El-Erian: Market Inconsistencies Can be Explained — And Acted On
One of the challenges investors face today is how to reconcile seemingly conflicting messages coming from different markets. Is Dow 13,000 consistent with a 10 year U.S. Treasury at 2% and gold at almost $1,800? Is $125 Brent oil consistent with cyclically low implied volatility in many market segments, as well as widening CDS spreads for Middle Eastern oil producers?
These are but some examples of what some market participants regard as inconsistencies (and what some policymakers feel is "typical" market irrationality). Yet they are rooted in four factors that investors need to understand well in order to navigate what is a remarkably fluid outlook for markets and, to use Federal Reserve Chairman Ben Bernanke's phrase, "an unusually uncertain" global economy:
Multi-speed world: While emerging countries are slowing and Europe is slipping into recession, the U.S. economy continues to heal. You see this in the recent numbers for the labor market, housing, confidence and other indicators. The net result is a rather complex and perplexing picture for the world economy as a whole. Importantly, some believe that the improvement is sustainable and, accordingly, the U.S. can regain its role as a locomotive for the globe; others feel that it is just a matter of time before external headwinds once again interfere with the country's growth momentum, similar to what happened in the last two years (and especially as the U.S. is yet to sufficiently address impediments that stand in the way of large and durable improvements in employment, housing and income distribution).
Impact of policies: Unusual policy activism on the part of central banks - including floored interest rates and balance sheets that have ballooned to a previously unthinkable 20% of GDP for the Federal Reserve and 30% for the European Central Bank — has inserted multiple wedges between valuations and the underlying fundamentals. It has also altered liquidity conditions and affected the functioning of certain markets. Moreover, as the real economy is unable to properly absorb all the liquidity injections, the spillover effects are consequential.
Difficulties in pricing geopolitical risk and bimodal distributions: Markets understandably find it very difficult to properly assign a risk premium to complex developments in Iran and Syria- two countries that, given regional network effects, could emit a series of cross-border waves and, in the process, could greatly weigh on the oil market and, therefore, production costs, consumption trends and global economic activity. They also find it hard to price what is now a bimodal outlook for Europe. The result is a differentiated approach among market segments, with those closest to the phenomenons reacting differently from others.
Short-termism: As many investors remain on the sideline, and as the obsession for daily and weekly performance continues to dominate, short-termism is a major driver of market action. Momentum overrides fundamentals as investors "stay in the trade" until they see overwhelming evidence that the "trend has turned." This takes market differences to extremes.
All this is real and will be with us for some time, though the net impact will vary as the relative weight of the four individual influences fluctuates. Some investors will opt for tactical positioning that is subject to rapid changes. Others will prefer to focus strategically on the long-term.
Those investors who combine a deep understanding of the destination with an agile handling of the journey stand to benefit most.
Dr. Mohamed El-Erian is CEO and co-CIO of PIMCO, the bond investment house and the author of, "When Markets Collide: Investment Strategies for the Age of Global Economic Change."