Central Banks Signal That It's Time to Be Selective
(Bloomberg Opinion) -- In his testimony to Congress on Tuesday and Wednesday, Chairman Jerome Powell confirmed that the Federal Reserve has undertaken a dramatic policy pivot, opening the door even wider for other central banks to also adopt more dovish stances.
The shift increases the risk that many on Wall Street could slip back into the comforting belief that renewed central bank support is sufficient to ensure another round of meaningful stock market rallies around the world. Already, the MSCI World Index has rebounded about 16 percent since its Dec. 24 low, and for understandable reasons. Going into last year, extraordinary liquidity injections and ultra-low interest rates had pushed up stocks dramatically. But investors shouldn’t view the recent monetary policy pivot as a green light for piling on risk assets as a whole. Instead, they should focus on three important qualifiers that favor domestically oriented U.S. securities, both stocks and bonds, and seeking greater credit quality and liquidity.
Fed officials cited international economic weakness and spillovers from disrupted financial markets as reasons for their decision to end both their repeated signaling of additional interest rate hikes and their auto-pilot approach to balance-sheet reduction, according to the minutes of the January Federal Open Market Committee meeting. Powell repeated the new patience-flexibility mantra in his congressional testimony. A growing number of other central banks in both advanced and developing countries have taken the same line, sharing similar global growth worries and/or wishing to avoid an appreciation in their currencies.
Importantly for investors, this central bank policy reversal concerns the two other systemically important institutions whose policies also have had a disproportionate impact on market valuations and volatility (though to a lesser extent than the Fed): the European Central Bank, which has started indicating that it will delay the already signaled first hike of its currently negative policy rates and that it may restart loans to banks under targeted long-term refinancing operations; and the Bank of Japan, whose governor, Haruhiko Kuroda, has said he is more open to expanding stimulus measures.
These developments have understandably reignited risk appetites, boosted markets and given investors hope for a renewed round of the exceptional 2017 mix of high returns, low volatility and unusual correlations that lifted every asset class. No wonder an increasing number of market strategists are now inclined to recommend an across-the-board increase in risk taking, both domestic and global.
Yet that reaction may be premature for three reasons:
- A more challenging global growth outlook: We are a long way away from the world of late 2017/early 2018 when almost all economies – and certainly the systemically important ones such as Brazil, China, the European Union, Japan, Russia and the U.S. – simultaneously experienced a pickup in growth. And while the strength of the U.S. leads me to reject the hypothesis of a notable 2019 synchronized global slowdown, I worry about major setbacks to both European and Chinese economic activity that would impact risk assets there, as well as American companies with considerable revenue and profit exposures.
- Central bank transitions: Divergent growth means the Fed will repeatedly be confronted with domestic data suggesting that its dovish swing in January was too pronounced. If, as I suspect, the U.S. economy continues to generate sizable job opportunities and if wage growth accelerates, the Fed’s strict adherence to its domestically focused dual mandate would warrant a less accommodating policy stance than what’s currently priced in markets. But the external environment will act as a counter, presenting a communication challenge for Fed officials. The ECB faces an even tougher policy outlook with a slowing economy, concern about its policy transmission mechanism and political transitions that essentially preclude any meaningful pro-growth government measures in the region’s five major economies (France, Germany, Italy, Spain and the U.K.). And let’s not forget that the European bank will soon replace its leader, President Mario Draghi, whose term ends in October.
- Less supportive market technicals: It is far from guaranteed that markets will be supported to the same extent as in recent years by corporate buybacks while corporate cash generation slows and the transactions themselves attract more political scrutiny. In addition, the strong conviction of investors in 2017 that all market selloffs are buying opportunities is unlikely to be repeated. Then there is the high possibility that divergent growth among the advanced countries will carry its own set of market risks given the pressure on exchange rates and traditional market relationships (such as the spread between yields on bonds and the bifurcation between ample liquidity for some assets and the risk of bouts of illiquidity for the structurally weaker ones).
The bottom line for investors is quite simple: Although central banks are again adding to the punch bowl rather than taking it away as they were threatening to do in 2018, this is not a green light for the sort of generalized risk taking that greatly rewarded investors in 2017. Rather, it’s a call for a selective approach that favors the stocks of domestically oriented companies, U.S. stocks and bonds relative to European ones, and a general increase of credit quality and liquidity.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”
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