The unwinding of central bank liquidity mechanisms is the biggest potential risk to investors in 2019, according to Mohamed El-Erian, chief economic advisor with Allianz, speaking in Hong Kong on Thursday.
US-based El-Erian, the former Pimco chief executive much in demand for his market views, said that with global growth slowing and also diverging in the major economies, trade wars impacting China and the US, and central bank liquidity being removed, “we are transitioning from relative certainty to uncertainty."
"And when you put all that together it’s inevitable you are going to have volatile markets," he told AsianInvestor.
With the effects of US interest rate rises in 2017 and 2018 becoming more apparent in dampening economic growth prospects, “investors realise we are changing to a less predictable situation with less ample liquidity,” El-Erian said.
The biggest risk is that investors who have relied on liquidity in illiquid asset classes will be caught out as that liquidity disappears. “For me, the biggest source of a market accident, which people don’t appreciate enough, is that the marketplace has overpromised liquidity.”
“Because we have had a period of ample liquidity from central banks, we saw not only investors taking on more liquidity risk but [also] a proliferation of products that offer liquidity on illiquid asset classes,” he said.
To illustrate the potential hazards that could follow from that he recalled the fallout when market volatility spiked in January and February this year, when “products that were three times leveraged just blew up completely [and] went to zero almost overnight.”
The proliferation of exchange-traded funds on segments of illiquid high yield and illiquid emerging market corporates are of particular concern, El-Erian added.
“So if you are looking for a potential black swan in 2019, one area to look at is what happens when people realise that they don’t have the underlying liquidity they thought they had,” he said."
On the question of global trade tensions, El-Erian told AsianInvestor that he thought it was possible for China and the US to come to an agreement but that any concessions would "mainly have to come from China".
He specified three distinct areas where there was scope for more constructive engagement, starting with non-tariff practices that force the transfer of technology and business knowledge, such as Chinese joint-venture requirements.
China would also have to make concessions to combat intellectual property theft more effectively and address “certain areas that can help reduce the bilateral trade imbalance between the two.”
All three of these concessions are possible and on the agenda, El-Erian said. “But if the Chinese authorities decide to rely on their long play – saying we plan for decades, not for presidential terms – that would be a mistake because a trade war could really derail China’s development process.”
His expectation, though, is that “something material will occur within the 90-day time period”.
As reported ahead of last week’s G20 meeting, some fund managers and advisers have been predicting a ceasefire in trade hostilities between the two largest world economies.
Alicia Garcia Herrero, chief economist for the Asia-Pacific region at Natixis, agrees but adds a proviso.
“It seems increasingly clear that even if an agreement were to be reached, it would be more of a truce than a final settlement of the trade war," she said in a note. "The US and China have become strategic competitors and will continue to be so for the foreseeable future.”
El-Erian adds two other provisos: global market sensitivities to political risk are much higher now than they used to be and positive news isn't as warmly embraced by markets as it used to be.
“We’ve entered a period where returns are uncertain because valuations were high and volatility is going back to more normal, higher levels. Bond prices did so well in 2017 when they shouldn’t have, so now they don’t offer as much risk mitigation," he said. “If you are an investor in that environment, you will take down risk. That’s why the markets don’t have the support currently.”
In the days of ample liquidity, he said “you buy every dip. Now it’s the other way round – people are using rallies to reduce risk.”