Sunday, October 26, 2014

Global Markets' Time Factor

BARCELONA – In recent months, the dichotomy between booming financial markets, on the one hand, and sluggish economies and dysfunctional politics, on the other, has loomed large. Yet insufficient attention is being devoted to a critical factor – time, and who controls it – that could well mean the difference between an orderly global resolution of today’s growing inconsistencies and a return to a more troubled phase.

Markets have been understandably buoyant in the first quarter of 2013. Most economic data confirm that, after the trauma caused by the global financial crisis, the United States’ economy is healing, and doing so in an accelerated fashion.

The sequence is now well established. It started with large multinational companies, which are on as solid a financial footing as I can remember. Smaller firms are gradually recuperating; banks have rebuilt their capital cushions and reduced their dubious assets; the housing sector has stabilized; and a growing number of households are reestablishing healthier balance sheets, especially as employment gradually picks up.

This private-sector recovery is helping government finances. The US budget deficit has been on a downward trend for now, helped by both higher revenues and lower pressure on spending (for example, payments to the unemployed have fallen as joblessness has declined).

The healing process is also evident in Europe, though, unfortunately, it is effectively limited only to sovereign-bond markets. The real economy remains under enormous pressure in several countries, as economies contract and unemployment remains alarmingly high.

After flirting with disaster last July, interest-rate spreads for eurozone bonds have generally been subdued, and financial segmentation has been slowly reversed (that is, at least before European officials embarked on the controversial path of trying to impose losses on guaranteed bank deposits in Cyprus). Moreover, as Ireland’s highly successful €5 billion ten-year bond issue in mid-March demonstrated, some countries are in the process of restoring normal access to capital markets.

The impact on markets of these trends has been turbocharged by central banks, which are risk markets’ best friends. This is not because they wish to play that role; rather, it is because higher asset prices are essential if central bankers stand any chance of delivering the desired economic outcomes of higher growth and stronger job creation.

This is most evident in the US, where markets love the Federal Reserve’s trifecta of near-zero policy interest rates (negative in real terms), aggressive forward policy guidance, and asset purchases – all of which push investors to take more risk. Markets also welcome the fact that the Fed’s hyperactive experimentation is forcing other central banks around the world to pursue more expansionary policies.

Indeed, from the Bank of Japan’s dramatic policy U-turn to the Bank of Mexico’s surprise interest-rate cuts, the Fed’s approach is affecting central banks in a growing number of countries. Pushed further away from best-case scenarios, they are unable to ignore the global liquidity impact of the Fed’s policies, yet they lack the right policy tools to address it.

The mix of endogenous healing and strong central-bank tailwinds, including from a “whatever it takes” European Central Bank, has also helped markets shrug off troubling political uncertainties. Be it the US Congress’s paralyzing polarization or Italy’s protest vote against the established political order, politicians are being given time to overcome their dysfunction, thereby minimizing any immediate disruptive impact.

Understandably, investors have interpreted all of this as a green light to take more risk. And with the hype this month over eight successive records for the Dow Jones index (and many other records around the world), excitement induces more investors to enter riskier asset markets.

The excitement is not anxiety-free, however, and rightly so. Investors worry about the longer-term consequences of political dysfunction, another year of European economic contraction, disastrously high unemployment, unprecedented – and thus untested – central bank policies, and increasing global tensions. And the recent bungling of the Cyprus rescue does not help. No wonder some have called the recent market rally “one of the most unloved” in history.

This mix of excitement and anxiety is, in fact, a sign of the looming crossroads that faces investors. One road, involving a relatively orderly handoff from policy-assisted recovery to self-sustaining growth, offers the possibility of even greater financial rewards, as rapidly improving economic and political conditions validate current artificial pricing and drive it higher.

The other road is a lot less attractive. With insufficient endogenous healing and no economic escape velocity, the effectiveness of central banks’ policies wanes and political dysfunction increases, leading to financial losses, volatility spikes, and huge risk-management challenges.

Given current policy and political uncertainties – and the multiple equilibria that they entail – it is difficult to predict with a high degree of confidence which road eventually will be taken and when. Those who claim otherwise may well fail to appreciate fully the exceptional nature of the current situation.

In these circumstances, timing may not be everything, but it may prove to be a key determinant of the probabilities. If the journey to the crossroads is accelerated by a large geopolitical shock (originating in, say, the Middle East or North Korea) and/or a serious political breakdown in Europe (for example, a meltdown in Cyprus or prolonged political paralysis in Italy), the probability of taking the adverse path rises to an uncomfortably high level. If, however, central banks can contain domestic and global inconsistencies long enough, the combination of endogenous healing and eventual political progress would significantly improve the probability distribution.

Have no doubt: today’s markets rely heavily on the old adage that “time heals all wounds.” The timekeepers are central banks. But their control of the clock is less than perfect; and it will become increasingly ineffective if economic improvement faces additional political headwinds in the months ahead.

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  1. CommentedParrain Boursorama

    The best model for expanding Alternative Energies and Environmental Protection globally is through using market equilibrium, whereas governmental subsidies and fiscal stimulus to be just supplementary

  2. CommentedParrain Boursorama

    The best model for expanding Alternative Energies and Environmental Protection globally is through using market equilibrium, whereas governmental subsidies and fiscal stimulus to be just supplementary

  3. CommentedMarc Herman

    I have noticed that Mohamed El-Erian has started talking about "healing" which is an odd economical concept that at the end he links to the economically equally absurd axiom of “time heals all wounds”. I am ready to accept this from my grand-mother, not from an econmist of his standing. In trying to understand what he's saying (apart from the fact that ultimately he too can only hope for the best) I find that he is substituing a traditional concept of "growth" with a new one of "health" and as such recalibrates a conceptual framework in which "expansion" is surplanted by "stagnation", even more so in pointing to the role of "time". To say that at best a stagnating economy is the best of two possible scenarios, seems to me an impossible thing to advocate in the US while a European mentality may be more disposed to consider that (though equally maybe not ready to accept it). I don't think that with his novel "healing cure" El-Erian is pushing an idea that things are going to revert to pre-2008 times which, I suspect, many are wishing by lack of any better alternative.

  4. CommentedBurak M

    As always mr El-Erian, your deep analysis which doesn't have the artificial optimism many possess is always appreciated.

  5. CommentedFrank O'Callaghan

    The implication of El-Erian's analysis is that a world wide tax has to be levied on the rich to protect the system from collapse.

  6. CommentedMark Pitts

    @Mr. O'Callaghan - The vast majority of the world's wealth is owned by the middle class. And if you look at the world as a whole, economic well-being becomes more equally distributed every year.

      CommentedFrank O'Callaghan

      @Mr Pitts - The economic inequality in the World has widened. The tiny minority of super-rich have taken most of the wealth generated by the growth since the 1970s.

  7. CommentedRay DAMANI

    ...: today’s markets rely heavily on the old adage that “time heals all wounds.”

    Perhaps. But what is more appropriate and needed today, as John Lennon said, is for time in some way to wound all HEELS (i.e. bankers, bureaucrats, and politicians) who created the problems that have wounded the lives of millions of people and are incapable of fixing them because they are all focused only on themselves and their personal needs and greeds!

  8. CommentedProcyon Mukherjee

    It has always been a matter timing and so it will be in the future; if one goes by P/E multiples or by valuation and if we choose the start date from the peak of 1999, the current values for S&P 500 would look rather pale in comparison.

    On the comment of the large multinational companies being on a solid footing, it must be the technology companies and banks that have been referred to as most of the commodity based companies or those in the core sector like Steel and Aluminum are way below their better days. I am not quite sure whether the current euphoria may last beyond a couple of months when forward projections start to dwindle.

    The rise of M2 and the component which has gone into fixed assets seem to be moving to two divergent trajectories, which can only happen when bulk of the M2 rise stays liquid, which can hardly be the cause for economic rebound.

  9. CommentedRonald Abate

    No mention in the article about demographics, which in the U.S., Europe and Japan, are only going to create huge additional burdens on the public that no CB will be able to reverse. Then there is the breakdown of public education, at least in America that I know of and in many European countries as well -- how about the fast growing and undereducated Muslim populations -- how are these future generations going to secure well paying jobs in an increasingly technological economy? The breakdown of the family in all the developed, welfare states is destroying the most important institution for the raising of the next generation. How will the Central Banks fix this problem? Print more money. Then we have the teeming Islamic world awash in a tsunami of young, uneducated and unemployable men and women. How is this mass of humanity going to find productive employment, other than as suicide bombers, when their economies, wracked with sectarian violence, make unsuitable places for the investment that brings the possibility of jobs. Keep printing Central Banks.

  10. CommentedFrank O'Callaghan

    The financial markets are booming BECAUSE of the global crisis. It is a reflection of the move of wealth and power to the tiny minority of wealthy parasites from the great majotity of the people of the world. It is more than a reflection. It IS the problem.

  11. CommentedShane Beck

    Corporate balance sheets be damned, unless there is jobs growth, especially in the PIGS countries, the sluggish economic recovery of 2013 isn't worth the paper it is written on (or written about). The clock is ticking not for the markets and Central Banks but for the extremely high youth unemployment in these countries which might end up as a lost decade for a lost generation.