Ugly Markets Might Contaminate the U.S. Economy

(Bloomberg Opinion) -- The U.S. economy, if left to its own devices, probably wouldn't even come close to falling into recession in 2019-2020, even amid the uncertain outlooks for Europe, Japan, China and the large oil producers. But the economy is not being left to its own devices.

In recent weeks, it has become more vulnerable to the possibility of policy mistakes and market accidents. These self-inflicted wounds, while yet to constitute a critical mass, have become more of a threat to economic and corporate fundamentals, rendering both more susceptible to the slowing global economy.

The U.S. economy has a lot going for it. Consider its three biggest drivers of growth:

• Consumer spending is underpinned by a robust labor market which, according to the last monthly jobs report, continues to create jobs well above what’s needed to absorb new entrants. Unemployment is at a historically low 3.7 percent, which is helping to deliver annual wage growth of more than 3 percent. Meanwhile, with a relatively low labor force participation rate and with job vacancies exceeding the number of unemployed, discouraged workers may be drawn back into the job market.

• Business investment is also in a good place. With deregulation and favorable tax treatment, more companies have been looking into how to deploy their considerable cash holdings into new investments, rather than for stock buybacks and higher dividends. This shift is happening at a time when many corporations are keen to improve productivity through the application of recent advances in artificial intelligence, machine learning, big data and other technological innovations.

• These private-sector growth prospects are turbocharged by higher government spending. 

Thus, the U.S. economy is in a good position to sustain a 2.5-3 percent growth rate in 2019, while also resisting the headwinds created by the following:

• Europe, where the implementation of pro-growth policies and a stronger regional economic architecture are hampered both by domestic political uncertainties in the five-largest economies and a pending regional parliamentary election; 

• China, where the government is tending to revert to policies that have lost potency,  risking greater distortions to the economy and the financial system;

• Japan, where the implementation of the so-called third arrow of the government’s pro-growth initiative continues to struggle in overcoming deep social and institutional inertia; and

• Oil producers, which are dealing with a sharp decline in crude prices that will quickly translate into lower export earnings and spending, including on imports.

The problem for the U.S. economy goes beyond just the challenges facing other major economies.

The  shutdown of the federal government amplifies uncertainties associated with what many market participants complain have become at times rather muddled and confusing signals from the nation’s two most important economic policy making agencies. Specifically: 

• Based on its recent communications, the Federal Reserve may be too focused on narrow, domestic economic issues and may underappreciate the need for greater responsiveness using a wider set of tools;

• The Treasury Department's effort to bolster confidence by calling banks over the weekend and issuing a follow-up statement about ample liquidity in the banking system, which ended up unsettling markets. 

The impact of these two factors would be less worrisome if it weren’t for the fact that markets already confront unstable technical conditions and  a growing inclination by some market participants to talk themselves into recession-like behavior.

This should all be seen in the context of the prolonged period of ample and predictable liquidity injections by central banks, which gave rise to market features that have now become a source of volatility and vulnerability.  These include asset prices that were decoupled substantially from less-buoyant fundamentals; the rapid rise of passive investing; excessive risk taking; and the over-promise of liquidity, including through exchange-traded funds, in market segments prone to bouts of illiquidity. With that, the past inclination of investors to buy on market dips -- a pattern that contributed to last year’s impressive market gains with virtually no volatility -- has given rise to consistent selling on rallies when these occasionally arise.

The risk of a downward overshoot for markets cannot be dismissed absent external circuit breakers and/or the internal self-exhaustion of poor fundamentals, neither of which seems imminent. This increases the risk of bad market technicals contaminating the economy through the combination of a negative wealth effect and diminished household and business sentiment.

As of now, these mounting threats to U.S. economic growth are still risk factors in a relatively positive baseline scenario. Keeping it this way will require policy mindsets that are more agile, more global and more understanding of the underlying and changing psychology of markets.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

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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