El-Erian - The Upside and Downside of Liquidity-Driven Markets

by Mohamed A. El-Erian
21 July 2017
Bloomberg View

Over the past few months, government bond yields have fallen, the dollar has weakened and financials have underperformed, yet the major stock indexes are at or very near record highs, as persistently supportive liquidity conditions have more than compensated for policy and growth disappointments. By boosting returns and repressing volatility, ample liquidity is a gift for investors. It makes the investment journey pleasing, comfortable and lengthy. But it is not a destination.

With the exception of buoyant stock market indexes, it is hard to find many financial markets that have managed to retain their post-U.S. election mood. Specifically:

•  After climbing to 2.60 percent, the yield on 10-year Treasuries has fallen to below 2.30 percent.
  
• The yield differential between U.S. Treasuries and German Bunds has narrowed from more than 220 basis points to just 170 basis points.
  
• The widely followed DXY dollar index, which reached a high of 103 on Dec. 28, has depreciated sharply to 94, a level not seen since August of last year.
  
• The Mexican peso has appreciated to its strongest level in a year, after falling sharply on fears of U.S. protectionism.
  

Much of this reflects the process of markets repricing to lower expectations for U.S. growth and for Federal Reserve policy tightening compared to the rest of the world, and especially relative to Europe and the European Central Bank. The main reason for this is reduced hopes for a rapid economic policy breakthrough powered by the implementation of tax reform and infrastructure programs.

Despite Republican majorities in both chambers, Congress has struggled to come together on major legislation, most visibly health care (an issue that dominated the party’s narrative during the campaign). This has delayed pro-growth economic bills, while making their prospects more uncertain. With Fed monetary measures already stretched, there has been little policy offset to a soft patch in indicators of household and corporate economic activity.

Yet none of this seems to have been reflected in the major stock indexes. All three -- the Dow Jones, Nasdaq and S&P -- registered more record highs this week. In the process, the leadership of the market has returned to tech and other disruptors, after a brief but intense post-election romance with financials and industrials deemed to be the largest beneficiary of Trumponomics.

The markets’ overall sense of "goldilocks" -- not too hot, not too cold -- explains much of the gap between buoyant stock indexes and lagging economic and policy fundamentals.

Growth may be low, but the markets perceive it as relatively stable. The Trump administration has not followed through on protectionist measures that would threaten a global trade war. Concerns about disruptive European politics, to the extent they even registered in stock markets, have been alleviated by President Emmanuel Macron’s victory in France.  

Interest rates continue to be low throughout the advanced world, with markets also marking down their expectations of Fed tightening in the last few weeks. Two systemically important central banks, the ECB and the Bank of Japan, continue to provide a lot of liquidity, and on a predictable monthly schedule; and, as signaled on Thursday by ECB President Mario Draghi, they seem in no rush to taper, despite the improvement in economic conditions. Moreover, with corporate balance sheets flush with cash, valuations are also influenced by understandable expectations of more dividends, stock buybacks, and mergers and acquisitions.

Liquidity, especially when ample and predictable, can fuel markets and condition investor behavior in a supportive manner for quite a while. But when judged against the objective of durable long-term gains, it is best seen as part of the investment journey. The destination, however, doesn't depend on liquidity alone. Economic and corporate fundamentals play a much larger role.

So far, equity investors have experienced an unusually long and fulfilling journey -- one that, absent a major accident, could last a little longer. What remains more elusive, however, is confidence that this will end up at an enjoyable destination.

But the most reassuring factor for traders and investors remains very loose financial conditions.