Wednesday, March 8, 2017

Prepare For Market Beliefs To Be Challenged

By Mohamed A. El-Erian
The Bloomberg View
March 8, 2017

Deeply ingrained beliefs can be hard to dislodge -- and especially in markets when they have led to high investment returns over a prolonged period. That can encourage certain behaviors to last even in the face of contradictory indicators; and it may take a very large set of inconsistent data for behaviors to change.

This tendency -- underpinned by what behavioral finance calls “belief perseverance,” “confirmation bias” and “attitude polarization" -- could be one of the reasons that financial markets have confidently brushed off what has been a growing list of developments that otherwise would have resulted in higher volatility. It includes just in the last couple of weeks:

--Sudden and large upward movements in expectations of an imminent interest rate hike by the Federal Reserve;
-- A speech by President Donald Trump that was constructive in tone but light on economic policy details;
-- Higher political risk in Europe (particularly linked to the French elections); and
-- In the developing world, the downward revision of China’s growth target, which was accompanied by a warning from Premier Li Keqiang in his speech to the opening session of the National People’s Congress about a “build-up of risks, including risks related to non-performing assets, bond defaults, shadow banking and internet finance.”

The particular beliefs I am thinking of relate to the trifecta of economics, finance and politics, and they have been extremely profitable for investors and traders. Specifically:

-- While low and insufficiently inclusive, global growth will remain relatively stable and predictable; and, to the extent there is a balance of risk, it is now clearly to the upside;
-- Central banks are still able and willing to repress financial volatility; and
-- Though noisy and unusual, politics will not adversely contaminate economics and finance; and, if there is an impact, it will provide an upside to markets now that the Republican Party has the White House and a majority in both houses of Congress.

While all three are fluid -- and, I would argue, quite uncertain and less predictable -- developments so far haven’t been enough to reach a critical mass, either on a standalone basis or in combination. As a result, most measures of market volatility remain very low and extremely well-behaved.

As to the next few weeks, this market calm would be upset unfavorably by signs such as:

-- Policy steps that markets fear, such as protectionism in the U.S., or the European Central Bank and Bank of Japan joining the Fed in adopting a strategically less dovish policy stance;
-- Lower probability of pro-growth legislation due to stress in the working relationship between Trump and the Republican establishment controlling Congress; and
-- Big wins by the anti-establishment parties in two European elections (the Netherlands and France).

Adding to the outlook’s fluidity, the risks are not just in one direction. Thus, markets would respond well to progress in detailing and implementing the Trump’s administration pro-growth measures relating to tax reform, deregulation and infrastructure, as well as dovish central bank statements out of Europe and Japan.

Then there are the longer-term issues that I discussed in prior articles and that also carry the risk of higher market volatility. Endogenously, the low-volatility market regime faces a potential headwind because of currency appreciation that is too strong and would slow growth, pressure corporate earnings and fuel protectionist rhetoric. Exogenously, markets may find it increasingly harder to be shielded from the cumulative adverse effect on the economy/politics/institutions of growth that has been too low and insufficiently inclusive.

Over the next few months, the markets’ faith in its three beliefs -- stable economics, low financial volatility, and politics that does not adversely affect either of these -- is likely to be more seriously challenged by the possible further accumulation of contrary data points, thus increasing the potential for a tipping point. And if it takes a long time for this to happen, the greater the likelihood that these cyclical contradictions could be accompanied by larger secular and structural ones.

Yet the consequences don’t necessarily have to be dire for markets.

Yes, one cannot ignore the potential for downside risk in which low growth gives way to periodic recessions, artificial financial stability yields to unsettling volatility, and the politics get so messy they result in disruptive economics. Depending on the timely response of politicians, however, there is also an upside in which growth is higher and more inclusive, financial stability is genuinely anchored, and politics improve and enable better economic governance.

With such a bimodal distribution of outcomes ahead, it’s good that we are learning more about which indicators to watch and why.


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