Outside-IN

Mohamed El-Erian: What the market rebound is telling investors

Answers to questions on policy, market and economy are already impacting portfolios

Jun 10, 2019 @ 2:24 pm

By Mohamed A. El-Erian

Investors heavily exposed to U.S. stocks just had their best week of the year. But the rebound also raised several questions related to market behavior, policy and economics. How they are answered will prove consequential not only for market prospects but for the global economy. And, notwithstanding the lack of decisive answers at this stage, there are already implications for investment portfolios.

Last week's strong U.S. equity performance stood in stark contrast to two other market developments.

(More:Mohamed El-Erian named president of Queens' College at Cambridge University)

First, yields on government bonds fell across the board, driving the benchmark 10-year to below 2.10% and that on its German counterpart to minus 26 basis points. The moves are good news for stock investors if they foresee more dovish central bank policies — but less so if they signal a lower global growth picture.

There is also uncertainty as to the repercussions of such low interest rates. Will they fuel "Japanification" in Europe and, to a lesser extent, the U.S. as households hold back on consumption and worry about shrinking access to long-term financial protection products, while companies hold back on investing? And how deep will the resulting damage be to the longer-term functioning of financial markets?

Another issue is the flood of investor money going into bond funds at such low interest rates. Is it a sign of appropriate, forward-looking risk-management or, instead, a backward-looking, pro-cyclical reaction that increases the vulnerability of investors to future losses?

The second big market anomaly relates to the performance of the higher risk asset classes known as "high beta." It was notable that, given the sharp rise in U.S. stocks, quite a few of them, including important segments of emerging markets and high-yield corporate bonds, did not rally by as much as would be expected based on historical experience. Was this just a temporary phenomenon or the result of spreading concerns about the global economy?

Turning to policies, there is a disconnect between the cuts now priced in by markets and the consensus justification for such an aggressive policy move by the Federal Reserve.

With the fall in yields, investors are pricing in interest rate cuts of 75-100 basis points over the next two quarters. That goes well beyond anything the Fed has signaled, or is likely to signal in the short-term. An "insurance cut" in interest rates is the most popular market justification for such a further dovish shift by the Fed. That is, rather than reacting to convincing evidence of a significant economic slowdown, the central bank would be building a buffer to counter the effects of trade tensions and weakness elsewhere, particularly in Europe.

(More:Mohamed El-Erian puts Democratic tax proposals in perspective)

Yet the 75-100 basis points priced in by markets goes well beyond an insurance cut, placing the Fed in a lose-lose situation: Either it fails to validate what markets expect or it ends up being forced to react to convincing evidence of a downturn. Neither would encourage market stability.

As I argued last week, the effectiveness of monetary policy is also an issue. The forces holding back growth, here and elsewhere, are not related to financial conditions (that is, the cost of borrowing and the availability of funding). Rather they reflect a series of structural and demand impediments to growth that lie outside the purview of monetary policy.

Continuing to rely on monetary policy to buy time, both for the economy and for other policymakers, is not without cost. While renewed central bank dovishness could succeed in elevating asset prices, that would only decouple them further from their underlying economic and corporate fundamentals. That hardly bodes well for the longer-term durability of investment gains or for financial stability.

Finally, the more the Fed cuts now, the smaller the ability of this policy instrument to counter future economic downturns. Policy rates are currently about half the average level of the cumulative reductions that have been required historically to counter economic weakness. The Fed balance sheet is also still large right now, while fiscally, the government is facing relatively high deficits and debt.

As regards trade, the other policy issue that attracts a lot of market attention, investors will be relieved by Friday night's agreement between Mexico and U.S. negotiators. But the deal leaves an important residual uncertainty that could dampen corporates' appetite to invest. After all, the US tariff threat against Mexico came on the heels of a recently renegotiated trade deal and it represents a clear case of weaponizing an economic tool.

These policy questions and, before them, those related to markets are amplified by two sets of numbers released last week.

The latest monthly data showed imports and exports both falling, raising questions about the health of global trade. Meanwhile, the politically sensitive trade deficit with China rose by 30% as U.S. exports to China fell 24% and imports grew by 12%. It remains to be seen whether this will aggravate already complicated and protracted China-U.S. negotiations, whose underlying drivers now extend beyond economics to national security issues.

Friday's jobs report also surprised markets. This widely watched data release disappointed on account of shortfalls in both job creation, which was widespread among economic sectors, and wage growth. Moreover, there was no pickup in labor force participation.

Having said that, the report also looks less worrisome when viewed through a multi-month prism. As such, there is genuine uncertainty whether its weakness is a one-off phenomenon or, instead, reflective of more durable challenges to the impressive labor market performance that has underpinned household consumption and encouraged companies to invest.

Inability to answer all these questions with conviction at this stage is reflective of the clouds of uncertainty hanging over markets, policies and the economy. But that doesn't mean there are no immediate implications for investment portfolios. Instead, there is enough unusual economic and financial fluidity to support the strategy of exploiting the recent rally by going up in quality while reducing overall risk exposures.

(More: Icons & Innovators 2017: Mohamed El-Erian)

To the extent that the answers bode less well for the U.S. economy, too, they are likely to imply even larger challenges for the rest of the world. As such, it may not yet be time for investors to give up the multiyear bond and equity positioning that, in relative terms, has favored U.S. securities.

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."

0
Comments

What do you think?

View comments

Upcoming event

Sep 10

Conference

Denver Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in six cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Most watched

INTV

Young advisers envision a radically different business in five years

Fintech and sustainable investing are two factors being watched closely by some of the 2019 class of InvestmentNews' 40 Under 40.

INTV

Young professionals see lots of opportunity to reinvent the advice experience

Members of the 2019 InvestmentNews class of 40 Under 40 have strategies to overcome the challenges of being young in a mature industry.

Latest news & opinion

New Jersey fiduciary rule: Pressure leads to public hearing, comment deadline extension

Industry push results in chance to air grievances on July 17 and another month to present objections.

InvestmentNews' 2019 class of 40 Under 40

Our 40 Under 40 project, now in its sixth year, highlights young talent in the financial advice industry. These individuals illustrate the tremendous potential of those coming up in the profession. These stories will surprise, entertain, educate and inspire.

Galvin to propose fiduciary rule for Massachusetts brokers

The secretary of the commonwealth is proposing a fiduciary standard in response to an SEC investment-advice rule he views as too weak.

Summer reading recommendations from financial advisers

Here are some books that will keep you informed and entertained during summer's downtime

4 strategies for Roth conversions

There's never been a better time to do a Roth conversion, and here are several ways to go about it.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print