“These issues share a potential for fuelling so-called jump conditions in which there is a leap to a different set of circumstances, rather than a smooth and incremental evolution,” El-Erian wrote for the Financial Times. “In turn, they could change longstanding economic and financial relationships, impact the way economic agents interact with each other, fuel political anomalies and, in the case of unusual asset class correlations and valuations, undermine some of the institutions and basic tenets of the capitalist system.”
Looking ahead, El-Erian warned of other potential jump conditions, such as the October referendum in Italy that could complicate European politics after the Brexit vote, a November presidential election in the U.S., a transitioning economic model in China that has created some hiccups along the way and a money-fueled world where central banks have brought us deeper into uncharted waters.
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However, El-Erian argued that markets remain relatively calm, with investors jumping on any drawdowns with a “buy on dips” mentality, especially as it has been a winning trade since the financial downturn. Moreover, investors lack any attractive alternative.
“It is understandable for markets to trade on the current reality of cash flow and put aside, at least for now, the possible consequences of the ever growing gap between investor behaviour and a growing list of unusual economic and political uncertainties,” El-Erian added. “In the process, however, a cocktail is brewing that risks future financial volatility and jump conditions in various market segments.”
Consequently, El-Erian advises investors to lower expectations, expect increased volatility, combine higher cash allocations with greater exposure to alternatives and become more tactical.