miƩrcoles, 16 de julio de 2014

miƩrcoles, julio 16, 2014

Markets Insight

July 14, 2014 6:24 am

Investors beware: economists at large




In a perfect world, investors would turn to economists for predictions on two key issues supporting equity prices at current valuations: productivity trends and the effectiveness of macroprudential policies. In the real world, however, I suspect many investors have yet to grasp the extent to which these arcane topics will influence the next stage of the market cycle; and those that do may get insufficient guidance from economists.

Let’s start with some context.


While counterfactuals are tricky, most market analysts would agree on two related market hypotheses: first, that unusually sluggish economic growth has not harmed stock market performance as much as would have been expected from traditional models; second, that hyperactive central banks have boosted asset prices using experimental measures, not as an end in itself but as a means of stimulating higher economic activity through the “asset channel”. The result has been a notable gap between a buoyant Wall Street and a struggling Main Street.

Fortunately, as illustrated by the recent set of US employment reports and the modest pickup in growth in Europe, economies heal over time. While such healing continues to fall short of the economic lift-off everyone seeks, it poses a growing policy dilemma for central banks, in particular for the Federal Reserve, given America’s economic outperformance relative to Europe and Japan.


Fed’s beliefs


Up to now, Fed officials have been comfortable keeping their foot on the accelerator while engineering a skilful transition from balance sheet purchases (known as “quantitative easing”, which they are likely to exit completely in October, according to last week’s release of the FOMC Minutes) to aggressive policy guidance on low interest rates. They have maintained a gradualist policy approach while recognising that certain assets are approaching bubble territory. Indeed, Fed chairwoman Janet Yellen recently noted that the risk-taking induced by unusually low interest ratescan go too far, thereby contributing to fragility in the financial system”.

There are two major reasons why most Fed officials are in no rush to take the punch bowl away, and they are critical to supporting current market valuations.

First, they feel that, notwithstanding the decline in the unemployment rate to 6.1 per cent, there is still slack in the labour markets. As such, they are not worried about inflationary wage growth. Second, they believe financial market excesses can be effectively countered by the recent revamp of macroprudential policies, both nationally and internationally.

Both hypotheses are just thathypotheses. And they are subject to notable risks given that the Fed, and everyone else for that matter, is in uncharted policy waters.

Should the recent disappointing productivity performance continue, the Fed may find wage pressures increasing at a faster rate than it finds comfortable. Also, strengthened macroprudential measures may have failed to keep pace with investors who believe the collapse in market volatility occasioned by economic and policy conditions is a green light for leveraging every risk factorbe it credit, default, duration, equity or liquidity.


Prediction failure


Judging by past experience, economists are not well placed to make confident predictions about the risk of greater economic and financial instability. Productivity trends are hard to measure accurately, let alone predict. The record on assessing financial instability is even worse. It is not just that most economists misjudged the run-up to the 2008 financial crisis; even Fed officials, who arguably are a lot closer to markets, were shocked by last year’s severe taper tantrum”. And if all these people cannot get their arms around the underlying fragility of the financial system, it is difficult to be confident about the effectiveness of macroprudential measures.

All of which is to say that the analytical underpinnings of the current phase of risk taking in financial markets are far from robust. Yes, the Fed’s policy approach could succeed in the next few quarters in engineering a handover from financial excesses to economic lift-off, thereby validating high market valuations and pushing them even higher, especially if the world has indeed transitioned to a paradigm of significantly and permanently lower levels of nominal and inflation-adjusted growth.

But the timing is inherently uncertain. And the probabilities of doing so may not overwhelmingly dominate those of a less pleasant scenario that of stagflation and greater financial instability. This configuration of more balanced risk is not yet reflected in asset prices and the levels of implied and realised volatility.


Mohamed El-Erian is chief economic adviser to Allianz, chair of President Obama’s Global Development Council and author of “When Markets Collide”


Copyright The Financial Times Limited 2014.

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