Mohamed El-Erian assesses the challenges faced by the global investment community and the contribution that gold can make within investment portfolios

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Mohamed El-Erian is chief economic adviser at global insurance giant Allianz and former CEO of PIMCO, the world’s biggest and most influential bond investment firm. Here, El-Erian, dubbed one of the ‘Top 100 global thinkers’, assesses the challenges faced by the global investment community and the valuable role that gold can play in today’s uncertain environment.

So far, markets have brushed off what has been, to say the least, a rather unusual election season. Valid reasons for this include the institutional checks and balances built into the US political system. Unless Congress swings in an unexpected manner in favour of the next President’s party, whoever is elected to the White House would find their degrees of freedom quite limited – especially given some of the statements that have been made on the campaign trail.

Yet such valid reasoning is not sufficient to explain the extent to which markets have ignored political developments. Moreover, you need only look at how fast investors overcame their initial Brexit fears to realise that something else has been in play – and that is, enormous faith in the ability of central banks to repress financial volatility and to succeed in doing so almost regardless of political and economic developments.

I suspect that such central bank effectiveness is in the process of changing, if not eventually waning. As such, political developments may have a bigger impact on markets in the months to come.

2. As the Chair of the President’s Global Development Council what do you think is the biggest threat to sustainable economic growth?

Like many economists, I worry about three main developments in advanced economies that accentuate the internal challenges facing many countries, as well as secular challenges (such as climate change):

First, the extent to which political polarisation is delaying and frustrating a much needed economic policy pivot: away from excessive reliance on central banks and towards a more comprehensive policy approach that includes pro-growth structural reforms, more balanced demand management policies (including larger infrastructure investment), addressing pockets of crushing overindebtedness, and improving global and, in the case of Europe, regional policy coordination.

Second, the excessive and alarming worsening of the inequality trifecta – that is, the inequality of income, wealth and opportunity. That tends to complicate the political environment, thereby further reducing the probability of good economic governance. It also fuels anti-globalisation pressures, including protectionist threats to growth.

Third, an economic and financial system that, for quite a few years now, has excessively borrowed growth and financial returns from the future; and has done so without improving the prospects for higher inclusive and sustainable growth.

3. Recently, you have talked about the impact that ‘jumps’ in market prices can have on investors. Do you think their frequency/ magnitude will continue to increase over time?

Yes, and for reasons pertaining to economics, policies and politics.

As more people are realising, there is a cumulative cost to running complex economies at low growth speed for a long time. Things start to break, and they could do so in a cascading fashion. The related risk of large jumps increases when financial markets have already been decoupled from validating economic and corporate fundamentals, as is already the case today.

A prolonged period of an unbalanced macro-policy mix, such as that which has been experienced by advanced economies, adds to the risk of jumps; and especially so when there has been excessive and prolonged reliance on experimental central bank policies. Add to that a political context that fuels the emergence of anti-establishment movements on both sides of the Atlantic, and you end up with the ingredients for more frequent and larger sudden market moves.

4. You have written about the distortions that low interest rates are creating. Given the current interest rate environment, how do you see negative interest rates affecting asset allocation and risk management?

A prolonged period of low and, especially, negative nominal interest rates was once thought unlikely if not unthinkable. It is now reality, with some 30% of global government debt trading at negative yields. While some of the consequences for investors have transpired or are in the process of doing so, I suspect that many more are yet to play out.

Ultra-low interest rates entice investors to stretch much more for returns. Combine this with repressed financial volatility, another objective of unconventional central bank policy, and you could well end up with excessive risk-taking on the part of too big a portion of the investor base. In the process, market valuations decouple meaningfully from underlying economic and corporate fundamentals.

Such an interest rate set-up also lowers the risk-mitigation effectiveness of portfolio diversification. As such, investors would be well advised to hold bigger cash cushions as part of their risk mitigation approach.

Finally, ultra-low interest rates make life more challenging for providers of long-term financial protection products, particularly in the retirement and insurance space.

5. What about the known unknowns (let alone the unknown unknowns) this low rate environment brings?

Given that we are essentially in unchartered waters, we do not as yet have a good enough handle on how modern market-based economies operate when faced with a prolonged period of artificial pricing. There is a sense that the risk of collateral damage and unintended consequences is meaningful, but specificity is understandably hard to pin down with sufficient conviction.

Unless validated by improving economic and corporate fundamentals, investors face major uncertainty with respect to the trio that determines their wellbeing – that is, expected returns, volatility and correlations between asset classes. In particular, there is the possibility of much lower returns given the decoupling of valuations from fundamentals, more frequent and sharper volatility spikes, and even more unpredictable correlations.

The institutional setup is also in play, including a growing threat to the political autonomy of central banks.

These are some of the known unknowns… and then there is the even more uncertain issue of the unknown unknowns – all of which speak to the ‘unusual uncertainty’ facing investors.

6. Might gold be part of the solution?

Yes, and this is increasingly recognised by the investor community.

As part of a diversified portfolio allocation that includes a higher-than-usual cash allocation, gold can play an important role in overall risk mitigation. It can also provide a notable upside should the enormous amount of central bank liquidity injection gain traction and result in higher inflation, be it actual or expected.

Having said that, investors should size their gold allocation in a manner that enables them to stomach considerable mark-to-market price fluctuations. Otherwise, they run the risk of doing the wrong thing during periods of unsettling market volatility. A 5% strategic allocation is appropriate.

7. The Japanese GPIF, the world’s biggest pension fund, announced a ~US$52 billion loss in the past quarter, highlighting the crisis affecting many developed market pension funds. What is your perspective of this problem?

This is a tough environment for providers of long-term financial security products, including pension funds. From ultra-low interest rates to unpredictable asset class correlations, it is hard for them to operate.

The prudent thing to do in such an environment is to lower return objectives and to save more – none of which comes easy to underfunded pension plans, be they in the private or public sectors.

8. In recent years, an increasing number of US insurance companies have included an allocation to gold in their investment portfolios. Do you see this trend continuing and will other institutional investors follow suit?

Yes, and driven by both positive and negative reasons.

A growing number of investors are recognising the potential of gold to increase returns and improve risk-mitigation attributes of well-diversified portfolios. At the same time, there are – understandably – growing worries about the over-valuation of public equities and fixed income, thereby strengthening the case for an appropriately-sized allocation to gold.

This article is here with permission. It is sourced from the October edition of the World Gold Council's Gold Investor download, which you can access here via registration. Mohamed El-Erian is chief economist at global insurer Allianz and former CEO of PIMCO, the world’s most influential bond investment firm.

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