Why the Fed will wait
WEISENTHAL: It's been an extraordinary week and there's a lot to talk about, so let's get right into it with a question that is sure to be on the minds of a lot of traders. Given the huge turnaround in risk assets in the second half of the week, is it possible the Fed will still go in September if the economic data hold up?
El-Erian: I don't think so. I think they will wait. Remember, the Fed wishes to avoid excessive financial volatility and market instability (something that I wrote about in the Bloomberg View column posted earlier today). In fact, for the last few years, its major policy bet has been to repress volatility in order to bolster asset prices as a way of encouraging household consumption and corporate investment.
I suspect that the last thing that Fed officials would wish to do is to fuel financial instability during a time of global economic weakness -- and this notwithstanding data that confirms that the U.S. continues to heal and economically out-perform others. So as much as risk assets have turned around dramatically during the second half of this week, this may not be enough to reassure the Fed just yet to hike interest rates for the first time in over nine years.
Weisenthal: Obviously today's market action is dramatically less volatile than what we were seeing in the beginning of the week. Can we say the coast is clear for now, or could the volatility and the selling resume?
El-Erian: Yes, markets have calmed down on the back of Chinese policy actions, dovish statements by Fed official Bill Dudley and some solid U.S. data. But the underlying causes of volatility are still with us. They include the challenging quest for high and sustained economic growth, overreliance on central banks and financial asset prices that are still decoupled from fundamentals. As such, there are still many economic and policy handoffs that need to materialize to establish a solid fundamental anchor for markets, and this in a political environment that is far from conducive. When you add to that the structural change in market liquidity -- one that reduces the size of the intermediation function relative to end user demand when the market operating paradigm changes -the outlook is for more bouts of volatility, some probably quite extreme.
Weisenthal: Mohamed, a customer is asking about whether the world is at risk of a global recession. Is that a possibility, if the Fed is tightening while China is slowing?
El-Erian: That risk has certainly grown. Europe and Japan remain mired in a vulnerable low-level growth situation. As today's Brazil GDP numbers show, virtually every systemically important emerging economy is slowing down. As such, the U.S. economy finds itself as the only meaningful engine of global growth.
That's the bad news. The good news is that there are policy solutions -- and they involve a lot more than just reliance on central banks -- and there is ample private-sector cash on the sideline willing to engage. The key is to evolve into a more enabling political process.
Weisenthal: This week we saw outflows out of emerging markets the likes of which we haven't seen since the week of the Lehman collapse. Are we near the bottom for EM assets, or do we have further to go?
El-Erian: The outflows were caused by the volatile losses experienced by the asset class. And, in turn, they amplify the pressures on emerging market assets, robbing it of investment capital and liquidity.
More generally, these outflows are a reflection of the difficulties that the asset class continues to face in establishing a large and secure enough base of "dedicated investors." Accordingly, with "crossover" flows often being an important marginal price setter -especially at market extremes -- this is an asset class that can (and does) overshoot both on the way up and on the way down (like now). So while considerable value has already been created in certain names and segments of the asset class, the path forward will be a bumpy one.
Weisenthal: Mohamed, another customer is curious about the idea of decoupling. In 2008, people were talking about the idea of China decoupling and growing despite a U.S. slowdown. Now it's the other way around, and people are saying the U.S. can grow even with the emerging world slowing down. So, can the U.S. grow with all this weakness around the world?
El-Erian: Great question! And it speaks to the difference between relative and absolute decoupling.