Investors Cautioned About Potential Big Risk For Investors

The risks facing investors and the global economy are myriad and growing. We asked three of the most visionary people in the financial industry what they’re most worried about over the next five to 10 years: Cathie Wood, whose Ark Investment Management attracted billions of dollars in the past year after her tech-focused bets trounced the market in 2020; Mohamed El-Erian, chief economic adviser to Allianz SE and a Bloomberg Opinion columnist; and Scott Minerd, chairman of Guggenheim Investments.

Their comments have been edited for length and clarity.

The underlying assumption out there is that we’re in an inflationary period turbocharged by supply-chain disruptions. I’ve seen a lot of markets and started in the business during the ’70s. I was in college when inflation was raging. So I know what that is. And I truly believe we’re not going back there and that anyone planning for it is probably going to be making some mistakes.

Instead, we see three major deflationary forces brewing.

On the innovation side, we’re in a period today like we’ve never been in. You have to go back to the telephone, electricity and automobile to see three major technologically enabled sources of innovation evolving at the same time. Today, we have five platforms: DNA sequencing, robotics, energy storage, artificial intelligence and blockchain technology — all of which are deflationary.

In artificial intelligence, training costs are dropping by 68% per year. What does that mean? We’re going to see a boom in a lot of products that use AI and therefore are better, cheaper, faster and more creative.

There’s also DNA sequencing costs. To sequence the first whole human genome, it took $2.7 billion and 13 years of computing power. That was 2003. Eighteen years later, we’re down to $500 and a few hours of computing power. For every cumulative doubling in the number of whole human genomes sequenced, costs drop 40%.

This is going to transform health care, helping us discern which health-care dollars we’re wasting. And we think more than half of all health-care dollars are wasted today.

Then we have electric vehicles and battery pack system technology. For every cumulative doubling in electric vehicles sold, those costs dropped by 28% for the battery, which means the EV costs are going to be dropping roughly 15% every time we see a doubling in sales and we’re in electric vehicle sales infancy right now. Another is industrial robots. Those costs are also dropping more than 20% for every cumulative doubling.

The good news is that this is good deflation, which causes a boom in economic activity, at least where the innovation is taking place.

The corollary to this is bad deflation. Since the tech and telecom bust and the ’08-’09 financial meltdown, there’s been a significant increase in risk aversion in the market. And so many investors and analysts invest very closely to their benchmarks. They don’t want to stray much.

The problem is this innovation is going to be very disruptive to the traditional world order. So the benchmarks today are constructed based on companies’ past successes. But if disruptive innovation is evolving to such a rapid extent, there’s going to be disintermediation and disruption. Companies that have learned to satisfy short-term shareholders — who want their profits and want them now — have been leveraging up to buy back shares and pay dividends.

Companies haven’t been investing enough in innovation, and we’re going to see a lot of carnage out there increasingly during the next five to 10 years. At the beginning of the S&P 500 indexes initiation, the average lifespan of a company was 100 years. We believe it’s down to a little over 20 years now — but it’s going to collapse going forward.

We’re also seeing some interesting signals in cyclicals.

Lumber prices shot up last year because of all the remodeling and demand for new homes in suburbs. Prices went to $1,700 and that’s down to $600 now. And a lot of people find that hard to believe because housing still seems so hot. I think it’s a leading indicator that prices probably went a little too far, too fast.

Consumers feel their purchasing power is going down. Prices of goods and services are moving faster than incomes are increasing. So there’s another reason we’re probably going to see a slowdown.

But even more important is what has happened with supply chains. If you looked at how businesses were positioned before the coronavirus, they’d been pulling back on inventory building and capital spending for about a year to 18 months. And the reason was the U.S.-China trade war, saber rattling, fear of the conflict blowing up in some way. When the coronavirus hit, businesses that had already been cautious slammed on the brakes. And what did the consumer do? The consumer started — after a month or so with the PPP payments — to stimulate the economy. They started spending because their savings rate in the previous few months had skyrocketed.

Businesses were caught flat-footed, and they’re still caught flat-footed. They haven’t been able to catch up. Inventory liquidation in the second quarter was near record-breaking levels. And so what I believe is happening now is businesses, in order to catch up, have been double- and triple-ordering. That’s what happened with lumber prices and why the decline has been so steep since mid-May. And once they see prices coming down, they’ll pull back on those orders. So I think there could be a big drop in commodity and other prices as the consumer has shifted from consuming goods, which are only a third of consumption to consuming services, just as businesses are scrambling aggressively.

A World of Inequality

MOHAMED EL-ERIAN
Chief economic adviser, Allianz SE, and president of Queens’ College, Cambridge

What worries me the most is inequality, both within and across countries. And it’s something that financial markets puts aside as a social problem, not really an economic or financial problem. And we’ve risked seeing the issue of inequality gather momentum. Covid has already been the great un-equalizer, but rather than go back to where we’ve come from, we are now creating the dynamics for inequality to worsen and to assume greater importance in disrupting all sorts of things in our society.

A highly unequal society is not an economic healthy society. But the thing that worries me even more than that is inequality of opportunity. We know what Covid did to people who had no WiFi at home, who had no computers. We know that public school districts lost touch with a lot of their students and these students were not only becoming unemployed, but unemployable, which means a lost generation of young people.

As we slowly emerge from Covid, its aftermath creates different dynamics around the world. If you’re in a developing country today, you can no longer assume that companies will come to you. The onus is increasingly on you coming to the employer. And that is the real issue when education is lagging, when technology is lagging. So I do worry that we’re going to see this massive process get larger, if we’re not careful.

We were watching a tragic movie in play mode and then Covid came along and pressed fast-forward. First, it worsened wealth inequality because the response to Covid involved massive Federal Reserve liquidity injections to boost asset prices. And who owns assets? It’s the rich. So if you look at what has happened, the top part of the wealth distribution, people are much better off than they were before Covid. But at the bottom end, that hasn’t happened.

Think of people whose jobs have been displaced by this big step toward digitalization, who have no financial assets to begin with and don’t benefit from what has happened to asset prices. In addition, they are hoping to buy a house and they’ve been priced out of the housing market. So suddenly both the actual and potential wealth and income has declined.

To add to that, if they are unemployed, there’s suddenly a skills mismatch. There are record levels of vacancies that the labor market is not able to match to workers. And then you get what economists called multiple equilibria: one bad outcome, resulting not in mean reversion, but a high likelihood of an even worse outcome.

We already know what it looks like because we’ve had a taste of it. On the economic side, it looks like insufficient aggregate demand, which is a fancy way of saying that as the rich capture more income and more wealth, they spend less of it. The poor tend to consume more. So if the incremental income and wealth all go to the rich, then you’re going to have the problem of demand, which means you’re going to have a problem of growth.

And we’ve already had a period of so-called secular stagnation, and what my colleagues and I call the new normal, where we get low and insufficiently inclusive growth. We know what that looks like. We know the social consequences. It is cultural war. It’s alienation. It’s marginalization. That’s not good for society. It eats away at the fabric of society.

We know what it looks like politically. People will become single-issue voters, and single-issue voters can be captured by all sorts of things. No wonder we’re seeing an increase in populism across the world. And then it means a less equal world. You know, I grew up interested in developing countries, and for decades it was almost an accepted fact — not a hypothesis, almost an accepted fact — that these countries would converge to the advanced economies.

Well guess what? We’re having divergence going on right now. And I suspect this divergence is not short term. So we may live in a less equal world, or to be more blunt, a much more unequal world. And that’s problematic for global economic policy coordination, interdependency, immigration. I mean, I can go on and on. So it is problematic. We’ve had a taste of it and we don’t quite like that taste, but it could become a lot worse.

The American dream is all about capturing these amazing opportunities and being able to go right up the income ladder. There’s a correct notion that inequality can incentivize people to work harder, to do better, but there comes a point when it goes from encouraging people to do good things to actually detracting from not just economic well-being, but social and political well-being.

I don’t think the American dream is dead. I think it’s harder to achieve. If you don’t have the right education to begin with, if you don’t have a set of assets to begin with, you’re looking at a much steeper curve, and that is a real problem for too many people.

The prescription is investing in human and physical infrastructure. It’s about enabling people to do more and to do better. It’s about providing people with transformational opportunities. It starts at a very early age, at pre-K, exposing bright minds to exciting education and opportunities. It continues throughout the middle school, high school, university, making elite universities more accessible to people who deserve to be there but may be held back because they come from the wrong zip code or because their parents have never had an education.

There’s a lot that can be done. It’s about fundamentally asking the question, ‘How do we enable our resources, human and physical, to be more inclusive and more productive?’

Hackers on the Loose

SCOTT MINERD
Chairman, Guggenheim Investments

The No. 1 one risk is the sustainability of the global payment system. And I choose the word sustainability over the word vulnerability, because the real key here is keeping the global payment system running, and we’ve had so many hacks, terrorist attacks, the Colonial Pipeline incident. It would appear that we are extremely vulnerable to having an attack against the payment system of the financial markets — and not just here in the U.S., but in Europe.

What I’m talking about is things like the Fedwire, where the banks’ money clears through. But also something like the DTCC, SWIFT, Euroclear. I mean, I can just keep going on and on and on. And if there was a synchronized attack, we would essentially bring the global financial market to its knees. The first response would probably be that securities prices would crash, and the second is we would probably have to close all the exchanges in the world in order to figure out how to restore the global payments system.

The thing that bothers me about the global payment system is, I don’t think anyone’s focused on it. And this really takes a high degree of international cooperation. It takes a real macro look, meaning there needs to be somebody or some group of people looking at how everything interconnects and where the potential vulnerabilities are.

I would put the probability [of it happening] as very high. Certainly well over 50%. I got accused once when talking about this that I’m actually alerting terrorists and other governments on how to attack us. But the likelihood is they’re already thinking about it.

With the Fed, when I speak to them, they don’t really comment on it. And there’s two interpretations to that: They just don’t think it’s that serious, or they believe it’s so serious that they don’t really want to say anything. Just as we found out with the electric grid, one vulnerability is that the system isn’t hardened enough and we need to harden it for security reasons. The payment system is the same sort of thing. Even though the Fedwire has been modernized over time, it’s still built off an infrastructure that’s extremely old.

We need international cooperation to assess the risk and figure out how we can harden the system that exists in the short run and, in the long run, modernize it. Delivery versus payment, which is the standard way that we’ve delivered securities for 100 years, is in an age like ours, kind of ridiculous. There’s no reason why that just can’t be instantaneous.

But that’s going to take a new generation of technology and whether that’s blockchain or whatever, it needs to be modernized. But in the short run, central banks, exchanges and so forth need to take a hard look at their systems, not just their system, but at the interconnectivity of the system and how secure is that connection that’s being made. Not just from the standpoint of it having being disrupted, but since you’re sending information through the ether, what’s the chance that that can be redirected somewhere.

Certainly, the internet’s vulnerable, right? One of the comments I made to people about cyber cryptocurrency in general is: Why do I need to transact through the internet? Why can’t I just text it to you?

There are other ways to transfer things through the ether, right? So for instance, if you look at crypto as an example, the weak link is the fact that it’s linked to the internet. Even if the blockchain was forever and perfect and hardened and you couldn’t steal from it — which is not true — if you pull the internet down, you’re done.

The U.S. government will play a huge part in [creating a new system] just because we are the financial center of the world. However, to quote Winston Churchill, the U.S. government will always do the right thing after it’s exhausted every other option. So, I don’t think they’re going to go there right away. I think that there’ll be a lot of patches.