What Last Week Told Us About the Market

(Bloomberg Opinion) -- Three events featured prominently in the financial news last week. Each was significant in its own right, but together they point to the risk in coming months that volatility and investor discomfort could follow what has been a comforting first quarter of across-the-board high returns, relatively low volatility and favorable correlations.

Messy Bexit Saga: Parliament was again unable to reach consensus on the way forward for the U.K.'s relationship with the European Union. It rejected for the third time a proposal tabled by the government of Prime Minster Theresa May, and also blocked eight other alternatives offered by lawmakers. The inability of Parliament to come up with a solution was another demonstration of deep divisions within the Conservative and Labour Parties and highlighted the broader splits within the U.K. on this issue.

What happens next is far from clear, especially as the deadline set by the European Union expires in less than two weeks. The elections for the European Parliament in May add to the complexity. A prolongation of the saga is certainly a possibility, as neither the current U.K. government nor EU officials wish to go down in history as having been the decisive force in a disorderly breakup. The developments last week have also increased the probability of three “tail events": a disorderly exit, a second referendum or an early U.K. general election.

One of the consistent messages from this crisis is that economic growth will again be the victim of a political process that is better at identifying what it doesn't want than at pursuing what it does. This is particularly true for the U.K., which is likely to experience continued uncertainty, postponed investment and slow growth.

The U.K.'s handling of Brexit also is relevant for European growth, albeit to a considerably lower extent. It amplifies the lack of decisive leadership that has rendered pro-growth policies elusive when annual GDP expansion could easily be half last year's level. If growth is at or below 1 percent for 2019, the risk of “stall speed” problems would be significant for certain sectors and countries. That would position Europe as a bigger threat to global growth and financial stability, for emerging economies in particular.

Fed Complications: After solidifying its dramatic dovish U-turn on March 20, the Federal Reserve had hoped to stay out of the spotlight for a while. Instead, it finds itself in a mounting public tug of war.

Several Fed officials cautioned last week that a rate cut is unlikely this year. Some even suggested that a hike is not off the table. At the same time, markets have rushed to price in a rate cut in the fourth quarter; and the White House has again placed pressure on the Fed: The Wall Street Journal reported that National Economic Council Director Lawrence Kudlow said in an interview that “President Trump wants the Federal Reserve to cut interest rates,” and that the administration “would like to see the central bank lower its benchmark federal-funds rate by half a percentage point.” 

These crossed signals increase the probability of Fed-induced volatility and the risk of a policy mistake. This possibility is higher in Europe given the tougher economic context as the European Central Bank undergoes a leadership change. And all of this is occurring as the operational autonomy and independence of central banks is under increasing pressure.

Mixed Market Signals: Lower yields on government bonds continued to attract a lot of attention last week. The auction for 10-year German Bunds cleared at a negative interest rate, yields on similar maturity U.S. bonds dipped below 2.40 percent for the first time since 2016, and those in some other jurisdictions, including Australia, hit record lows. The end of the previous week brought another important development, as the U.S. yield curve inverted for the first time since 2007.

Although the movements in government bonds have attracted a lot of attention, it's not clear that they should be interpreted in the traditional way as signals of a looming recession as some have suggested. Moreover, that view was contradicted by other market indicators in both fixed income and equities. Risk spreads on both corporate and emerging-market bonds have remained well behaved and stocks had a solid week around the world. Meanwhile, stock initial public offerings, including the closely followed one for Lyft, and new bond issuance generated solid investor demand. And although there were cases of market dislocations, including in Turkey in anticipation of local elections on Sunday, they remained contained with little, if any, contagion spillover.

Market Context and Prospects: This solid performance, and in some cases historically unusual correlations (for example, government bonds and stocks) marked the end of a quarter that featured the highest returns that several segments of the markets -- equities, corporate bonds or emerging market bonds and securities -- have registered for a number of years. Volatility measures have been well behaved, with the VIX falling during the quarter from 25.5 on Jan. 3 to 13.7 on March 29. And correlation broke markedly in favor of investors as stocks, bonds and commodities all moved higher during the quarter.

This occurred despite a global economic and political environment that remained at least as fluid as the one that accompanied the highly contrasting negative market developments of the final quarter of 2018. This illustrates once again the extent to which last quarter's dramatic central bank U-turns toward notably more dovish policy stances, both in the U.S. and Europe, together with cash hitting the markets from corporate balance sheets, can still compensate for shaky global growth and political uncertainty when it comes to investor risk preferences and positioning.

Ample liquidity can indeed boost markets, especially if there is the prospect of more. But the longer-term durability of these conditions remains dependent on a handoff to better fundamentals. Last week highlighted the significant challenges that confront such a handoff in many advanced countries, starting with Europe. Rather than the higher synchronized and inclusive growth that they need, investors will continue to be confronted with uncertain and divergent growth dynamics as politics continue to complicate economic decision making and corporate earnings face greater pressures.

While most investors should celebrate a rewarding quarter and a marked improvement from the misery of the preceding three months, they would be well advised to remember that the driver of the good times – ample liquidity – can only do so much for so long, especially at current valuation levels. Absent a determined politically led pickup in the conditions for improved fundamentals over time, investors should take advantage of their good fortunes to prepare for higher volatility, less favorable asset-class correlations and more uncertain return generation. In addition to moderating risk exposures, the latter stages of the economic and market cycles require investors to reconsider the traditional view that cash and tactical overlays do not belong in strategic asset allocations. In addition, the more top-down driven approaches to investing that rely heavily on the use of passive index products should give way to more bottom-up portfolio implementation driven by a careful, risk-management-inclined selection of securities that depends less on income support and more on balance sheet resilience.

To contact the editor responsible for this story: Max Berley at mberley@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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