By Lance Roberts: From the 10th annual Strategic Investment Conference, presented by Altegis
Investments and John Mauldin, Mohamed El-Erian ties together the views
of the previous presenters.
Mohamed El-Erian: I want to try and build on what you have
heard so far. I want to focus, in particular, on two statements that
have been made so far at this conference.- The need to put the pieces together
- To make sure we give ourselves a chance to win.
So, how do we put the pieces together to give us the best chance to win? I will try and give you an answer.
If you knew nothing of the markets, and
just showed up at this conference, you would be very confused. The world
is awash in contradiction with stocks rising to new highs as interest
rates reflect a slowing economy. It is an upside down world.
Individuals are both excited and
anxious. They are excited by the rally in the markets as they see their
portfolios increase in values but at the same timed overwhelmingly
concerned about the economic future. It is a world with an enormous
contrast between the markets and the real economy.
That is the world we are navigating and it is incredibly unusual. This is why it is an unloved rally.
That is the world we are navigating and it is incredibly unusual. This is why it is an unloved rally.
Therefore, I want to provide a simple
framework to reconcile these issues. The long term view matters greatly -
but the short term matters also.
First, acknowledge that we are here, in
terms of current policy, for a good reason. Most countries are shifting
from a growth model based on leverage and credit creation to trying to
find a new growth model based on new realities. Emerging markets are
shifting from exports to internal growth. Developed economies are
shifting to a lower growth economic cycle due to ongoing deleveraging.
These shifts require assistance from the Central Banks. However, this assistance leads to disconnects.
"The question, however, is what the “hand off” from assisted support to organic growth will look like and when will it come?""The hand off is the 'destination.' The 'journey' is getting there. Investors must invest for both the journey AND the destination. Investing for only one part will lead to unhappiness during the journey or pain at the destination."
At Pimco this reality is what we call the “stable disequilibrium.” The world will not reset in cyclical manner and a “new normal” has arrived.
The look of the “new normal” is
that the West will be stuck in a low growth and high unemployment cycle
for quite some time to come. Conversely, the emerging world will
continue to bounce back and begin to close the gap between wealth and
incomes.
There are three speeds to the “new normal.”
- Slow: Europe and Japan that will live continue to live through lost decades.
- Medium: Countries like the US are healing - but not fast enough to get obtain “escape velocity.”
- Fast: Emerging countries with strong balance sheets and favorable business economies.
This is the reality of the world that we
live in today. If this three speed theory is correct then there are
three questions that must be answered:
- Can it persist and for how long?
- Will it add up?
- What do you do about it?
Yes, it can persist but not forever.
The timing, which is tricky, differs on
where you look. For example, in Europe, Cyprus tells you much about the
entire European structure. The Troika is no longer operating in an
efficient manner. The creditors are also tired of supporting the
Eurozone as they see no end to the checks they are writing.
Likewise, the debtors are tired from
adjustment fatigue. The problem is that the majority of Eurozone
countries not only lack growth but, much more importantly, they lack a
growth model.
The financial markets don’t care because
there is the ECB. Whatever happens - the ECB, as Mario Draghi
promised last June, is willing and able to support them. However, the
ECB only supports the journey – not the destination. The Eurozone is
nearing the end of its journey and they will soon be forced to make
tough choices. They will be forced to either opt for a stronger, and
smaller, Eurozone which will begin to grow again, or, fragmentation
which will end miserably.
In the U.S. - the Fed is fully engaged
in artificial support to give the system time to heal. There is no
question that the economy is healing. Corporations, banks, and housing
are all healing. If this continues it will allow for a handoff from
supported growth to real growth. If the structural problems don’t
improve then we will slip back into a slow growth economy.
Emerging markets will either continue surge or slip back to moderate growth.
So, the reality is that when you live in
an interdependent world your competitors are your friends. In an
independent world your competitors can bring you down. The world, today,
is unlike what we have ever seen before. Unfortunately, global policy
coordination is really non-existent.
Historically, when the core has been
weak there has been someone to step in to support it. After WWII the
U.S. stepped in to support Europe. Today, with the entire world weak –
there is no one large enough to support the core.
When it comes to investing the majority
of recommendations to investors is not based on fundamentals but rather
stocks are cheaper than something else. This is potentially very
dangerous.
What Should Investors Be Doing
Ride the central bank wave. The more
intervention done by one Central Bank forces other countries to do more.
The Fed forced Japan into its policy shift. Japan has now forced the
ECB to move further.
The Central Banks have little choice
other than to continue on their current trajectory. They cannot get to
their objective unless they make you feel better by boosting confidence.
However, it is also important to understand that all waves eventually break. The question is whether you crash or “walk off”
the surf board. This wave will crash. When it does it will depend on
how you are positioned that will determine whether you suffer or not.
Secondly, there are other waves out
there. There are too few people looking for other waves where central
banks cannot reach. In these areas there is genuine growth potential.
These include selected currencies, bonds and other types of assets.
Third, understand that past models are
broken. The world today is far different that it has been historically
and therefore new models must be built.
Fourth, you cannot disconnect the
markets from the fundamentals forever. There is a limit and when the
reversion of markets to the fundamentals occur the devastation to
capital will likely be severe.
Fifth, do not give up liquidity cheaply.
In the world today it is very binary. It will either end well, or
very badly, with no middle ground. Optionality and liquidity is the key
to surviving and profiting from a binary world.
Finally, realize that risk mitigation is
going to have to evolve. Cost effective tail hedging is going to be
critically important. This is a choice that all investors must make: Do
you leave some capital on the table as markets rise or suffer large
capital losses later. The choice is critical.
Conclusion
Why is it that the Pimco’s of this world
are not disciplining a system that is becoming more and more
artificial? Why do we allow the manipulation?
In a classroom you can discipline a
single a person. However, if the whole class misbehaves it is an
entirely different issue. Currently the whole class is misbehaving and
that is a very different paradigm than what we have seen in the past
which has led to unprecedented, unproven and untried interventions that
are likely to have far reaching outcomes.
Investors that are overly invested in
stocks will eventually pay a very high price for taking on excessive
risk. We are approaching the end of the journey for this experiment and
it will either result in a return to organic growth or economic
disaster. The problem is that we really don't know which it will be.
What we do know is that eventually, regardless of the outcome of these
monetary experiments, the disconnect between the fundamentals and the
markets will revert which will prove painful for unhedged investors.
Written by Lance Roberts: In Part IV of the series of reports from the 10th
annual Strategic Investment Conference, presented by Altegis
Investments and John Mauldin, Mohamed El-Erian ties together the views
of the previous presenters. You can read the previous presentations by
clicking the links below.
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