An unsettling trifecta for market contagion

October 3, 2011

By Mohamed El-Erian
The opinions expressed are his own.

Friday’s worldwide sell-off was a fitting end to a miserable month and a horrible quarter for equity markets.

The 14.3 percent quarterly loss in the S&P, a widely-followed index for the largest stock market in the world, was its worst performance since the fourth quarter of 2008 — a particularly bad omen given the additional market collapse that followed in the first quarter of 2009 and that brought the world to the brink of a global economic depression. Meanwhile, market and economic narratives are dominated even more now by words such as alarm, anxiety, worry and, to quote from the latest Federal Reserve statement, “significant downside risk.”

Is all this an exaggeration? Are markets stuck in an irrational cycle of self-feeding fear? Is the volatility, including eye-popping intra-day swings, just a head fake?

As much as I would like to say yes — after all, the balance sheets and income statements of multinational companies are still rock solid — the answer is no. The system is sending signals rather than making noise. It is warning about the highly uncertain and rapidly deteriorating outlook for the global economy; also, it is lamenting astonishingly inept policy-making in far too many western economies.

I know exactly how many feel. At an event last week in Washington, I was asked about my feelings about the global economy. My response was “between concerned and scared.”

I worry that, absent a dramatic change in policies in America and Europe, things will get worse before they get better. I fear that, given this possibility, it would then take years, if not decades, to repair the underlying damage done to economies, jobs and people’s lives around the globe.

We are here because of the interactions of three distinct, yet inter-related forces: poor economic growth, excessive contractual liabilities, and disappointing policy responses. The result is that western economies are getting trapped by the lethal combination of an unemployment crisis, a debt crisis, and mounting fragilities in the banking sector.

The longer this persists, the greater the risk that even the healthiest parts of the global economy, and thankfully there are still quite a few, will get dragged into a prolonged period of economic and financial stagnation. No wonder the cover of this week’s Economist magazine portrays the global economy as a black hole carrying a simple yet powerful message “Be Afraid.”

It should come as no surprise that, despite record low interest rates, companies with massive cash would rather stay on the sidelines than engage more fully in the global economy. It is also not surprising that, after showing resilience and tremendous relative strength because they sell to affluent people around the world, even high end retail stocks have been hammered recently.

If the three underlying crises — unemployment, debt and bank fragilities — continue to be left unattended by policymakers, the de-leveraging of the global economy will accelerate in the next few weeks and months. Selling will beget selling. Economic weakness will sap the willingness to spend by those with healthy wallets. And, over time, strong balance sheets will be infected by the growing economic, financial, political and social malaise.

Only policymakers, supported by more enlightened politicians, can change this outlook. Fortunately, there is now heightened awareness in American and European policy circles of the severity of the situation.

The fear of impending generalized dislocations — what the Managing Director of the IMF, Christine Lagarde, correctly labeled a “dangerous phase” — must now transition into three effective responses: immediate circuit breakers in Europe (what I call “very important and very, very urgent”); structural reforms in emerging economies, Europe and the US (“very important and very urgent”); and demand stimulus in emerging economies, Germany, and the US (“bridging mechanisms”).

The bad news is that having been “missing in action” for so long, policymakers will find it challenging to regain immediate control of a rapidly deteriorating global economy. This is particularly true for Europe where the feasible set of policy alternatives is now very far from a “first best.” Every approach that promises considerable benefits comes with substantial costs and risks as well.

Yet this is no reason to procrastinate even more. The longer policymakers wait, the smaller the room for orderly maneuver. In the meantime, dissatisfaction of electorates with the political process will continue to grow. Indeed, as this week’s Economist cover also notes, “until politicians actually do something about the global economy … be afraid.”

Markets are in the unusual and very uncomfortable position of being wholly dependent on policymakers and politicians. The investment relevance of company analysis, no matter how good, pales in comparison to the importance of getting the policy calls correct.

Faced with this, investors should also remain cautious. Yes there are already opportunities but they will be even more attractive down the road given that the world is now subject to both a synchronized slowdown and de-leveraging.

Investors should wait for stronger evidence that policymakers have the willingness, ability and effective instruments to respond properly. This is a time where cash and cash equivalents provide investors with tremendous optionality as the volatile winds of de-leveraging force far too many others into firesales. It is a time to be patient. And it is a time to strengthen firewalls that limit the further spread of economic contamination and financial contagion.

Photos, top to bottom: An artist’s impression of a growing supermassive black hole located in the early Universe is seen in this NASA handout illustration released on June 15, 2011. REUTERS/NASA/Chandra X-Ray Observatory/A.Hobart/Handout;  Anti-capitalist student protestors demonstrate outside the Bank of England in London October 10, 2008. Britain’s top share index slid 8.2 percent by midday on Friday in a global sell-off in equities as investors feared government efforts to unclog liquidity strains would not avert a global recession. REUTERS/Luke MacGregor; A reporter gestures at a board showing NASDAQ losses at midday at the NASDAQ Market site in Times Square, New York, January 22, 2008. REUTERS/Jeff Zelevansky


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Very astute observations, as usual, and diplomatic language regarding the asinine leadership of policy makers, as usual. One hopes they would finally get a clue, but alas…..

Mr. El-Erian hopes for the world’s players to get together and act in everyone’s best interests, but that really isn’t the way our world works – unfortunately. It’s very idealistic to think or hope as he does.

No – instead, we’re going into the black hole. We could stop it, as he argues, but that would mean acting completely outside our inherently greedy nature.

Posted by NukerDoggie | Report as abusive

I believe that the writer is pointing to the pillars of industry, just as the news people did at the beginning of the great depression. I had two good teachers, my dad and granddad that went through it. To quote them, “they said the pillars of industry would stand and not fall, but they fell”. We are at that point again and greed is still king in industry and government. Hang on tight, here we go.

Posted by fred5407 | Report as abusive

On the cover of the latest Economist, a magazine I value highly,”Be Afraid” at the top of a whirlpool.

Posted by Seafarer20 | Report as abusive

Great observation, the trouble is i dont think policy makers are going to react quick enough. We’ve been talking about Greek bailout for how long, it is not the policy maker but the average citizen who loses out.

we’re entering a very dangerous phase where protectionist policies will be the rule of the day, more banks will need bailouts and there is a real threat from the right and left wing parties.

Nationalization of weak banks in europe might help to get a control over situation. my personal view all southern europe countries should leave the euro and peg their currencies to the euro for the next 10yrs and get the house in order

Black Swan event – germany will leave the euro

Posted by envy | Report as abusive

Mr.El-Erian is correct in perceiving the world as a dangerously delicate place to own equities right now. I’m as scared as he is!

Posted by MOgambo | Report as abusive

Politicians can’t fix the problem. They would be fired if they actually tried. If you try and “fix” healthcare, there are 50 million AARP voting you out of office. If you try and tackle any issue that is large enough to make a difference, you are taking something away form someone else, and they will vote you out of office.
These old 20th century social structures must collapse. Then we can re-build them. That is how the haircut will happen.
What is the stock market? Banking systems? They all need major overhauls to handle 21st century globalization. Again, they can’t be “fixed” as they are not broken. They are just outdated.

Posted by tmc | Report as abusive

El Erian is right, but neglects to mention that politicians and their policies got us where we are.

And many commenters have neglected to notice that the modern form of greed is for power, not necessarily money.

Posted by Harry_Bergeron | Report as abusive

Takes a crisis for people to change! When liberals are in control of government, it’s a crisis! A vision without a way to pay for it is a dangerous gamble now!@ No substitute for making deep cuts and raising some taxes (was there really any doubt we’d be raising taxes soon-be honest?) The real question is: with government at 40% of US GDP, can we make the cuts!

Posted by DrJJJJ | Report as abusive

Social cohesion is likely to go first, which will change everything. Everything. And probably not for the better either.

The wealthy and powerful live in the illusion that their positions can never change dramatically. This is very foolish and very destructive.

Yes, hang on tight!

Posted by txgadfly | Report as abusive

Deleveraging, deleveraging, deleveraging! Does the world have any other option but to deleverage? When Soth Africa transitioned to a post-apartheid regime, the financial juggernauts of the ‘blue-eyed’ West, as Brazil’s President Lula did not hesitate to call those who had, by then, been re-baptised ‘banksters’, insisted that South Africa’s debt stock (foreign plus domestic) should not exceed 50% of GDP. The apartheid-era masters of SACOB (South African Chamber of Business) imposed on Mandela a ‘blue-eyed’ financial wizard as Minister of Finance, and made sure that his government rejected Lance Taylor’s structuralist model in favour of Jeffrey Sach’s “Wshington Consensus “model for planning the future policy orientation of South Africa. And, when the ‘blue eyed’ financial wizard was replaced as Minister of Finance by the ‘coloured’ Trevor Manuel, they engineered a huge capital flight that sent the Rand tailspinning from 6 to 14 to a US dollar within a week. Similar stories can be told about the rest of the BRICS plus Thailand, Turkey, South Korea, Argentina. Why should these emerging economies and those of the energy-resource rich Central and West Asian countries stimulate their economies to save a profligate West that continues with its mad military bravado and hubris? For far too long, the US and Europe had thought that ‘structural adjustment’ is only a witch’s potion meant only for half-wit ‘less-developed’ economies. Let them take the potion that they so ruthlessly imposed on others not so long ago or leave them to their debilitating fate. Asia, at least, can safely decouple from an unrepentant West.

Posted by MohamedMalleck | Report as abusive

@CarlOmunificent: I love that movie too!!!

I see in the news tonite that the entire Greek rescue is evidently ‘under review’ and in all likelihood is now in the proverbial toilet. No funds until sometime in November at the earliest. I think this means a Greek default about mid-month October, or earlier perhaps.

There’s no firewall in place to protect Spain and Italy, and today Spain came under greater pressure in the credit markets. Italy won’t be far behind.

Jeeze, I wish we in America had one of those doomsday devices!

As Mertin Muffley frantically scrambles to come up with the recall code to stop the detonations – ope poe oep ?

Mein Fuhrer! I can walk!

Posted by NukerDoggie | Report as abusive

As usual, the writers suggest every possible reason for what’s going on but the right one, in this case, Peak Everything. See “The Imminent Crash Of the Oil Supply:” 230410.htm . This article (from April of last year and nothing has happened to change its projections) shows that the oil supply is about to crash globally, but because world corporations and policymakers are favoring East Asia over the rest of the world, there is superimposed on the overall impending collapse a decrease in oil supplies for the West of approximately 1 million bpd each year, over 1%. The world outside China is worse than running on empty, and there can be no recovery this time. See “Running dry, Oil production fails to keep up with demand,” Jun 9th 2011, 15:09 by The Economist online t/2011/06/oil-production-and-consumption

It’s time to face what’s going on and deal with it.

Posted by narguimbau | Report as abusive

CarlOmunificent, you seem to be advocating isolation and sterilization to address the spreading crisis – but if I’m going to be isolated in order to prevent contagion from getting me, I want all the necessary comforts in my ‘mine shaft’.

Down there, we’ll have to start all over to build a new society and financial/economic system. We’ll need to multiply and eventually spread our new society around the earth once the euro virus dies off. We’ll need to select females of the most stimulating nature in order to be sure to multiply our own kind faster than the eruos, who might also take refuge in their own mine shafts. I think you know where I’m going with that one.

But on the matter of isolate and sterilize – it’s too late for that. Greece cannot now be isolated from the rest of the eurozone. Its debt cannot be sterilized without inadvertently toxi-fying all that is sovereign-type debt.

Sovereign debt is turning toxic as an asset class.

…in the purity and essence of our precious bodily fluids…

Posted by NukerDoggie | Report as abusive

As usual, Mr. El-Erian is just describing the situation without giving any CONCRETE recipe to solve the so-called “sovereign debt” situation. A situation people LIKE HIM have provoked with Bill Gross´statement of a “new normal” and other recession/depression language. Mr. El Erians language of “effective instruments” to be established is as vague and nebulous as his comments are in general. What is the “right medicine”, Mr. El Erian? What is it? You are such a smart man, why don´t you consult European politicians and tell them what the “market” wants. The truth is: Mr. El Erian is as clueless as politicians themselves. He is just giving the impression of staying above the game. No substance. Just a nice written article. That´s all he´s got to offer!

Posted by PMueller69 | Report as abusive

…..Mandrake, do you know why I drink only branch-water and grain alcohol?

Posted by Robertla | Report as abusive

There is no “Union” in the EU. It remains a collection of feudal tribes connected only by geography. Self-preservation (or conquest) remain the usual agenda.

The 1800’s to 2000 were driven by invention and industrial revolution. This is long since over in the US, and today’s “emerging markets” have caught up pretty quickly. The demand drivers for manufactured goods will continue to drop, and service economies will deflate on ever-falling margins.

The tribal uprisings in the middle east (cultural contagion?) haven’t occurred since before the time of the First Crusade. Idle hands, hunger, class (caste)societes, and oppression breed revolution. Who in the Arabian Pennisula and Horn of Africa remains to fall, and who will fill the power vacuum? History is littered with the dead of those attempting to ascend to power. Only the most violent and idiological will emerge.

And hence the demonstrations on Wall Street and in other western countries. From such things the seeds of revolution are sown. Let’s just hope they don’t start handing out brown shirts to everyone.

Posted by ThinkPeople | Report as abusive

You Dr. Strangelove fans are becoming hysterical. Listen to the band. They’re playing their hearts out.

I love the Titanic movies. All four of them. But I don’t know anyone with a life-boat. Are any of you in them? Most of the people I know are in steerage and it’s getting wet down here. No body admits it but we were keeping first class alive all along. Our tickets were the gravy for the Line and the upper decks. The freight paid the freight. Those arrogant so and so’s tended to forget that.

One thing about living on a sinking boat is sooner or later it takes the heat off.

Posted by paintcan | Report as abusive

Whadddya MEAN they used sub-standard materials in this skyscraper! It made of the highest quality particle board and paper mache – made from ground up euro notes and plaster! Now I smell smoke! There’s a bunch of euros burning in a utility closet on the 39th floor, and the whole damn building’s about to become engulfed!

Quick! Break open the floodgates of the Deutsche Mark reservoir on the roof and flood the whole damn building before we’re all incinerated in this raging euro fire!

Posted by NukerDoggie | Report as abusive