Resilience, agility and optionality – golden nuggets from Mohamed El-Erian
Mohamed El-Erian needed little introduction at the start of Tuesday afternoon's keynote session at FundForum 2016 in Berlin. It seemed as if the entire conference had piled into Potsdam 1 to hear the views of this global thinker and Obama Global Development Council Chairman.
Picking up on the one constant theme of the conference he told the audience that his talk would be about change: "Not just change, but the accelerating pace of change. We as an industry have to think differently."
The message of the last 12 months, he said, was the fact that "improbables" – 30% of government debt trading in negative yields; ECB and Bank of Japan venturing into negative policy; Donald Trump having a real chance of becoming becoming President – had become reality.
"The common element throughout all these things," he explained, "is that the advanced world has lost the ability to grow in a high and inclusive manner, and when that ability is lost and people lose confidence, things start going wrong; things start to break.
"If you understand this basic issue it gives you a framework to understand the future."
Good news, bad news
That said, there had been an evolution in the thinking of the advanced world, he explained: "Finally, there is an understanding that we live in a world where we have cyclical, structural and secular issues, but it's taken us a long time.
"The problem is, because it took so long to understand – we continually overestimated growth and potential, we continuously underestimated the impact of inequality – politics has turned really nasty," he said, referencing the emergence of anti-establishment movements.
"It's about a loss of trust. When you don't grow enough, and the fruits of that growth go to the few, people get angry."
And this complicates the solution, he said. The only response on the policy side so far has been through the central banks. The good news was that the central banks did indeed respond, but the bad news was there wasn't much they could do:
"While central banks have stepped up, and have done so in a manner very few people expected in terms of their willingness to take risk, they simply don't have the tools – they can't do structural reforms, change infrastructure etc. The result of that is enormous fluidity on the macro side."
"We have to think collectively about not just what does it mean to run sophisticated democracies at low growth, but also what does it mean that central banks have used the wrong medicine for a very long time - not because they're stupid but because they had no choice."
Disruption from above and below
Our world was being shaken by things from above and below, explained Mohamed.
"From above, with the loss of low but stable growth, and the loss of central banks’ ablility and willingness to suppress financial volatility; and from below by anytime/anywhere disrupters," he said.
FinTech, he argued, was nothing compared to what was coming: "We're now living in a world where you can disrupt an industry from another world," he said, using AirBnB and Uber as examples.
Because of these two things, he explained, "improbables" were going to become more common:
"We are all anchored to think in terms of bell-shaped distributions. We know how to live in that world, but that is not the world we’re living in any more.
"We’re now living in a world where the road we’re on is being undermined by growing tensions – political, economic, financial – and we can flip one way or another in the next three years.
"This is not a reassuring world. Behavioural science tells you that we are likely to make bad decisions when facing bimodal distributions," he warned, before going on to list four types of common reactions to such environments.
Some won't see it because they have a blind spot; some will be "like a married couple: they will hear one thing but internalise it differently"; some will have active inertia - the most dangerous of the four. "The active part is great: you recognise things are different. But then you don’t end up doing anything about it". And the remainder will “do the right thing".
What is the "right thing?"
"You have to have a much more open mindset – be willing to use scenario analysis and ask difficult questions," explained Mohamed. "If you don't have cognitive diversity you will have difficulty getting it right.
"You have to work hard at identifying your blind spots and overcoming them - and brand becomes very important."
He told us that there were three things that we needed to do to satisfy our clients:
"You have to get the expected return right," he said. "You have to get the variance of volatility right and the covariance right.
"If you believe in my world, which is that the world we have been living in is coming to an end, then suddenly a lot of conventional wisdom gets questioned:
- Long term beta will no longer do it for most people; most people, if they want to generate the sorts of returns they expect, will have to consider being a lot more tactical in their investing.
- We have to understand that markets will become more volatile, they will naturally overshoot and we need to understand that there will be undue contagion – ask yourself if you will be able to take advantage of that.
- Diversification is no longer sufficient for risk mitigation; the only risk mitigator is if cash becomes part of your strategic asset allocation.
- Finally, understand that central banks are pushing you to take more risk. If you want to really derive proper returns you have to go to places where central bank liquidity doesn't come easy.”
[video src="https://www.youtube.com/embed/NWPcLAkzfNs"]
Float like a butterfly, sting like a bee
No one could be unaware that the we lost the world’s most famous boxer at the weekend. Mohamed used 1974’s Rumble in the Jungle between Muhammad Ali and George Foreman to illustrate his concluding point on how to deal with this bimodal world:
"All the experts assumed Ali would lose. The only question on the table was how badly would he be injured.
"The Ali camp immediately recognised that this wasn’t a normal distribution, it was a bimodal distribution – a very high probability of Ali being knocked out quickly, very low probability that he could win, but no probability that he could last 15 rounds.
"So they did two things. They changed his training programme – he got pounded in the ring every day in order to increase his resilience, and during the fight, he waited for Foreman to get tired by using the ropes to diffuse Foreman's blows, thus inventing the now well-known boxing style "rope-a-dope".
"At the beginning of the 8th round Foreman was visibly tired, Ali saw an opening and he knocked Foreman out.
"Resilence, agility and optionality," concluded Mohamed, "is what is required to deal with a bimodal world."
Watch now: Mohamed El-Erian: The two things investors have relied on will come into question