An unsettling trifecta for market contagion
By Mohamed El-Erian
The opinions expressed are his own.
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