The global economy is too levered: Some go further and note the concerning increase in indebtedness around the world, particularly in the corporate sector, as well as pockets of excess risk taking in markets. They fear these developments will cast a dampening cloud over the global economy (a debt overhang) that forces the Fed to cut rates and the ECB to return to quantitative easing to avoid inadvertently triggering a damaging disorderly deleveraging.
Determining which of these six main explanations, alone or in combination, is the most valid really matters for investors’ portfolio positioning. For example, the first scenario (structural upside to the U.S. economy) would imply considerable secular risk taking and tolerance for volatility given that fundamentals would drive the economy and markets forward and wouldn't be derailed by premature Fed tightening. The second explanation (the Fed cowed by markets) would suggest a more tactical risk positioning, which involves surfing the central-bank liquidity wave once again but being ready to get off before it breaks. The other possibilities suggest up-in-quality trades and more defensive investment positioning.
As frustrating as this is, there simply isn’t enough data as yet to point with a high degree of confidence to a dominating explanation or combination of explanations. In addition, most model portfolios and, more generally, historically based analytical models may not be sufficiently structurally robust to capture this moment accurately.
Rather than let this uncertainty lead to either paralysis or excessive speculation about the influence of one or more tentative explanations, investors should take away three messages: We are in a period of inherently greater economic, policy and financial uncertainty, instability and unpredictability; the main risks to the U.S. economy are less organic than political, external and financial; and the risks of a policy mistake and/or market accident are increasing. All of this calls for well-constructed tail protection and readily available cash to exploit the possibility of subsequent technical overshoots.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”