Why this uncertainty is so unsettling and so unusual for investors

Leading economist Mohamed A. El-Erian tackles client behaviour, changing liquidity regimes and late central banks during Canada Life live event

Why this uncertainty is so unsettling and so unusual for investors

This article was produced in partnership with Canada Life.

Advisors are urged to help clients guard against “unrecoverable mistakes” as they guide them through this period of economic uncertainty.

That’s the view of internationally renowned economist Dr. Mohamed El-Erian, who was speaking at the virtual “Canada Life presents Investments Live!” event on October 6 where he addressed the major economic trends, including inflation, rising interest rates, central bank policy, and market volatility.

El-Erian works with the highest levels of business and government. He is president of Queens’ College Cambridge, chair of Gramercy funds management and a best-selling author of a number of finance books. He is also a respected columnist for Bloomberg and The Financial Times. During his session, he highlighted three main behaviours advisors should watch out for among your clients.

“One [behaviour] is denial and blind spots,” he explained. “We continue thinking we are living in a different world. That was the central bank [saying] ‘transitory, transitory, transitory’. It was a complete blind spot - they didn't have an open mindset.”

The second behaviour is “reframing”, when investors recognize a change but reframe it to something they feel more familiar with. This may take the form of a “pivot”. For example, interest rates are going up, but the client believes they will pivot and come down soon. El-Erian added: “We tend to do that to regain our comfort zone, but it is hard to reframe secular changes without changing their meaning.”

The final element is “active inertia”. This is when a client might be able to recognize they need to act differently but end up doing the same thing. El-Erian opined that these mistakes are the result of human error and how we tend to “react when we come out of our comfort zones.” He added: “That's why I always keep an eye on the [investment] destination, because we need some anchor in this process.”

One of the causes of this overriding uncertainty is, of course, inflation. The unnerving story of the first nine months of 2022 was that investors lost money no matter where they put it. Even in cash, purchasing power went down.

El-Erian said it’s important to remember the reason for the uncertainty. Central banks are shifting from a strategy of low interest rates and big injections of liquidity to its exact opposite. Consequently, investors are in the midst of “unsettling, unusual uncertainty”.

The economist delved into the main drivers behind this during the Q&A. He said the number one reason is that the global economy no longer has a powerful growth model because of deficiencies on the supply side. The second driver is not only the changing financial picture but that central banks – in particular the U.S. Federal Reserve and the European Central Bank (ECB) – were late to act. He said: “If you're driving along a highway and you have fog and debris on the road coming up, you should ease your foot off the accelerator. The Fed, and the ECB in particular, did not do that. For all of last year, they had pedal to the metal. In March of this year, when the U.S. printed a 7%-plus inflation rate, the Federal Reserve was still injecting liquidity into the system. So, when you suddenly find yourself without visibility and hitting things, what do you do? You slam on the brakes. So, we are changing financial conditions in a very abrupt manner.” The third element, he added, are the numerous geopolitical shocks hitting us all at once.

However, El-Erian warned advisors not to expect an early return to a world of very low inflation and 0% interest rates. We have entered a different paradigm and they have to be prepared and communicate effectively to clients.”

He said: “You have to keep them informed, you have to explain why the journey is bumpy, and do not lose sight of the destination. That’s the risk for clients right now – that this journey is so bumpy they lose sight of their destination.”

While he expects inflation to ease - unless central banks lose their nerve in raising rates - the question is: at what cost? The delay in raising rates by central banks means inflation is likely to involve more growth shortfall than necessary. The Fed would be mistaken if they started to pivot too early, he said.

With that in mind, a “financial accident” remains the most likely Black Swan event, an unpredictable event that has a major effect and is often rationalized with the benefit of hindsight. This was exemplified by the UK government’s recent mini-budget misstep, which almost crashed the UK pension system had the Bank of England not intervened. El-Erian said: “If that were to occur, it's more likely to occur in the non-banks, and it is likely to occur because people got too conditioned to assume that zero interest rates and ample liquidity would last forever.”

Despite the “unsettling, unusual uncertainty” globally, the economist believes Canada is in a relatively good place. Looking at the three major areas, North America, Eurozone and China, Europe is most exposed to recession risk, followed by China and then North America. Canada, he added, is a “good house … in a relatively okay neighbourhood”. Canada’s proximity to the U.S. is a positive given its economic strength and the two country’s business ties, while Canada is well placed to be on the receiving end of the energy diversification that has to happen in Europe because of Russia’s invasion of Ukraine.

“Canada's neighborhood is challenging, but certainly not as challenging as others,” he said. “Inflation, higher borrowing costs, and concerns about recession mean it’s not a perfect house, but in relative terms, you have better initial conditions. It doesn't mean it's easy, but it's easier than if you were in the middle of Europe, or if you were dependent on China right now.”

Advisors navigating these choppy waters can take a degree of comfort from Canada’s position and relative strengths. The focus should be on clients’ long-term financial destination and helping them avoid costly behavioural missteps.

The views expressed in this commentary are those of this investment manager as at October 6, 2022 and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.

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