Practical analysis for investment professionals
04 November 2014

The Tipping Point in a Bimodal World: Insights from Mohamed El-Erian

The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 17–18 October.

After more than two decades in finance, I have heard many hundreds of presentations and read thousands of articles — it is rare to hear unique points of view. Rarer still is to hear something new that not only informs, but also instantly changes how you see the world. At the CFA Institute Fixed-Income Management 2014 Conference in Huntington Beach, California, a casual conversation between Mohamed El-Erian, chief economic adviser to the management board of Allianz, and Marc P. Seidner, CFA, head of the fixed-income team at GMO, offered just such a rare perspective.

Here are highlights from their discussion:

What Is Happening in Fixed-Income Markets?

El-Erian believes the current attitudes of regulators and investors are an attempt to continue the financial market status quo of 2011–2013, which is currently much harder to do. Specifically, coming out of the crisis, it was clear to a lot of people that the economy would not bounce back as normal. Put another way, the pre–Great Recession growth model that the West fell in love with — where finance was seen as a source of growth, rather than servicing growth — would not function as it had before the crisis.

This left two possibilities. Either the political system would rise to the challenge and come up with new growth policies, or governments would not be innovative and the world would end up in a “new normal” of disappointing growth. Given fiscal gridlock in both the United States and in the European Union, each year central banks had to compensate for the lack of comprehensive policies.

In turn, this meant it was likely the economy would fall short of what was needed. Not only would growth disappoint, but also the benefits would be less than what was needed. And that is before the costs and risks of this outcome are considered. For example, one cost is the risk of greater financial instability down the road because the Fed does not have the right instruments to foster growth in the long run. And in 2014 the benefits of central bank choices are declining while the costs and risks are increasing.

What Are the Big Problems Worth Working On?

In answer to this question, El-Erian responded that most economists agree about the big problems facing the global economy:

  • From a fiscal policy perspective, there need to be structural reforms aimed at enhancing US growth potential.
  • There are problems with the composition of aggregate demand — where there is a will to spend there is no wallet, and where there is a wallet there is no will.
  • The marginal propensity to consume is much lower the further down the income stream you go.
  • There are debt overhangs in the system that have to be addressed.
  • Even where there is political agreement, to be seen working with the other side is political suicide.

To this last point, El-Erian said:

The good equilibrium is politicians responding . . . and if you do that, you unleash trillions of dollars that are sidelined today, that can be invested in productive activity, and in addition you get turbo-charged by some very meaningful innovation going on in technology and in energy. So, you tip from this low-growth equilibrium to an equilibrium that has high growth; has durable job creation — it’s much more inclusive in the way it grows — and then you start validating prices that have been artificially boosted by central bank action.

El-Erian did not pull his punches, stating that the alternative is an ultimate fragmentation of the global system, even within individual economies. He believes that the tipping point into catastrophe or growth will happen within the next three years, and it will happen in Europe before it happens in the United States.

The Importance of Scenario Planning

Unlike many in finance, El-Erian steered clear of making specific forecasts, which are always off by degrees, and instead emphasized the importance of planning for both possible scenarios simultaneously. Specifically, he believes that current asset allocations do not reflect the possibility of a bimodal world. People commit behavioral biases — that is, they prefer one outcome over the other — without seeing their bias. This creates a blindness to the bimodal world.

Some people in finance can see the bimodal world, but unfortunately they plan not for both scenarios, but for the middle. Thus, they convert the data to something they want to see: a weighted average probability. Still further, there is a third category who knows they have to do something, but do nothing or engage in active inertia.

How Do You Survive the Bimodal World?

In a bimodal world, you apply fewer dollars to higher risk markets. You also go to assets that are not crowded. You have a higher cash position than otherwise to build in resilience and agility. You use options a lot more, because covariance among different assets changes signs so quickly. In a bimodal world, correlations are entirely unstable. Last, you have to explain what is happening to your clients over and over again so they understand your strategy.

How to Be Less Taken off Guard by What Is Happening?

El-Erian finds it interesting that economists and financiers are routinely surprised by what occurs in the world, and he offered a belief as to why. To be a successful investment professional demands skills in four main circles: economics, geopolitics, policy, and markets. Most of us can do two of these skills well and make successful predictions from them. So long as problems do not arise requiring skills in all four major circles, we are fine. When all four areas have problems simultaneously, professionals are in trouble. To mitigate being taken off guard, therefore, become better at understanding your areas of weakness.

What Grade Would You Give the Fed?

El-Erian gives an A+ to the Federal Reserve in its response to the sudden stop of markets at the outset of the Great Recession. In his opinion, the Fed’s actions restored the financial payments system:

If you talk to Fed Governors they felt a moral and personal responsibility to step in and they thought it would serve as an example to others to step in. I believe they are surprised that they are still here after four years. If they had let the world have a small heart attack in 2011, would that have gotten Washington, DC, to focus? The problem, of course, is that you cannot predict what happens. So I grade them as incomplete. It is not dependent on what they do, but instead on what Washington does.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

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