GLOBAL TUG OF WAR IS FOCUS FOR INVESTORS / THE FINANCIAL TIMES COMMENT & ANALYSIS

Markets Insight

February 9, 2015 6:17 am

Global tug of war is focus for investors

Mohamed El-Erian

Markets are already responding to divergence between US and rest of world

 

©Bloomberg

 

There is an economic and policy tug of war going on between the US and most of the rest of the world. Data releases, official statements and markets underline the power of this divergence. It is also consequential for investor positioning.

 

In spite of impressive job creation and robust personal spending, the US economy is still struggling to achieve lift-off. Imports are surging ahead of domestic production for foreign markets and companies remain reluctant to unleash capital investment plans, partly because a sharply rising dollar makes it harder to compete overseas.

In an unusual occurrence for a central bank that is domestically oriented in its policy focus and communication, the tug of war made it to the Federal Reserve statement issued on January 28.

Observing that “economic activity has been expanding at a solid rate” — a view that will be confirmed by the “wow” monthly employment report released on Friday — Fed officials noted “international developments” as one of the factors to take into account in assessing future policy steps.

For their part, financial markets have already been responding to the divergence, particularly when it comes to the more macro-dominated currency and fixed income segment.

Over the past six months, the dollar strengthened markedly against a basket of its trading partners, with an even stronger move against the euro. Meanwhile, market-determined yields for US Treasuries were pulled down by German Bund rates that have plummeted in response to both a weaker eurozone economy and new quantitative easing from the European Central Bank.
 

The yield curve also flattened, with yields on longer-maturity Treasuries declining a lot more than those on shorter-dated ones.

 

Volatility from these two market segments spilled over into equities, shaking the comforting notion of a “low vol paradigm” that had provided major and consistent support to stock prices.

There is little reason to expect the underlying forces of economic and policy divergence to change any time soon, especially when it comes to the contrast between the US on the one hand, and the eurozone and Japan on the other.

The US economy should heal further, aided by a surge in consumer confidence fuelled by lower energy prices. Continued robust job creation and a further decline in unemployment will support wage growth.

All this, along with concerns about the risk of future financial instability, is likely to translate into the Fed tweaking its “patient” language in March, and starting its rate rise cycle this summer. This would involve small, measured moves, be supported by reassuring forward policy guidance, and involve a policy end rate below the historical average of 4 per cent.

Unfortunately, European and Japanese prospects remain quite different. Persistently sluggish growth dynamics will be threatened even more by the spectre of damaging deflation. Central banks will keep pressing hard on the QE stimulus accelerator, but the transmission to higher growth and inflation will remain patchy.

Meanwhile, tricky national politics, as illustrated by last week’s frosty meeting between Greek and German officials, and greater vulnerability to geopolitical shocks (particularly the escalation of violence in eastern Ukraine) will add significant downside risks to economic growth.

 

All this makes absolute market calls a lot tougher than the relative ones. To navigate well such a tug of war, investors need to be able to gain exposure to relative as well as absolute positioning — be it in the foreign exchange markets favouring further dollar strength, in the government bond markets favouring additional flattening of “high quality sovereign” yield curves, or in the corporate markets favouring higher quality bonds versus those issued by high yield and low quality emerging market companies.

 

In scaling such relative positioning, investors would be well advised to keep one more issue on their radar screen. The prospective moves in markets implied by the divergence theme would tend to complicate rather than facilitate policy making in a world subject to increasingly bimodal distribution of potential outcomes and low availability of broker-dealer liquidity during transitions.

The possibility of policy mistakes and market accidents inevitably rises, as does that of a US-led global economic breakthrough.


Mohamed El-Erian is chief economic adviser to Allianz and chair of President Obama’s Global Development Council