In bestselling author Macolm Gladwell's debut book, "The Tipping Point: How Little Things Can Make a Big Difference", he defines a tipping point as "the moment of critical mass, the threshold, the boiling point." The tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire. Just as a single sick person can start a flu epidemic, this human phenomenon can give rise to a rapid adoption of new technologies or trends like cryptocurrencies such as Bitcoin.
Mohamed El-Erian, chief economic adviser at insurance and financial services firm Allianz, parent company of PIMCO asset management, believes the world will converge on an economic and investing tipping point in the next two years. He expects a fundamental shift in the global economy that will either result in a powerful economic boom or in renewed economic tremors which will shake financial markets. While at PIMCO, a team led by El Erian and "Bond King" Bill Gross developed the concept of "New Normal" in early 2009 to describe their concept of a novel economic reality of slow growth and super low interest rates that they expected to emerge in the aftermath of the global financial crisis in 2008/09. The New Normal economic concept is broadly accepted today. With El Erian now forecasting an end to the New Normal and a foreboding economic crossroad ahead, the remainder of this feature article will summarize his views and consider its implications on portfolio construction and the current global investment opportunity set.
The following are the most relevant excerpts on this crossroad theme from an interview with El Erian covered in a blog post at Value Walk.
"Rather than seeing the New Normal continuing I think the world is nearing a tipping point. We are heading toward a T-junction which has three fundamental implications: One is, that the road we’re on is going to end. The second message is that what comes afterwards is very different from what we’ve had. And the third message is that it can be one of two things. So it’s a bimodal distribution with two modes: really good or really bad. We either tip into high and inclusive growth or we tip into recession with renewed financial instability."
"I think within the next two years we are going to tip one way or the other. The probabilities are pretty equal and that’s what makes it very hard for decision making."
When asked "What will define the direction in which we are going to tip?" El Erian replied:
"The major difference will be what the politicians do. It’s not an economic question, it’s a political question. When you grow an economy slowly and in a non-inclusive way, the politics of anger take over and you get improbable outcomes like Brexit, the election of President Trump in the US or the difficulties chancellor Merkel is having in coming up with a new coalition. The list is long. Sometimes the politics of anger result in growth reform candidates likes President Macron in France, sometimes they result in a very disruptive outcome like Brexit. But the politics of anger starts dominating which means that the political establishment becomes less secure."
"This anti-establishment-movement is like a technological disruption: It shakes the system to a better or to a worse equilibrium. In the case of Macron, what you see is a shake to a better equilibrium. In the case of President Trump, we are starting to see congress take on measures that it hasn’t been able to take on for a very long time."
The last thought provoking comment from the interview related to the question, "What’s your take on the financial markets after an exceptionally good year?"
"Markets have been conditioned to buy every dip, regardless of how elevated asset prices are and regardless of how decoupled asset prices are from fundamentals. That can continue for a while. It takes a lot to derail this market because that strategy to keep buying the dips is very simple and it has been very profitable repeatedly – and there is nothing that markets like more than a simple strategy that is repeatedly profitable. But when it stops, there’s an air pocket that comes afterwards."
This chart displays Hussman's Margin-Adjusted CAPE, which improves the correlation of the Shiller cyclically-adjusted P/E (now at 34.4 times) with subsequent total returns by accounting for variation in the embedded profit margins (assumes currently high corporate profit margins will experience mean reversion to historical lower averages). Hussman's Margin-Adjusted CAPE is at 45 times and is now beyond both the 1929 and 2000 extremes, placing current market valuations at the richest level in U.S. history. If the aftermaths of the 1929 and 2000 bull markets are any guide, we are in for one doozy of an air pocket.
From a portfolio construction and risk management standpoint, these obscene domestic equity valuations have led Servant Financial to seek relative values across global asset classes and adopt a bar bell approach with client portfolios. As the chart of expected 10 year real returns and volatility from Research Affiliates below graphically depicts, this risk bar bell includes an overweight allocation to higher expected returning emerging market equities (6.0% real return and 22.6% volatility) and developed international EAFE equities (4.4% real return and 18.0% volatility) while underweighting U.S. large cap equities (0.2% real return and 14.6% volatility). To dampen the volatility of our international equity overweights and reduce overall portfolio risk levels below strategic levels, we are overweight high quality domestic fixed income securities and cash while aggressively managing portfolio duration and interest rate risk - U.S. bond aggregate (0.5% real return and 3.7% volatility) and U.S. Treasury intermediate (0.5% real return and 3.5% volatility). As we articulated a year ago in the January 2017 post "Omne Trium Perfectum," we have assembled a diversified portfolio of inflation hedges to provide a Third Pillar to traditional client allocations to stocks and bonds. This potential inflationary backdrop with the incoming Trump administration led us to research various asset classes that provide protection as inflation hedges - U.S. Treasury Inflation Protection Securities (TIPs), commodities, real estate investment trusts (REITs), floating rate senior bank loans (where interest rates are reset every 30 to 60 days), emerging market equities, debt (local and U.S. dollar based), and currencies. Many of these Third Pillar securities have been added to client portfolios and will benefit if the road ahead leads to a powerful economic boom.
We need to do more work on this topic, but we initially think this is an appropriate way to respond to El Erian's economic intersection theory and expected bimodal economic distribution of high and inclusive growth or recessionary conditions and renewed financial instability. In a continued global synchronized growth scenario, we would expect emerging and developed international equities and Third Pillar inflation hedges to outperform U.S. equities. Both developing and developed international equities outperformed U.S. equities in 2017. Meanwhile, in a recessionary scenario we would expect the overweight to high, quality domestic corporates and U.S. treasuries to provide much needed ballast in a recessionary induced market correction. Developing and developed international equities would arguably outperform domestic equities in a recession given their substantial valuation discounts.
In the case that the foregoing analysis was insufficient justification for exploring unconventional portfolio construction approaches in these unusual times, we've included the following forward thinking investment analysis by Jeremy Grantham entitled "Investing in A World of Overpriced Assets", part 2 of this linked GMO quarterly letter to add further credence. Grantham's analysis of liquid securities markets concludes it is time to overweight emerging market (EM) equities.
The synopsis of his investment analysis and recommendation is as follows:
"To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival."
"Since February 2016, EM equities have already moved 11% relative to the US. But their three earlier moves since 1968 were at least 3.6x the developed world markets! Absolutely, at around 16x Shiller P/E, EM equities can keep you alive."
"Exhibit 3 (chart above), from Minack and Associates in Sydney, suggests that GMO’s forecast may still be understating the opportunities in EM equities. It plots the straightforward measure of Shiller P/E (price over 10 years of average real earnings after inflation). My using an outside source is deliberate: to cross-reference and also to suggest that GMO’s estimates, in the interests of safety, are conservative. Note that at the recent low in February 2016 (Point 1), the multiple on EM equities was lower than after the crash in 2009! Remarkable. Meanwhile (Point 2), the multiple on the US had gone from 12 to 22, an almost 100-percentage-point spread in favor of the US in just 7 years. The Emerging index had sold at 38x in late 2007 (Point 3), a very substantial premium (52%) by any standard over the 25x of the US index. It had sold again at a premium as recently as 2011 after the crash. And early last year, the US was at a 120% premium the other way. When you see the absolute and relative volatility of these three indices in Exhibit 3, doesn’t it suggest money to be made and pain to be avoided, even with less than perfect predictive power? It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level."
"Be brave. It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior. I believe a conventional diversified approach is nearly certain to fail."
The data and analysis of each of the foregoing experts - El Erian, Hussman, Research Affiliates, and Grantham - point to very hazardous conditions and a potential economic conflagration ahead. They have all signaled in different ways an economic and investing tipping point ahead the likes of which we have never seen before. Proceed with caution. Look for alternative routes and unconventional methods to preserve your financial wellbeing.