By Mohamed A. El-Erian
Week in and week out, three hypotheses invigorate and sustain the stock market rally. The three are valid. Yet their longer-term implications may be far more complex than most investors fully appreciate.Equity markets believe in the "Fed put," or the view that the Federal Reserve will increase its monetary policy stimulus in response to any (and all) meaningful decline in risk assets.
This dynamic is reinforced by the revealed preference of the Fed. It is also consistent with the institution’s policy objective – that of enhancing economic growth and job creation by pushing up financial asset prices and thus reviving animal spirits and triggering wealth effects.
Second, market participants also have reason to believe that the steadfast focus of the Fed forces other central banks around the world into more accommodating monetary policy.
The ongoing U-turn by the Bank of Japan, a central bank that long held the view that the collateral damage of prolonged unconventional monetary policy exceeds the benefits, is just the latest example of a "Don’t Fight the Fed" mantra that applies both within and outside America’s borders.
Then there is the "kick the can" hypothesis, or the view that even unusually dysfunctional political systems, be they European or in America, repeatedly find ways to avoid outcomes that would be really disruptive to markets.
Consider this week’s last minute drama on the Congressional fiscal sequester. The likely outcome – a deadline lapse that, rather than trigger a technical default or deep spending cuts, would be followed a few weeks later by a clumsy compromise on a continuing budgetary resolution (another Band-Aid government funding vehicle) – would certainly not be pretty, but it would be effective in avoiding a big shock to risk assets.
Now, each of these hypotheses is understandable and valid. Yet, for two inter-related reasons, their sustainability is subject to complexities that many may well underestimate: increasingly unstable internal dynamics, and a handoff process that is far from assured.
Let us consider each in turn.
The longer the Fed maintains its unusual policy activism, the higher the costs and risks. This reality was vividly illustrated in the minutes of the last Fed policy meetings released last week, with several officials referring to the rising probability of both direct and indirect damage.
As I argued last week, this does not mean that the Fed will abandon any time soon its current policy stance. It won’t. But it does mean that the overall impact on the economy – and, consequentially, companies’ top line revenue growth and their ability to contain non-wage costs – is indeed uncertain.
Uncertainty increases when other monetary institutions are forced into the same policy approach – and not by choice but by perceived necessity.
The scope for truly independent monetary policy is much reduced when the central bank in America, the supplier of global public goods (including the world’s reserve currency), goes unconventional; and especially when other countries have limited appetite for currency appreciation.
Politics adds to sustainability concerns. Citizens are increasingly frustrated with the behavior of bickering and dithering politicians. The result is a growing wave of popular dissatisfaction that undermines the traditional political system, but without offering a durable alternative. This is apparent in a growing number of European countries, including last week’s shock government resignation in Bulgaria.
All this makes the handoff question both urgent and important.
For the rally in equity markets to continue, the current phase of "assisted growth," as anemic as the outcome is, needs to give way to genuine growth. And the latter depends on the engagement of healthy balance sheets around the world.
Continued robust risk asset markets require that strongly-capitalized companies, and there are many, use their ample cash holdings to invest in new plant, equipment and hiring; that wealthy households in Western economies reduce their self-insurance; and that the growing middle classes in emerging economies, and Asia in particular, increase their marginal propensity to consume.
Investors are right to focus their short-term strategies on the three big macro factors; they have been important, and they will remain in play for a while. But this should also be combined with a proper longer-term perspective.
For the three factors to continue to pay off in a big way over the longer-run, they would need to act as transitions to more sustainable growth, economic wellbeing and corporate profitability, and this would need to occur in a timely fashion. Otherwise, internal inconsistencies, rather than favorable macro effects, would eventually become investment themes for markets – an outcome for which some investors seem ill-prepared at this stage.
Dr. El-Erian is CEO and co-CIO of PIMCO and is based in the Newport Beach office. He re-joined PIMCO at the end of 2007 after serving for two years as president and CEO of Harvard Management Company, the entity that manages Harvard’s endowment and related accounts. Dr. El-Erian also served as a member of the faculty of Harvard Business School.
- Investment & Company Information