The Bumpy Road to an Economic Recovery with Mohamed El-Erian
Welcome back and welcome aboard, and how about a rally for the ages? October has lived up to its reputation as a bear market killer, as my favorite month of the year posted the tenth strongest month ever for the Dow Jones Industrial Average (DJIA) since 1915. If the Dow closes higher this Monday, it will be the best month for the average since the 1930s. Month-to-date, the Dow Jones Industrial Average, which was formed all the way back in 1896 by Charles Dow and Edward Jones, is up 14.4%. It has been positive for four straight weeks, far outpacing the S&P 500 and the Nasdaq. While it’s hardly just industrial stocks these days, the Dow is still a pretty good representation of the biggest companies and industries in the U.S., with technology, banking, health care, materials, consumer staples, and industrials.
As far as the benchmark S&P 500 index goes, it’s holding its own throughout this rally as well. It jumped 3.9% last week, including a 2.5% rally on Friday, to close above 3900 for the first time since September, and is now trading well above its 50-day moving average (MA). We’ve seen head fakes like this before, including a couple of bear market rallies since June that faded like morning mist. But take a look inside the index, and you will see something that we haven’t seen in a very long time. More than two dozen stocks hit 52-week highs last week, and that, my friends, is not a bearish trend. Companies hitting those highs include McDonald’s, Biogen, PepsiCo, Hershey, Chevron, Amgen, Gilead Sciences, Lockheed Martin, Northrop Grumman, and Raymond James, to name a few. That’s consumer staples, defensive stocks, financials, and big pharma. You could say that investors are circling the wagons on quality, consistent cash flow, and companies that can weather the economic storm everyone keeps talking about.
And that storm hasn’t gone anywhere. The drumbeat around a potential recession hitting our shores in early 2023 just keeps getting louder, and it’s expressing itself in the Treasury market in a variety of ways. The most pronounced is the yield on the three-month Treasury bill, which ended the week at 4.18%, the highest level since October of 2007. It entered the year at 0.06%. When short-term Treasury yields spike, that’s a sign—my friends—that big investors have little faith in the near-term economic prospects. And that leads us right into our Big Three for the week.
Number one. The last eight recessions in the United States were all preceded by an inversion of the ten-year and three-month Treasury yields. As a refresher, when short-term Treasury yields spike, it’s a blaring signal that investors and traders have little faith in the economic prospects of the near term. They are selling short-term paper—driving up yields—just as they shift over to buying long-term Treasuries in a quest for safety and stability, which drives those yields lower. When the yield on short-term Treasuries crosses through the yield on long-term Treasury yields—that’s yield curve inversion—a painful warning that the economy is heading south.
Well, that spread between the yields on the three-month and the ten-year is now the most inverted since February of 2020. Forget what Jamie Dimon, Jeff Bezos, Elon Musk, and every other CEO and economist is saying about the mother of all recessions. Look at the inverted yield curve, and that’s all you need to know about what’s coming our way. But also, don’t forget this: the stock market usually bottoms and turns higher before the economy hits the skids, because investors are always betting on the future, and the future they appear to be betting on now looks a lot better after the first half of next year.
Number two. As the great Jimmy Cliff sings, the harder they come, the harder they fall. And how the mighty have fallen. Just look at the FAAMG stocks—that’s Facebook, Amazon, Apple, Microsoft, and Google. At their height during 2020, they accounted for around 23% of the market cap of the S&P 500, which, as we know, is a market cap-weighted index. As they went, so went the index. If we add Tesla and Netflix to that list, $3 trillion in market value has been wiped off of the S&P 500 in just one year, from just those stocks. Facebook, now called Meta, is down 70% this year, falling 24% alone just last week after disappointing earnings. It’s the worst of the bunch, but the picture isn’t prettier at Netflix either, where shares are down 57% so far this year, or Amazon, which has seen a 39% decline in 2022, according to YCharts.
So, what has all this done to the concentration of the biggest tech stocks in the S&P 500? Well, the FAANGS now account for just over 16% of the S&P 500. The important takeaway from all this, is that the S&P 500 is up 7% in just the past month, just as many of these tech giants have posted a terrible 30-day stretch. The market is not being dragged down by these guys anymore. It’s a more balanced index that finally has some strong representation from consumer staples, financials, energy stocks, health care, and materials. These sectors are less vulnerable to interest rate hikes, and many, like financials, actually benefit from them.
Just check out the returns over the past thirty days for bank stocks. Bank of America (BAC) is up 20%, JPMorgan (JPM): up 22%, Citibank (C): up 22%, Wells Fargo (WFC): up 15%, and Goldman Sachs (GS): up 17%. Long-term investors should celebrate this balance and recognize that it could lead to a much healthier, more sustainable rally over time. From a valuation standpoint, look at the trailing 12-month operating earnings for the S&P 500 too. The average year-end P/E ratio for the S&P 500 since 1989 is 19.6. We enter this year 17% above that level, and are currently now 3% below it. This rally has been happening even as operating earnings for the 500 largest companies in the U.S. have been tumbling. Do investors sense that all the bad news has been priced in? Maybe.
Meet Mohamed El-Erian
Dr. Mohamed A. El-Erian is President of Queens’ College at Cambridge University, and serves as part-time Chief Economic Advisor at Allianz and Chair of Gramercy Fund Management. Dr. El-Erian is also a professor at the University of Pennsylvania’s Wharton School of Business, and a Lauder Senior Global Fellow at the University of Pennsylvania. He is also a contributing editor to the Financial Times, an opinion columnist for Bloomberg, and the author of two New York Times best sellers. Dr. El-Erian serves on several nonprofit boards, including the National Bureau of Economic Research (NBER), as well as the corporate boards of Barclays and Under Armour.
Dr El-Erian formerly served as Chief Executive Officer (CEO) and co-Chief Investment Officer (CIO) of PIMCO from 2007 to 2014, where he worked for fourteen years, and as chair of President Obama’s Global Development Council from 2012 to 2017.
Dr. El-Erian has published best-selling books on international economics and finance. His 2008 book, When Markets Collide, won the Financial Times/Goldman Sachs 2008 Business Book of the Year award. His second book, The Only Game in Town, also became a bestseller. Dr. El-Erian was added to Foreign Policy’s list of “Top 100 Global Thinkers” for four years in a row. He’s also been widely recognized for his philanthropy.
What’s in This Episode?
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Almost two years ago, amid the depths of the pandemic, the lockdowns, the fatalities and the near-shutdown of the global economy, Mohamed El-Erian joined the Express to warn us about the potential long-term effects that this would have several years down the road. None of us could have predicted what would ensue exactly, but Mohammed’s predictions about the long-term scarring of the pandemic have been on-the-spot. Today, as we face an uncertain recovery, the threat of a global recession, and capital markets in disarray, the future is even more unclear. That’s why we’re bringing Mohamed El-Erian back to the podcast to see what he sees coming, and how we can prepare for it. He’s the president of Queens College, Cambridge, and Chief Economic Advisor at Allianz, and he’s our special guest this week on the Investopedia Express. Welcome back.
Mohamed: “Thank you for having me.”
Caleb: “I want to play just a bit of our interview from almost two years ago, exactly—November of 2020, when I asked you as a social scientist, what worried you most about the pandemic back then? What concerns you most as a social scientist right now? You’ve seen many cycles, but this is very unique. What makes you very concerned at this point in time?”
Mohamed: “So what makes me most concerned are the longer-term effects. The longer-term effects, not just on the economy and finance, but on people—what we call scarring. The fact that people will come out of this differently, and I’m not just talking about economic insecurity, which I think is considerable, but also mental anguish.”
Caleb: “Sadly, Mohamed, your prediction came true. And we’ve seen social and mental scarring among children, families who’ve lost loved ones, business operators who didn’t make it through the past few years. Was this worse than you imagined?”
Mohamed: “Some of it was, some of it wasn’t. I think we are dealing with resilience issues at every level, certainly at the human level. People’s resilience has been run down. They’re less capable to deal with new shocks. It’s certainly true in terms of governments’ ability to respond, and central banks‘ ability to respond. The space for proactive policies has been reduced significantly when it comes to protecting the most vulnerable segments of the population. So that part has played out, unfortunately. But also, I’m very impressed by how quickly we’ve come back to normal operation, how quickly we’ve overcome this counterparty risk—this human counterparty risk of people not trusting each other’s health. And that has happened faster than I expected, and it speaks to the amazing advancement on vaccines.”
Caleb: “I totally agree with you. And we were, at that time in November 2020—vaccines were on the way—we were all eagerly awaiting them coming to market. And the fact that they got to market so quickly, and were adapted so quickly in a lot of the world was super impressive. So let’s turn to the economy today. Back in 2020, we had supply-side shocks, and we couldn’t get enough inventory of a lot of goods. In 2020, we saw the bullwhip effect, where retailers in particular were oversupplied, and the demand just wasn’t there. But we still have that rampant inflation across many categories and industries. Should we have seen this coming?”
Mohamed: “I think we should have. I think we had early indications that the supply side was going to remain problematic, that the issues went beyond just COVID, beyond energy and food. And they involve changing globalization. They involve companies rewiring their supply chains for more resilience. And, they also involved central banks being late to the inflation fight. So quite a few of us saw it coming 12-to-18 months ago. We’ve warned, we wrote about it. We said to keep an open mind, to not get cognitively trapped by this notion that inflation will just be transitory. You know, transitory is a very powerful word, because when I tell you something is transitory, it means you don’t change your behavior—it’s temporary, it’s perishable—so you don’t change your behavior. And I think we lost a lot of time mislabeling inflation as transitory.”
Caleb: “That word—that “t” word—was a favorite word for policymakers for a long time. I’ve heard you say this before and you’ve written about it as well in your opinion columns—policymakers like the Federal Reserve—should they have seen this coming and acted faster, or acted more preemptively, to prevent what we have now—not just here in the U.S., but around the world, except for China and Japan, which are not messing with their interest rates and are going in the opposite direction. But should they have seen this coming and been more proactive?”
Mohamed: “Yes, undoubtedly they got trapped by the concept of transitory, but that’s not where the mistake stopped. Even when the Fed retired the word “transitory” from its vocabulary, which happened at the end of November, it did not move fast enough in terms of taking policy action. So we had this ridiculous situation that in the middle of March, when we printed the CPI inflation number for February, which was above 7%, the Fed was still injecting liquidity into the economy. It stopped by the end of March, but it took it a very long time to start tightening monetary policy. And now we are in the bad world, where the Fed is front-loading its interest rate hikes—we’ve had a series of 75 basis point (bp) hikes. This is one of the most front-loaded interest rate cycles we’ve seen in decades. And that means that the risk of an economic accident, and the risk of a financial accident—those risks are much higher, because the Fed playing catch-up is having to front-load its interest rate increases.”
Caleb: “You’ve written and spoken about the “trilemma” the Fed has faced, which makes it a much different problem than what Fed Chair Paul Volcker had to deal with back in the early 1980s, when inflation was 12, 13, upwards of 14% at times. I call it a hydra—inflation, a growth slowdown, and financial instability all at once. How can the Fed battle inflation when its mandate is price stability, and there are forces outside of its control right now?”
Mohamed: “It has to do it very carefully. You know, central banks need three things: time, luck, and skill. The Fed doesn’t have time—it’s way behind. So it’s going to need a lot more skill, and a lot more luck. And it’s not easy. Even if we’re just dealing with the dilemma of how to lower inflation without causing undue harm to growth and to jobs—that’s hard enough when you’re starting late. It gets even harder when you have a whole financial system that was basically conditioned to optimize a world of zero interest rates forever, of quantitative easing (QE) to infinity, and now suddenly is seeing that world change very rapidly. So there is the risk of financial stability on top of the risk of creating a recession. So it’s really hard—it’s really, really hard.”
Caleb: “Nearly every CEO and forecaster is calling for a recession in 2023. First of all, do you agree with them? But let’s say they’re right. What can policymakers do to mitigate it? First of all, do you agree? And if so, what do you think they can do right now?”
Mohamed: “So, you know, we’ve had some very dramatic calls, saying it’s 100% likely that we will have a recession. Look, the risk of a recession is uncomfortably high. It worries me, because think of the average person. They have had their purchasing power eroded by inflation, sometimes eight, nine percent. Second—they’ve also seen their 401(k)s hit hard by what has been happening to markets, and there’s been nowhere to hide. If you had a 60-40 portfolio, you lost money on bonds as well as losing money on stocks—there’s been nowhere to hide. That is very unsettling.”
“So you have a price shock, you have a wealth shock, and now people are telling you that you may have insecurity about your income, because we may have a recession. So this is a terrible situation to be in. And I really worry about the most vulnerable segments of our population. Is it a done deal? No. It can still be avoided. But I must tell you that the pathway for avoiding it is very narrow.”
Caleb: “You talk about the wealth effect and the fact that people have been hit in their 401(k)s, they’ve been hit in their retirement accounts, they’ve been hit in their nest eggs at the same time, and they’re facing an uncertain economy right now. But let’s talk about what investors can do—if anything—to brace themselves, given that the traditional approaches like the 60-40 portfolio has had its worst year ever, and a lot of other asset classes have not been reliable for investors. So what can investors do, especially older investors, as they’re approaching, thinking about that retirement, thinking about not earning an income anymore to brace themselves, to get them through whatever the next couple of years will bring us?”
Mohamed: “The bad news is that the three things that matter most for investors have turned nasty. One is returns. Year-to-date returns have damaged in you a big way. Two is volatility—you’ve had really unsettling volatility. And three, your correlations have broken down. So this has been a hard year for investors. And I fully sympathize with this feeling of “enough already, we’re being hit from so many sides.” The good news is that value is being restored in the marketplace, and that’s good news for long-term investors. We needed to get out of this artificial regime in which central banks repressed yields, and basically boosted every asset price beyond what fundamentals justified—that wasn’t healthy. We needed to get out and we are getting out of it. I think of it as a very bumpy journey to a better destination. So you must not abandon the destination because of the bumpy journey.”
“Now you raise the critical issue—for certain segments of our population—they don’t have time, because they assumed that the 60-40 would give them enough protection to be able to pay bills and run down your wealth, without incurring massive losses. And this, unfortunately, is not the case today. But for long-term investors, there is seriously good value being restored to financial markets.”
Caleb: “Let’s get back to the distortion in asset prices that you’ve written a lot about. We probably should have expected that, given that the Fed is now raising interest rates and selling bonds, which is, as you say, quite the opposite of what it’s been doing since the Great Financial Crisis in one form or another. Are you surprised at how distorted capital markets have become?”
Mohamed: “No. You know, I wrote a book in 2016, warning that if we continued down this path of solid reliance on central banks, and if we continued to distort the financial system, we risked a crisis at the end of that journey. I called it the “T-junction,” that we had two choices: either we look to get out, and get out in an orderly fashion, or we forced out ,and we forced out in a disorderly fashion. And of course, inflation is what forces you out in a disorderly fashion, as we discovered. Am I surprised? No, I’m not surprised. I’m more frustrated than I am surprised, because I think a lot of the damage that has been incurred—and that will be incurred—was avoidable.”
Caleb: “The books you mentioned: The Only Game in Town. Also, you have Money for Nothing: When Markets Collide. Folks, I’m going to link to these in the show notes, because you have to read Mohamed El-Erian’s writings on this stuff. You’ve been spot on about it for years and years. We talked about older investors as they approach retirement. What about younger investors? A lot of investors, maybe this is the first bear market they’ve seen. It could be the first recession they’ve seen if they’ve really, you know, just become active investors. But for folks who are under 40 right now—you’ve got assets on sale. But that doesn’t mean we’re going back to an everything rises type-of-environment. The dynamic has changed, has it not? What would you suggest for them?”
Mohamed: “It has. We’ve learned a lesson. A lot of the under-40s went into crypto and are sitting on significant losses, unfortunately. They’ve learned the lesson that previous generations have learned—that you’ve got to be a long-term investor, you’ve got to be disciplined, and you’ve got to focus on where there’s fundamental value, and don’t get tricked into various other schemes. You know, it’s very easy. I always tell people when they ask me, “What’s the one thing that we should know when we go into investment?” And they expect me to talk about bond math and to talk about all sorts of other stuff.”
“I tell them, “Understand behavioral finance, understand the mistakes, the behavioral mistakes we make as investors.” I make them, and I have to force myself to ask whether I am once again falling into a trap—because we’re humans—and when we get taken out of our comfort zone, we tend to do silly things. We’re not wired to operate well outside our comfort zones, and markets have a way to take you out of your comfort zone. And the result of that is you buy when you shouldn’t be buying, and you sell when you shouldn’t be selling. Those are typical behavioral traps, and you’ve got to really understand the history of behavioral mistakes, because most—most mistakes in the investment world are recoverable with time. And that’s a great thing. Some are not—default is not, for example. But most are recoverable with time, if you’ve got a strategy and if you’ve got this problem.”
Mohamed: “The big deal is that we find that there are pockets of excessive leverage in unusual places, mostly outside banks. A few weeks ago in the United Kingdom, the whole pension system almost collapsed. It collapsed because no one ever expected that long-dated gilts—government bonds—would increase in yields by 125 basis points (bps) in a few days, and many people were caught offside. Margin calls—they were being forced to dispose of assets, and you literally had the survival of the entire pension system in play. If you had asked people a month earlier if that was possible, they would have dismissed it as unthinkable.”
“I also worry about Japan. Japan is going to exit its yield curve control regime at some point. That is when they cap a key interest rate, and in order to be able to cap it, they increasingly distort their markets—they have to intervene in the currency. But the bond market has gone days without trading, as you know, because it’s become so distorted, and they’re going to be forced to exit. And that exit is not an easy exit. So there are pockets of massive distortions borne of too many years of artificial monetary policy that are going to have to be resolved, one way or the other. Most of the time they can be resolved in an orderly fashion, but as we saw from the U.K., all it takes is one mistake—one policy mistake—and you’ve got a near-market accident facing you.”
Caleb: “Flip side—what makes you optimistic, Mohamed? What are you seeing out there that says, “You know what, we might get out of this, this might be not as bad as we think,” or, “This looks better than I thought.” What looks good to you right now?”
Mohamed: “So that’s why I call it “the bumpy journey to a better destination.” I truly believe that we are heading to a better destination, absent any big policy mistakes. So we are having significant transitions going on in the real economy that are good for the wellbeing of our kids and our grandkids, and also for the planet. We are seeing a better understanding of how public-private partnerships work. As I mentioned earlier, genuine value is being restored to the financial markets.”
“So as we navigate this this bumpy journey—and it’s unpleasant—I remember when I used to take my young daughter to an amusement park that was two hours away, and there were times in which she would start within five minutes saying, “Are we there yet? Are we there yet? Are we there yet?” And that wasn’t exactly comforting. And then it would be stop-go traffic, and next thing I know, she’s sick in the back of the car. And by the time we got there, the journey was so painful that we hadn’t even thought about the destination, and it took away from the destination.”
“So I tell people: “Yes, it is a tricky journey and we’ve got to navigate it, but keep an eye on the destination. Prepare.” So in terms of investment, theme-led investments are absolutely critical. The real economy is changing, and it’s changing in a manner that is going to have different winners than what we’ve had in the past. And that’s why theme investing, as opposed to simply benchmark investing, becomes really important in this transition.”
Caleb: “And because the economy is going to recover at different speeds, different things are going to happen before other things happen, that is so critical right now. As a father of two daughters who took them on many drives, I know the feeling exactly the way you’re describing.”
“Okay—let’s go out on this. You know we’re a site built on our financial terms and our dictionary. A lot of people refer to us. What’s your favorite financial term or your term-of-the-moment right now, and why is it so important?”
Mohamed: “Trilemma. Understanding that central banks face this trilemma, where it is very difficult to solve all three challenges, and the tradeoffs involved are not easy. They are now the determinants of how we navigate this bumpy journey. So understanding that trilemma, and assessing every day whether central banks are good at navigating it—is going to be critical, certainly for investors. But well beyond that.”
Caleb: “We appreciate your time. You’ve been such a good friend to Investopedia, and so helpful for those of us out there trying to navigate our way as educated investors. We appreciate you so much. Mohamed El-Erian, thanks for joining The Express again.”
Mohamed: “And let me thank you for everything you’re doing. Financial literacy is really important, and the more you do, the better off we are. So thank you very much for everything you do.”
Term of the Week: Emerging Markets Bond Index (EMBI)
It’s terminology time. Time for us to get smart with the investing term we need to know, this week. This week’s term comes to us from Mario on Instagram. Mario suggests the EMBI, or Emerging Markets Bond Index, this week, and we like that term given the relative weakness of bonds around the world, but especially in emerging markets. According to my favorite website, the EMBI, or Emerging Markets Bond Index, tracks the performance of emerging market bonds, and was first published by investment bank JPMorgan. Emerging market bonds are debt instruments issued by developing countries which tend to carry higher yields than government or corporate bonds of developed countries.
Most of the benchmark EMBI Index tracks emerging sovereign debt, with the rest in regional corporate bonds. The largest emerging markets include countries like Nigeria, India, Brazil, South Africa, Poland, Mexico, Turkey, and Argentina, among others. And the global Ex-Emerging Markets ticker EMBD, which is a decent proxy for the Emerging Markets Bond Index, is down 24% so far this year. No shelter there, as investors steer clear of the debt being issued by those countries. It’s rare to see that kind of underperformance in the sovereign debt market, but 2022 has been the rarest of years. But if there is a global recession coming our way, emerging markets are going to feel it the most. Good suggestion, Mario. We’re sending you a pair of Investopedia’s finest socks for that.