Investors are too optimistic and need to prepare for tough times ahead, warns Mohamed El-Erian, Allianz’s chief economic adviser and former CEO of Pimco.
El-Erian says the financial stress created by the coronavirus pandemic is “far from over,” in a recent op-ed piece for the Financial Times. He expects a “reckoning” as liquidity concerns spread from the most vulnerable businesses to sovereign borrowers.
What Investors Can Do
Investors can get ahead of the coming troubles by not buying assets at “valuations stunningly decoupled from underlying corporate and economic fundamentals,” he said. Instead, they can focus on the recovery value of their assets to get ahead.
Because the country avoided the worst-case projections for the pandemic, a sense of complacency has overtaken investors. El-Erian says all the liquidity created by government money printing coupled with a surge in new retail investors has helped push stocks higher.
“Liquidity-driven rallies are deceptively attractive and tend to result in excessive risk-taking. This time, retail investors are front and center.”
El-Erian also says you can see cracks starting to form if you know where to look. This is despite the stock market surging higher.
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“There are already plenty of worrying signs: a record-breaking pace for corporate bankruptcies; job losses moving from small and medium-sized firms to larger ones; lengthening delays in commercial real estate payments; more households falling behind on rents and continuing to defer credit card payments; and a handful of developing countries delaying debt payments.” says El-Erian
He adds that investors are all too happy to ignore these worries. Some even believe that the government will step in and provide help.
“Yet, judging from a range of market indicators, investors are showing insufficient concern. Some continue to expect a sharp, V-shaped recovery in which a vaccine, or a build-up of immunity in the population, allows for a quick resumption of normal economic activity. Others are relying on more backstops from governments, central banks and international organisations.”
How Things Can Fall Apart
Should we not see a v-shaped recovery or a vaccine soon, things could quickly fall apart. Also, El-Erian warns the destruction will spread beyond the financial markets.
“The potential damage is not limited to finance. Disruptions in capital markets could also undermine the already sluggish economic recovery by making consumers more thrifty, as they worry about their job prospects, and by encouraging companies to postpone investment plans pending a clearer economic outlook.”
This means investors need to be prepared and shift their investing approach.
“The investing challenge may well shift in the months ahead from riding an exceptional wave of liquidity, which lifted virtually all asset prices, to steering through a general correction in prices and complex individual non-payments, says El-Erian.
He adds, “No wonder, then, that an increasing number of asset managers are raising funds in the hope of deploying a dual investment strategy.”
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“The first involves waiting for a correction to buy rock-solid companies trading at bargain prices. The second involves engaging in well-structured rescue financing, debt restructurings and collateralised lending as countries, and some bankrupt companies, seek to reorganise and recover.”
Investors should also consider increasing their cash position to have dry powder ready to go. They should do so in case we get the correction that El-Erian expects.