How to think about the mar­ket sell-off

MO­HAMED A EL-ERIAN

Financial Chronicle - - EDIT, OPED, THE WORKS -

THE 3-4 per cent plunge in the ma­jor Amer­i­can in­dexes on Wed­nes­day is un­set­tling for in­vestors who have grown ac­cus­tomed to low US mar­ket volatil­ity in re­cent years. What’s more dis­turb­ing is that most of the tra­di­tional hedges against such a large eq­uity sell-off, both within and across mar­ket seg­ments, did not work well.

Yet nei­ther of these de­vel­op­ments should come as a great sur­prise given the fol­low­ing five fac­tors that also point to what’s ahead:

Af­ter years of seem­ingly un­ques­tioned cen­tral bank sup­port – in­clud­ing the so-called “Fed Put” – stock and bond mar­kets are tran­si­tion­ing away from a world where liq­uid­ity in­jec­tions un­der­pin as­set prices and mov­ing to­ward a greater role for fun­da­men­tals. Al­most by def­i­ni­tion, this is a volatile process: Think of a plane chang­ing en­gines while fly­ing at a high al­ti­tude. Tur­bu­lence is to be ex­pected.

Un­usual di­ver­gence in eco­nomic per­for­mance and poli­cies within the adva-nced world is com­pli­cat­ing this liq­uid­ity-to-fun­da­men­tals mar­ket tran­si­tion. The US growth is in­creas­ingly out­pac­ing other coun­tries’, pow­ered by the com­bi­na­tion of higher house­hold in­come, in­creas­ing busi­ness in­vest­ment and gov­ern­ment spend­ing. In ad­di­tion, the Fed­eral Re­serve is well ahead in nor­mal­is­ing mon­e­tary pol­icy, af­ter end­ing quan­ti­ta­tive eas­ing, hik­ing in­ter­est rates eight times, pub­lish­ing the timetable for re­duc­ing its balance sheet, and sig­nal­ing fur­ther rate in­creases for both this year and next.

The re­sult­ing dis­per­sion in as­set prices has placed some ex­tra strains on mar­kets. And it’s not strictly a mat­ter of di­ver­gence. There are also a wide range of views on whether other coun­tries will even­tu­ally con­verge with the US in achiev­ing higher growth or whether the US will be pulled down.

Trade ten­sions are adding to the un­cer­tain­ties about the mar­ket tran­si­tion. Specif­i­cally, it’s not yet clear how long it will take China to re­alise that the least bad al­ter­na­tive for its de­vel­op­ment is to pur­sue the same path that other coun­tries (South Korea, Mex­ico and Canada) ul­ti­mately follo-wed — that is, make con­ces­sions to the US. It also isn’t clear what con­ces­sions would sat­isfy the Trump ad­min­is­tra­tion.

Fi­nally, tech­ni­cal con­di­tions in mar­kets are not help­ing by am­pli­fy­ing large moves in the short term rather than tem­per­ing them.

Over the longer term, suc­cess in the ongoing tran­si­tion in the liq­uid­ity-fun­da­men­tals paradigm will place mar­kets on a more solid foot­ing. So will repric­ing that al­lows tra­di­tional stock­bond di­ver­si­fi­ca­tion to pro­vide bet­ter risk mit­i­ga­tion. The short term, how­ever, is likely to be quite volatile.

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