

Transcript

Greg Dowling (00:00):

Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG, an institutional investment consultant and OCIO firm serving nonprofits across the U.S. This show spans global markets and institutional investments through conversations with some of the world's leading investment, economic, and philanthropic minds to provide insights on how institutional investors can survive and even thrive in the world of markets and finance.

Greg Dowling (00:30):

From geopolitics to global economics, the world has been a crazy place this year. To help us better understand the implications on markets, we have brought out the big guns today. Our next guest on the Insight Bridge is Mohamed El-Erian, and just listen to this resume: Mohammad is the current president of Queens College, chief economic advisor to Allianz, and chair of the Gramercy Funds. He is also a columnist for Bloomberg View and a contributing editor for the Financial Times. Previously, he served as a CEO and co-CIO for PIMCO, president and CEO of Harvard Management Company, and deputy director of the IMF. Additionally, he served as the chair of President Obama's Global Development Council and is a New York Times best-selling author. One word: wow. So don't miss a minute.

Greg Dowling (01:28):

Mohamed, welcome to the FEG Insight Bridge.

Mohamed El-Erian (01:30):

Thank you, Greg. It's wonderful to be with you.

Greg Dowling (01:31):

So I'm going to ask you a lot of global macro questions. I know your professional background and I imagine many of the listeners know your professional background, but I was a little surprised on your personal background, because it's also very global. Your dad spent time as an ambassador to France for Egypt and later worked at the UN, and you spent a lot of time shuffling between the U.S., Europe, and the Middle East. Do you feel that gives you a little bit of a different perspective than most U.S.-centric investors?

Mohamed El-Erian (02:03):

So like you say, I got moved around a lot. I said “I got moved” because those decisions weren't mine until I got to the age of 15 and I told my dad, “I can't do this anymore,” and I got sent to boarding school. But up to that point, we would just move from one country to another. Look, the advantage is that you learn to live in different cultures, you learn to look at things from different perspectives, and that gives you a more diversified approach to analyzing issues. The disadvantage, on a personal basis, is you don't feel you have roots. When someone says, “Where's home?” I say, “Well, home is in lots of places.” It has advantages and has disadvantages. But when it comes to the analysis, what moving around taught me is that you should ask a question from very many different perspectives, not just one.

Greg Dowling (02:49):

That's super valuable, especially when we have a globally interconnected marketplace. Maybe becoming a little less connected, but certainly very, very connected. Have you ever felt like that diplomatic framework was helpful in your investing career?

Mohamed El-Erian (03:05):

It was helpful in interacting with authorities and in talking to governments about policies. And I must say, I had 15 years at the International Monetary Fund, where you end up in many policy discussions. So that really had a huge impact on how to think about policies, how to interact with policymakers, how to understand their language, how to read communiques. People don't realize that communiques take a very long time to draft. That people can argue literally for 20 minutes whether the word should be “significant” or “substantial.” Where you get an advantage is that you've seen that world, you've lived in that world, and in the few cases where that world dominates from a top-down perspective, you have a feel for what they're thinking and the likely mistakes. Because policymakers also are human beings, and they're also subject to all sorts of behavioral biases.

Greg Dowling (04:00):

That's interesting, the one word “significant.” You've lived everywhere, and that gives you an opportunity to choose many homes, but somehow you've gravitated to being a Mets and a Jets fan. Could you pick better sports franchises to root for?

Mohamed El-Erian (04:16):

Oh, I should have picked better franchises, but one of my traits is loyalty.

Greg Dowling (04:20):

[laughs]

Mohamed El-Erian (04:21):

So once I back a team, I find it very hard to change. And believe me, both teams have given me every reason to look for other teams. Look, it's easy to figure out how did I end up a Mets and Jets fan—I'm 10 years old, I'm living in New York, it's the miracle Mets. In 1969 they shock everybody by winning the World Series. Then Joe Namath and the Jets win the Super Bowl. Once you live through these two things, especially when you're 10 years old, you never forget them.

Greg Dowling (04:49):

Yeah.

Mohamed El-Erian (04:49):

I got hooked then and I've suffered ever since, with—

Greg Dowling (04:53):

[laughs]

Mohamed El-Erian (04:53):

—with one exception, 1986, for the Mets. But for the Jets, it's been absolute torture every single year. And I don't learn, I start the season with great hopes and I get disappointed over and over again. Who do you support, by the way? Because that's going to determine where we go with this podcast.

Greg Dowling (05:09):

You know, we're here recording this in Ohio. So I root for all the Ohio teams. I was born in New York, but I was really raised in Cleveland and spent a lot of time in Cincinnati, so I go…

Mohamed El-Erian (05:19):

So is it Cincinnati or is it Cleveland baseball?

Greg Dowling (05:21):

I like Cleveland baseball. I'm a Reds fan as well, I root for the Reds and…

Mohamed El-Erian (05:27):

Because the Mets beat the Reds recently, so that's why I’m asking.

Greg Dowling (05:29):

Yes, yes they did. The Reds are pretty bad. And I’m a long-suffering Browns fan, although maybe I should become a Bengals fan, because they've had a pretty good run recently.

Mohamed El-Erian (05:39):

Oh, the Browns are coming back.

Greg Dowling (05:40):

I hope so. I hope so. I've been saying that since I was 10 years old. Let's get into the investment stuff. You wrote a book. I read it. It was written in 2016. What a great title for a book: The Only Game in Town: Central Banks, Instability and Avoiding the Next Market Collapse. In retrospect, what did you get right and what did you get wrong?

Mohamed El-Erian (06:02):

So in retrospect, I wrote it too early--or I published it too early. Had I published this a year ago, it would've had a lot more attention than it did back then. The thought experiment at the time was that we had had complete dominance of central bank policies coming out of the financial crisis. That central bank policymaking was the only game in town—there was political reasons why other policymaking entities were paralyzed—and central banks took on more and more responsibilities, venturing ever-deeper into experimental policies: zero interest rates, negative interest rates in the case of the European central banks, massive injections of liquidity, very aggressive forward guidance. We really ventured into uncharted territory. The question I asked is, “How long can this go on?” At the time that I wrote it, I had this notion that it could not go on for more than 5 years, because there was 10 contradictions that were playing out under the surface, and if you got a catalyst that exposed them, then we would have an issue. And of course, today we are living that issue. The catalyst was a change from a regime of insufficient demand to a regime of insufficient supply. Inflation is the result, and that is acting as a catalyst to disrupt all sorts of things. That's what we've been living through for the last 15 months.

Greg Dowling (07:29):

So you wrote it too early. If you were going to write it again today, what would the book be called?

Mohamed El-Erian (07:33):

It would also be called Exiting the Regime of the Only Game in Town.

Greg Dowling (07:37):

[laughs]

Mohamed El-Erian (07:37):

And again, How to Avoid a Major Crisis. I think that that is the question facing us today. We know that central banks can no longer continue what they're doing, we know that other policymakers need to step in and central banks need to somehow find an orderly way to reduce their distortions of markets, and we haven't quite figured out how that's going to happen. That is a fundamental question for the economy, for markets, but has massive social, political, and geopolitical dimensions.

Greg Dowling (08:06):

If I think of the quote, “the only game in town,” I believe it references a gaming institution, a casino, and it says: “Hey, the casino is rigged.” Then the person says, “Well, it's the only game in town.” So I guess we're looking for the next game right now, right? Even though it might be a little bit rigged still.

Mohamed El-Erian (08:21):

So as I say at the beginning of the book, the phrase is not mine. The phrase is a central banker’s. I was attending a central bank conference in Paris, and it was hosted by the central bank of France, the Banque de France. The governor got up and said, “We don't want to be the only game in town. We've been carrying all these economic responsibilities, and we know that we don't have the tools to deliver good outcomes. We have the tools to build a bridge, but we're bridging to some other policymakers, and we don't like being the only game in town.” So the phrase itself came from the French central banker. And then it evolved into that. I think the only game in town is exactly what you said, it’s who's hosting policymaking.

Greg Dowling (09:01):

Yeah.

Mohamed El-Erian (09:01):

Who's responsible for it? And in a good, well-functioning system, it's many different policymakers, because it's not just monetary policy. It's monetary policy, it's fiscal policy, it's potential policies, it's structural reforms. And central banks just don't have the tools or the authority to venture into these areas.

Greg Dowling (09:19):

So let's talk about that. Let's go to central banks and let's focus a little on the Fed. The Fed has raised rates, big moves here—75 basis points—and looks likely to make further increases down the road here, probably in September and later after that. Has it reestablished its credibility or is it still a little behind the eight ball?

Mohamed El-Erian (09:39):

So I am sorry to say it is still behind. I say this because I have great respect for central banks, and I think that politically independent central banks are a critical element of a well-functioning system. But with that comes accountability, with that comes an obligation to be a technocrat and not a politician. And the Fed in particular has fallen behind significantly and has failed to fix four mistakes that speaks to its credibility. One is analysis. This is a Fed that unfortunately got stuck on the notion that inflation is transitory, did not listen to what the companies were saying, to what the micro was saying, and took way too long—until the last day of November last year—to acknowledge that inflation was not transitory. To this day, they haven't explained to us why they made that mistake. Unlike the ECB, which came out with a white paper explaining why it is that they had made a mistake.

Mohamed El-Erian (10:38):

So the first mistake was one of analysis. The second mistake was forecasts. Greg, you and I have been around for a long time. I don't remember a time in which the Fed issues quarterly forecasts and they are dismissed not only by serious economists, but by former Fed officials. And the phrases they use: “laughable,” “dreamy,” “fairytale,” “unrealistic.” Again, we've had not just an error of analysis, but one of forecast. The third is action. Even when the Fed recognized that inflation wasn’t transitory, it didn't move fast enough. It should have moved earlier than November last year, but it didn't. So we had this ridiculous situation that in mid-March when we got the CPI print for mid-February and it was a 7% handle, the Fed was still injecting liquidity into this economy. That's how late it was. So you've had a failure of action. And finally, you've had a failure of communication.

Mohamed El-Erian (11:29):

And you've had it again recently with all this back and forth. “Let's walk back chair Powell’s comment that ‘we are at the neutral rate.’” The Wall Street Journal publishes an editorial, the Fed talks again and again and again and again—there's been awful communication. So when you have these four issues and you're not moving fast enough to fix them, you have a credibility problem. And credibility is critical to a central bank, because forward policy guidance is one of the tools. Now the market itself has been—especially if you look at the 2-year yield—has been incredibly volatile, it's gone all over the place. In one week alone, we traveled almost 40 basis points back and forth on the 2-year yield. It just shows you that we have a problem with the Fed’s credibility. My hope is that we're going to be able to restore it quickly, otherwise we're going to lose a very important anchor to economic and financial stability.

Greg Dowling (12:23):

It seems like they've almost kind of walked back any forward guidance. They won't be projecting anything, so perhaps their only action is just following through on promises they've made. So how do they… ? If they're not going to communicate—and maybe they will at Jackson Hole—what do they need to do to get that credibility back?

Mohamed El-Erian (12:39):

I think they want to stop forward guidance, but they don't know how to do it. I'll give you the example. It was clear from the scripted part of Chair Powell’s press conference that they wanted to walk away from forward guidance, because they've been burned so many times. And then he goes unscripted, and for reasons best known to himself, he says that we are at the neutral level in terms of interest rates. Within two days, you have Larry Summers coming out saying that this was “analytically, indefensible,” “inexplicable.” Those were his words. And then on the following Monday, Tuesday, Wednesday, you have five Fed speakers come out and basically give you completely different forward guidance with regard to rates and saying, “No, no, we're not at neutral.” So yes, they're trying to walk away from it, but for some reason they end up not walking away from it, and they end up adding volatility.

Mohamed El-Erian (13:25):

There was a big chuckle at Powell's press conference in July when he said that “our intention is not to add to volatility.” People laughed in the room because they knew that the Fed had, at every press conference, added to volatility. So what should they do? I think first and foremost, they need to be honest. They need to be technocrats. They need to take a page from the Bank of England's playbook, where you just say, “Based on what I know, this is why I made the mistake. This is how I've improved my forecast. These are my technocratic forecasts.” The bank of England came out with a set of forecasts that were scary. They said inflation would go up to 13%—it’s currently 9% there—that the UK would enter in a recession in the fourth quarter and stay in a recession throughout the next year. And the Bank of England said that in order to act as a catalyst, not just to deeper policy discussions elsewhere, but policy action to avoid an outcome that no one wants. That's the role of an honest central bank. The Fed needs to be able to put out projections out there that people think are realistic and that form the basis of a good conversation and analysis as to what policies are needed in order to get us to a better outcome. The last thing anybody wants is to sleepwalk into a recession.

Greg Dowling (14:42):

It's amazing. We all follow earnings releases and economic reports as they come out, but I've never seen a time where you have to be aware of every Fed speaker. It's not just even Powell, but you'll leave your desk and the market's up, and you'll come back and the market's down and you're like, “Well, what happened?” “Well, there was a Fed speech at 2:00 PM today.” It's uncanny, which has led to a lot of fixed income volatility—not even equity market volatility, fixed income volatility is off the charts. And you have that. You have inflation. I can't imagine how difficult it must be to manage a core or core plus fixed income portfolio. So if you were back in your PIMCO days and you were a practitioner doing that, what do you do? How do you manage this?

Mohamed El-Erian (15:27):

It's hard. First you have to decide: is volatility your enemy or is volatility your friend. If you think volatility is going to be contained, it can be your friend. If you think volatility, risks, tipping points--what economists call “multiple equilibria,” then it is your enemy. So the first decision is what type of volatility it is. The second thing, which most investors hate to have, is to start with the assumption that you're going to make a mistake. No one wants to make a mistake, but if you are sensitive to… If the market is sensitive, as you said, to every comment, the likelihood is that there'll be outcomes that are going to surprise you. So you've got to be very clear as to what is a recoverable mistake and what is an unrecoverable mistake. The good news is that in investing, as you know, Greg, most mistakes are recoverable with time. But some mistakes are unrecoverable, and you've got to be very clear in your head: What is that unrecoverable mistake?

Mohamed El-Erian (16:21):

Now, of course, default is an unrecoverable mistake, but there are other unrecoverable mistakes. If you don't understand your investor base well, and it turns out that your investor base doesn't have the appetite for the volatility that the market is going through and starts withdrawing money, that can cause all sorts of issues for you. Even though you've got the investment call right, you haven't got the flow call right. It's a different type of discussion than when you are in a relatively stable environment. And it's one that is hard to have. I go back to the importance of having three elements in any investment approach. And I go beyond that in life, for governments, for families, for companies. In a world where the unthinkable becomes reality… Who would've thought we would have negative interest rates? Who would've thought we would have a pandemic? Who would have thought that Russia would invade Ukraine?

Mohamed El-Erian (17:10):

We are being told that we live in an unusually uncertain world—not just uncertain, unusually uncertain world. And there's three characteristics that you need for an unusually uncertain world. One is resilience; the ability to fall down and get back up. And that speaks to balance sheet resilience, it speaks to institutional resilience. You need resilience. The other one is you need optionality. You need an open mindset that allows you to visit your criers as conditions change, not to become cognitively captured by a certain paradigm, as happened to the Fed, that is no longer in place. And that speaks to cognitive diversity, it speaks to gender and other types of diversity, and an open mind. And then the third thing you need is agility. The ability to move quickly when there are clear risks and clear opportunities. That, ultimately, is what helps people navigate not just a difficult investment outlook, but an uncertain overall macro framework. And for those who think the macro framework is not important to them, I always remind them, “You cannot be a great house in a difficult neighborhood. The neighborhood matters.”

Greg Dowling (18:15):

If we look—and I think this is across most asset classes—I find that most active managers are really good at security selection. Sometimes there's a handful that are really good at macro, but most of them aren't good at macro. And I just think of duration, trying to manage duration in this timeframe. If you have too large of a bet either way from your benchmark, boy, with this amount of volatility that can probably put you into an early grave.

Mohamed El-Erian (18:39):

You're absolutely right. The first five months of 2022 were a great example of that, when inflation disrupted interest rate risks. When interest rate risk—when that risk factor’s on the move, the three things that matter for you suddenly become problematic: return, correlations, and volatility. What investors learned is it didn't matter how good their single-name selection was, because the macro factor, the “common global factor,” as the economists call it, was on the move in a big way. And we saw what happened. Massive negative returns, correlations broke down completely, there was no risk mitigator in the system anymore, and volatility went through the roof. So every once in a while, when a global factor moves, it does put a tremendous pressure on bottom-up investment selection. It doesn't mean that's not necessary, it’s absolutely necessary, but there are certain regimes in which it's not sufficient.

Greg Dowling (19:31):

It's not unusual that the bond market sends different messages than the stock market. And as we're recording this right now, we've had a pretty nice rally off the bottom on equities. Perhaps it's a bear market rally, time will tell, but on the yield curve side, we're pushing through 40, moving towards 50, it's pretty inverted. So what is the fixed income market telling you versus the stock market right now? And which one do you think is correct?

Mohamed El-Erian (19:59):

I think they're both consistent with each other, even though they're giving you different signals. I know that sounds strange, so let me explain. The bond market is pricing off fundamentals. And the bond market is worried that because the Fed is so far behind, the Fed is going to have to continue hitting the brakes hard and that is going to push us into recession. And we have already, as you pointed out, when I've last looked, the 2/10 was at the negative, -46, and it's been getting more negative over the last few weeks. So the bond market is clear in terms of the recession risk is high. The reason why is that the Fed is going to be forced to raise interest rates, inflation at the core level is going to prove more sticky than we'd like it to be, and therefore the fundamental outlook is concerning. That's the message from the bond market.

Mohamed El-Erian (20:46):

The message from the equity market—that rallied significantly in July, for example, when the economic data was flashing yellow, if not red—is not that the fundamentals somehow are very, very different, it is that the two other drivers of valuations are in command and they have overwhelmed fundamentals for now. One is simply what we call technicals, the amount of liquidity still sloshing around the system. You know, when you double your Fed balance sheet from 4 to 9 trillion, when you inject so much liquidity through the fiscal mechanism, when you take saving rates to levels we have not seen for a very long time in terms of how high they are, that liquidity is not absorbed overnight. It's still sloshing around the system. And combine that liquidity with attractive relative valuation. You had certain equity names, as you know, that were down 60, 70, 80%, and you get that part, the technicals and the relative valuations, overwhelming the fundamentals.

Mohamed El-Erian (21:47):

And then you get one last issue that I'm sure a lot of listeners to your podcast have come across. For me, it really was illustrated in an investment committee for a nonprofit that I sat through last January. The discussion started by people feeling uncomfortable about equities. “Let's reduce equities.” This is a traditional nonprofit, small endowment of about $100 million, and it's 80/20, 80% equity, 20% bonds, so there was significant exposure to equities. We go around the table and everybody agrees, this is going to be a difficult outlook for equities. So what to do? Someone says, “Go into bonds.” And then the reaction is, “What are you talking about? Yields are highly repressed. Inflation is high. The Fed is going to be on the move. If you're going into bonds, you're going to suffer a price loss and you don't get paid much for that.”

Mohamed El-Erian (22:39):

Everybody agrees. “Go into commodities.” “Well we can't go into commodities, it is so volatile. And how much could we put into commodities anyway?” “Go into crypto.” “Oh no, we can't do that, our reputation.” “Go into private markets.” “We're too small.” So we go through the whole thing and we end up exactly where we started because of what I call the concept of the “cleanest dirty shirt,” that there is no clean shirt in investment anymore. Markets have been distorted for too long for that to happen. So investors are running around, and cash wasn't attractive at that point because everybody was looking to an inflation rate that continues to go up, and that means a guaranteed real negative return. So when you do the relative valuations, equities still look attractive at a time when the fixed income market hasn't fully adjusted. When the fixed income market fully adjusts, then equities will lose that element of “there's nowhere else to go.”

Greg Dowling (23:31):

I wanted to ask you to add to that, because you are the current president of Queens College. And that's Cambridge. Even though you're Mets and Jets fan, this is not Queens, New York, this is Queens of Cambridge. You are also the former president and CEO of Harvard Management Company. We have a lot of higher education clients. And that discussion that you just told is the same discussion that all of them are having. So if you can't change asset allocation, what are you telling them? Are you changing your return expectations, your spending policy? What are things that institutions should be thinking about right now?

Mohamed El-Erian (24:03):

So again, it varies tremendously from one institution to another. If you are 60% reliant on your endowment, it's very different than if you're 10% reliant on your endowment. Again, I go back to the first discussion to have is: “What is our nonrecoverable mistake?” If your nonrecoverable mistake is that you're forced to sell because the market is down 30%, that is a catastrophe, right? Because you don't have a way back. Most endowments have the advantage of permanent capital, so they can take a much longer-term view. And depending on the initial conditions, you come up with very different conclusions. If you were conservatively positioned and you have permanent capital, you had—and still have—attractive entry points. But this is not a general market statement, this is a very sector- and name-specific fact. This is a world in which portfolios are built from the bottom up, then you look at it for overall consistencies, and then you go back again from the bottom up. This is not a world in which you build from the top down and just stick to your optimizer, because your optimizer itself is having problems dealing with what's happening on the ground because we are changing liquidity regimes. We've gone from a world of insufficient aggregate demand to a world of insufficient aggregate supply, and that has a huge impact on the assumptions you put into your optimizer.

Greg Dowling (25:20):

There's always science and art, and you can't forget the art piece right now. Talking about maybe one specific area where you have a lot of experience at, both from your time at IMF, but then at PIMCO, and then even at your current role at Gramercy, you spend a lot of time on emerging and frontier markets. That is one area that, at least on paper, looks pretty cheap, but are they investible?

Mohamed El-Erian (25:43):

So again, on paper they look cheap. If you look at it top-down, they look cheap in an absolute sense, in terms of spreads, in terms of overall yield. They look cheap relative to high yield. They look cheap relative to U.S. investment-grade. So yes, they are cheap. But it's really important to build the portfolio from a bottom-up perspective, because even though we call it EM, it's a very heterogeneous asset class. So there are real attractive opportunities, and there are other opportunities that you should be avoiding. The heterogeneity of the asset class is critical in terms of how you build your exposure. And the heterogeneity applies to three different levels. One is: don't go for indices, go for individual names.

Mohamed El-Erian (26:27):

I'll give you an example. When I started, when I went from the policy side to the investment side back in 1999, a very long time ago, most of the universe of EM-dedicated investors like PIMCO were worried about Argentina's outlook. Argentina was 21% of the index at the time. We'd sit with other managers and everybody would agree that Argentina was problematic. Everybody would agree that Argentina should be an “underweight.” And then the question was, how big is that underweight? You'd hear 4 percentage points, 5 percentage points—that's huge. At PIMCO, we took a completely different approach, we had no Argentina. I remember being told that that's irresponsible because it's 21% of the index and the tracking error is huge. And my response was, “Well, I don't mind having a tracking error to a country that's going to default,” which it did. Secondly, you can reduce the tracking error by taking advantage of regional correlations. If you look at that year's return, if you had invested in the index, you would have gotten -8, because Argentina was down 60 or 50.

Mohamed El-Erian (27:34):

If you had invested in the index minus Argentina, you were in positive territory. And if you had taken the PIMCO approach, you made 20%. So it's really important to recognize that there are times when it makes sense to invest via indices and there are times when it makes sense to invest away from indices. The second heterogeneity is between external debt, local markets, and sovereign corporates. These relative valuations move all over the place, and it's important to take advantage of them. And that's why it's better to take an overall EM approach where you can move, have a multi-asset approach to emerging markets, as opposed to simply focus, “I’ll put bonds in the bond bucket, I'll put equities in the equity buckets, I’ll put local currency in the exchange rate bucket.” You have to have the flexibility, the agility. And then the third one is private versus public. I think what some of the biggest opportunity is today is in private markets in emerging markets. They're not as well-developed as private markets in the developed world, and therefore there's a lot of inefficiency still that can be taken advantage of.

Greg Dowling (28:40):

Well that's great. And you bring up a great point indirectly, that there's a huge difference between equity benchmarks and fixed income benchmarks. If you're an equity benchmark, usually the largest holding and something that's cap-weighted has done the best. If you're looking at emerging markets, it's usually the country that needs to issue the most debt [laughs] so it’s very different.

Mohamed El-Erian (29:00):

You’re absolutely right. In one case you reward success. In the other case you reward irresponsibility. That's what the index does, right? When it's based on the amount of debt you issued.

Greg Dowling (29:09):

Absolutely. And I love the looking at the correlations between other countries. It's been a weird time. I agree with you on the private side, but it's weird that we've seen... Maybe it's not weird, but it hasn't happened in a while where we've seen civil unrest in places like Sri Lanka and Laos. Should we expect more and could that then play itself out into an EMD crisis like we've had in years past?

Mohamed El-Erian (29:36):

If you look at the asset class, and this comes back to the importance of differentiation, the average of the asset class tells you it's a much more resilient asset class. The dispersion of the asset class tells you, you have to be really careful about where you invest. So you mentioned the civil social unrest that we're getting, the political unrest that we're getting. Look, if you shock countries with a food crisis and an energy crisis at the same time, fragile countries will tip over. They'll tip over into either an economic crisis or social crisis or political crisis, or all three. And we're seeing that happen. We're seeing political stress, we're seeing social stress. Remember, a lot of resilience was used up during the pandemic, so countries don't have the resources to deal with high food prices, irregular supplies—which is worse than high food prices—and then an energy issue at the same time.

Mohamed El-Erian (30:32):

So the dispersion is such that you will see a few countries get tipped over by these exogenous shocks. But the average EM is much more resilient than I remember in my career, in terms of external shocks. And therefore, if you are able to differentiate, if you're able to avoid the vulnerable ones and focus on the strong ones, you have a good investor hypothesis. Why? Because the market doesn't differentiate well enough because of the index effect. The index is such that contaminated. I learned this, by the way, in a very interesting way back in 1984. It's a long time ago. I was at the IMF. Mexico had defaulted. This was the beginning of the Latin American last decade. And the IMF had this very bright idea that maybe they should send the economists to talk to market participants, which was unheard of. The notion that IMF economists would go talk to market participants in New York was a very alien concept.

Mohamed El-Erian (31:29):

So I was part of the team. I was a year into my career, I was the most junior one. I was sitting at the table. We were talking to a Latin American equity manager and we asked him, “What's the first thing you did when you realized that Mexico was going to default in August 1982?” And he said, “I sold Chile.” And we, as economists said, “That's typical market irrationality. You can't differentiate between Mexico and Chile. Chile is such a stronger credit.” And he said, “You don't understand. It's about technicals.” And we had no idea what technicals meant. He said, “My clients would read on the front page of the newspapers that Mexico was going to risk a major default and they would pull money out of the Latin American funds. I would have to sell everything to redeem their cash. Given that that was coming, it was much better to sell something that hadn't yet sold do, because it was going to get contaminated by the technical effect, and that was selling Chile.”

Mohamed El-Erian (32:27):

And we said, “Wow, we never thought of it that way.” So what you do get is this contamination contagion. There's a theory called “the market for lemons that you know,” that explains why it is that good cars can sell at low prices when there's a lot of uncertainty about the car market in general. So when you have this amount of dispersion and when you have the unfavorable part of the distribution impacting the average, that means there are good opportunities. And that's what, I must say, attracted me to Gramercy. I had no intention of going back into EM, then I met Robert and the team, and their ability to think about particular cases and their ability to both be in the public markets and the private markets is what made me realize I'm going to learn a lot just from watching them invest. And that has been the case for the last few years.

Greg Dowling (33:12):

That's great. No, it's the old saying, “Sell what you can, not what you should.”

Mohamed El-Erian (33:18):

Right.

Greg Dowling (33:18):

You can't sell Mexico, so you sell Chile. So we're talking about emerging and frontier markets, but if we looked at international developed markets, in some ways they might resemble the old classic emerging markets with their debt levels and with their currencies. What should we make of the country bloc of the EU, the euro. Japan, the yen. The Bank of Japan. I mean, it's pretty crazy. How do you even approach these?

Mohamed El-Erian (33:44):

Yeah, I think, and this is important, you don't want to upset people when you tell them that “you're starting to look like an emerging economy,” but it's true. You know, a lot of the problems, the challenges that countries have, are challenges that you have found in emerging economies. Central banks lacking credibility, that's not something that you normally see in the developed world. We haven't seen it, in fact, since the 70s and the 80s in the way that we've seen it today. But you see it in EM all the time, how a very localized shock to the price level of energy and food can become an entrenched inflation process. You don't see it a lot in the developed world; you see it in the emerging world all the time. Well, we're now seeing it in the developed world.

Mohamed El-Erian (34:24):

So you are getting these tendencies, these similarities, and the biggest similarity was that for a very long time, investing in the mature markets in economic thinking was all cyclical. That yes, you have cycles, but they’re mean-reverting. Whereas in the developing world, it's much more structural, it's much more secular. You don't have cycles; you can have very long declines, or you can have very long maturation processes. Think of Argentina versus China as an example of that. Asia versus Latin America. Now we see increasingly structural factors becoming important in the mature countries and the mature markets. And I think that that is a really interesting evolution that started with the global financial crisis and has continued since.

Greg Dowling (35:12):

Do you worry that the U.S. may lose some of its role as a global leader, especially when it comes to being the reserve currency?

Mohamed El-Erian (35:22):

No, I think the U.S. is the best-positioned economy. I go back again to this concept of the “cleanest, dirty shirt.” We certainly are not pristine, but we are a lot cleaner than elsewhere. When I compare us to other advanced economies, I think the U.S. is best-placed. When I ask, “Are we going to give up these ‘exorbitant’ privileges we have?” The answer is, “Who's going to replace us?” If you look at global currencies, you cannot replace something with nothing. So while the dollar may not seem as pristine as it has been in the past, show me who would replace the dollar. What I worry about is not the U.S. being replaced, what I worry about is that the system starts fragmenting more and more and evolves into blocs. So it's the fragmentation risk that I worry about. And when you put geopolitics into this, that fragmentation risk is something that you have to keep on the radar screen.

Greg Dowling (36:14):

Yeah. Larry Summers had a great quote recently. I'm paraphrasing it, I'm probably getting it wrong, but he said, when asked that question, I think he said, “Well, you know, China's a jail and Europe's a nursing home, so the U.S. is not great, but it's the only game in town,” to kind of use your terminology. Thinking—we’ve talked a lot about monetary policy, and you can comment on that as well here, but I'm thinking more about just policy in general and probably more fiscal policy. You were chair of former President Obama's Global Developmental Council. If you were in that role today, what would you be telling the current president?

Mohamed El-Erian (36:49):

So what these councils do, as you know, Greg, is they bring external perspectives to government work. And we meet with different agencies, or we met with different agencies, and we were from across a political spectrum. The idea is to increase cognitive diversity in government by having a group of outsiders comment on what's going on. What I would say right now is that in the development world, we've lost sight of both our absolute and relative standing. Relative we know vis-a-vis China. China has been making major advances, not only in terms of providing funding and people for infrastructure in Africa, but also in terms of… They had the vaccine diplomacy, they had the mask, the face covering diplomacy. So we have to keep an eye on the fact that we have fallen behind in terms of the range of interactions.

Mohamed El-Erian (37:42):

And then the second thing I would say is always think beyond aid. This is not about financial assistance only. This is about providing countries with technical assistance to be able to do things better, something that China doesn't do well at all. When a country in Africa interacts with China infrastructure, next thing you know, China brings in the workers and everything else. Yes, you end up with having your bridges and highways and ports built, but you don't develop the internal expertise that's so important to your future growth. And we can be huge providers of internal expertise on this. I think there's tremendous respect for the U.S. around the world and for what we are in terms of structure and setup and innovation and everything else. We just have to realize that our interactions with the rest of the world are really important. Otherwise, what you'll get is a more fragmented world. And a more fragmented world becomes a more dangerous world.

Greg Dowling (38:38):

That is well said. So a couple last questions for you. What should our listeners be reading or following to better understand the world ahead? Do you have any recommendations?

Mohamed El-Erian (38:48):

So I will tell you… Let me tell you that my own reading is distorted. Okay. So what I read is distorted by what people recommend to me, but is distorted by something else—for the last 8 years, I've had the privilege of being on the Financial Times Business Book of the Year jury. Each year we start with 16 books that are economic, business, etc., and end up with a short list of 6 books, and then we end up selecting 1 book. I'm saying that because if you were to look at the amount of books I read during the year, it's heavily dominated by the books that the FT chooses to be on that list. So I just want to say I'm biased.

Greg Dowling (39:25):

[laughs]

Mohamed El-Erian (39:25):

But I will tell you, go through that list over time, because there's some incredible books. If you want to read a book on the importance of cognitive diversity, on how it is that you should think about talent, there's two books that you should read. One is called Talent, which speaks to how you pick talent. And it's really hard about how important talent is from a micro and macro perspective. And the other book is Invisible Women, and it really opens your eyes to how important diversity and inclusion is. If you want to read books about how the world is changing and how technology is changing, and you want a really thought-provoking book as to how to think about machine learning, AI, etc., read the book called Surveillance Capitalism. That will re-open your eyes on that. If you want to read a book about how irrational the investment world can become, read Bad Blood, and that's…

Greg Dowling (40:12):

The Theranos story. Yep.

Mohamed El-Erian (40:14):

The Theranos. It reads almost like a novel. I'm currently reading the histories of GE, which is an eye-opener in terms of how you run businesses and how, as your business gets more complex, how you deal with the various challenges. So a shortcut, if you like, is go have a look at those lists of books. And there are some really interesting ones depending on whether you want to focus on the macro, the micro, or operational issues.

Greg Dowling (40:40):

This isn't my last question, but do you read anything fun? Do you have anything fun for us to read?

Mohamed El-Erian (40:45):

So it's a shame—I'm embarrassed to tell you that I found that reading fun.

Greg Dowling (40:50):

[laughs]

Mohamed El-Erian (40:51):

We some really fun, real Filter the history of Instagram.

Greg Dowling (40:54):

Gotcha.

Mohamed El-Erian (40:54):

Filter is a fun book to read. If you want to read something also that's fun but it's a bit heavier, The World for Sale is written as a suspense as to what commodity broker traders have done and do. That's another fun book to read.

Greg Dowling (41:09):

That's great. People who are listening to this can't see that as I'm talking to you, Mohamed, it looks like you're in your study or your office and there are books everywhere. So you are surrounded by books, including, as I can see, many of the FTE selections. You've been a fountain of knowledge, and we really appreciate you doing this. If people want more from you, how can they follow you or read more?

Mohamed El-Erian (41:31):

So what I do is I use structure to discipline me. If I didn't have structure, I would be watching sports all day long--

Greg Dowling (41:38):

[laughs]

Mohamed El-Erian (41:38):

--which maybe is what I should be doing. But what I have done is that I commit to writing a column every 10 days. And I publish in 3 different places: the Financial Times, Bloomberg, and something called Project Syndicate, which syndicates to newspapers. And then I bring them all together. If you want an easy way, I have a website, Mohamed El-Erian.com, which brings these readings together. The reason why I've done this is it disciplines my thinking. It keeps me sort of alert. I've learned that if you want to run a good business, or if you want to sort of be well-organized, to use structure to do the heavy lifting. And my structure is to commit to these columns, and that reflects my thinking of what's going on.

Mohamed El-Erian (42:24):

I also try as much as I can on social media to share articles that I find interesting, to share charts that I find interesting. Because when I left PIMCO, I realized that I was no longer surrounded by hundreds of really, really smart people. So I've developed a social media community, which, part of the community is that you share things with others that you find interesting, they share things with you that they find interesting, and the community is better off. Does it mean every member of the community is well-behaved? Of course not. Every community has people who will say silly things, but that's why I share quite a bit on my Twitter, LinkedIn, and Facebook, as a way of being part of a community.

Greg Dowling (43:02):

Fantastic. So if you want your Mohamed fix, you can go to his website, you can go to Instagram, LinkedIn, the Financial Times, Bloomberg--you are everywhere. And sometimes you're even on CNBC. I often see you working out in the morning, speaking of habit, and you're there.

Mohamed El-Erian (43:18):

So what time is that for you?

Greg Dowling (43:19):

I'm usually in that 6:30 to kind of 7:30 range.

Mohamed El-Erian (43:24):

And what time do you think that is in California?

Greg Dowling (43:26):

Yeah, that's pretty early for you. So maybe, yeah.

Mohamed El-Erian (43:28):

And for those of us who get really nervous about TV and prepare an hour and a half. People think that TV is fun. Not when you have to get up at 2:30 or 3:00 in the morning—

Greg Dowling (43:37):

[laughs]

Mohamed El-Erian (43:37):

—in order to prepare for what looks like a 7:00 or 8:00 AM Eastern slot, but in fact it's a 4:00 or 5:00 AM California slot.

Greg Dowling (43:46):

Next time I see you, I'm going to be even more impressed, because you're going to be coherent and you're with it at some ungodly hour in the morning.

Mohamed El-Erian (43:54):

I'm trying to explain—I'm trying to say why I'm not coherent, and why I’m up at…

Greg Dowling (43:58):

[laughs]

Mohamed El-Erian (43:58):

But thank you, Greg, very much. It's been a real pleasure to have this conversation with you.

Greg Dowling (44:01):

Oh, it's been great. Thank you so much for your time.

Mohamed El-Erian (44:04):

Thank you.

Greg Dowling (44:05):

If you are interested in more information on FEG, check out our website at www.feg.com, and don't forget to subscribe to our communications so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client; therefore, nobody should consider these to be FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views and opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of their firm or of FEG.

DISCLOSURES
This was prepared by FEG (also known as Fund Evaluation Group, LLC), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. Past performance is not an indicator or guarantee of future results. Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss. The views or opinions expressed by guest speakers are solely their own and do not represent the views or opinions of Fund Evaluation Group, LLC.

WANT TO RECEIVE MARKET UPDATES & PODCAST NOTIFICATIONS?

Join other institutional investors receiving FEG’s updates, including market perspectives, white papers,
podcast episodes, and event invitations.

 

Subscribe Now