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Commentary

Mohamed El-Erian Explains the Coronavirus' Impact on Global Markets

In our podcast, Allianz’s chief economic advisor discusses the effects of financial contagion, a bond market breakdown, and the coronavirus’ impact on global supply chain.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Mohamed El-Erian--chief economic advisor at Allianz, the parent of Pimco--recently spoke to Jeff Ptak, global director of manager research at Morningstar Research Services, in a special edition of Morningstar's podcast The Long View.  

As the world grapples with the fallout from the coronavirus, El-Erian talked about the impact this pandemic has on world markets and international investing.  

Here are excerpts of El-Erian's comments during the interview, which aired on March 23, 2020. 

Financial Contagion and Its Effects on Market Volatility 
El-Erian: What is occurring in the markets is that people are unable to do what they want to do. Let me give you an example; I take money out of a mutual fund because I need cash. The act of me taking out money forces my fund manager to raise cash, and they in turn will have to sell something. When markets are under stress, the managers are not able to sell what they want to sell--so they sell whatever they can. 

That results in a number of unintended consequences. First, it takes the pressure that was supposed to be in one segment to something else. When selling pressure contaminates something else, that's called contagion. Second, it results in the fund manager having a portfolio that is now different from what they want. Third, it puts enormous pressure on the value of the fund, which means that others are going to start looking and worrying. Next thing you know, you're cascading the self-feeding mechanisms. People are worried about these dynamics that can spread disruption. 

The Breakdown of the Bond Market 
El-Erian: We've come from a period where investors were living the dream, as I call it. Despite sluggish economic and corporate fundamentals, the S&P was up 30% in 2019. At the very same time that that happened, you also made money on U.S. government bonds. So, you made money on the risky stuff and you made money on the risk-free stuff. That is not supposed to happen. At the same time, volatility was very, very low. What that tells you is that the marketplace has been conditioned to care about only one thing to the exclusion of everything else. And that is central bank liquidity, particularly the predictable and ample injection of central bank liquidity. The result of that is the market underappreciated liquidity risk, credit risk, and equity risk. Now, we’re unfortunately reversing all three

De-Globalization Accelerated by the Coronavirus 
El-Erian:
What people have realized is that as efficient and as cost-effective as global supply chains are, they are not as resilient as people thought they were. The conventional wisdom was first shocked by the trade war, which was unthinkable. How could the U.S., the champion of free trade, become the most protectionist advanced economy? But it happened, and it opened the possibility in future of weaponizing economic tools much more.  
 
The second shock, which makes the first one pale in comparison, is the coronavirus shock, where you simply can't get things moving. You can't manage inventory. This makes people think a lot more about resilience. How do I build in resilience into my system?  

Part of building in the resilience is having more of your supply chain close to you, even if that is more costly. We are going to see, unfortunately, a dynamic that you often see in the insurance market, which is that when the shock hits, after the shock, people overinsure. If they cannot overinsure collectively, i.e., if there isn't an insurance company that pulls their risks, they will self-insure. So, we will see the self-insurance behavior more, which will mean a de-globalization of supply chains. 

Impact of the Coronavirus on the Southern Hemisphere  

El-Erian: Every day I get up and I check the numbers--I look at Latin America and Africa. If it spreads there, the human suffering is going to be absolutely enormous, because the healthcare system will be overwhelmed very early on.  

In terms of economic and financial consequences, it will reinforce the breakdown of global trade and supply chains. I've been warning for three years now that we must be careful when we enter a more fragile landscape economically and financially. We must remember that emerging markets don't have the resilience of markets.   

One of major investment recommendation for the past three years was to fade the U.S. equities, because they've outperformed the rest of the world by so much, and thus people should move into international and emerging markets. I said over and over again, there's a reason why you should not do this now. It's about resilience. The time will come when you should fade U.S. equities in favor of international exposures, but we're not there yet. I think people are going to realize that investing in less developed areas comes with a host of risks, one of which is less structural resilience. 

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.