MARKETS REFLECT TOO MUCH CONFIDENCE IN U.S.-CHINA TRADE DEAL / THE FINANCIAL TIMES OP MARKETS INSIGHT

Markets reflect too much confidence in US-China trade deal

Investors learn not to rely unduly on central banks, but still show undue optimism

Mohamed El-Erian


© FT montage; Getty Images; Bloomberg


The more it changes, the more it remains the same.

Markets and central banks have been stuck in an unhealthy co-dependence since the global financial crisis. Spoiled by too many years of timely and significant liquidity support from central banks, investors have long transitioned away from their traditional role of pressing for favourable policy changes — their longstanding role of “vigilantes” — to happily backing policies that have narrow chances of delivering durable economic improvements.

While the market is evolving away from a sole reliance on monetary policy, the relationship that is replacing it calls for greater longer-term caution than many investors seem willing to embrace.

It is increasingly evident that investors are, at last, becoming less confident about the ability of central banks to stimulate growth, repress financial volatility and boost asset prices to ever higher levels — especially in risky asset classes such as stocks and high-yield bonds.

But, looking at market developments over the past month, overly optimistic policy expectations continue to have a material impact on asset price movements, raising interesting questions for both market and economic prospects.

While abandoning unquestioned faith in the ability of both the Federal Reserve and European Central Bank to support asset prices, investors have found a new way to profit. That is to anticipate good news on trade, in the form of an early and durable China-US truce that rolls back the tariffs imposed by both countries and lifts uncertainties in a decisive manner.

Yet the chance of this holding is slim. If it does, it would not be sufficient to compensate for a host of other cyclical and structural impediments inhibiting high and inclusive growth. With that, the risk is rising that economic and corporate fundamentals will fail to improve to the extent needed to validate already-elevated asset prices and avoid global financial instability.

While consensus expectations continue to look for a significant loosening of monetary policy by the Fed, the ECB, the People’s Bank of China and many other central banks — starting in September and playing over the subsequent months — fewer market participants and economists expect this to materially alter the darkening prospects for the global economy.

European growth continues to weaken, with this week’s manufacturing data out of Germany suggesting a deepening economic contraction. China struggles to come up with stimulus measures that are both effective in the short run and consistent with needed reforms over the longer term. Emerging market currencies continue to weaken, opening the door to destabilising debt dynamics. Even the US, the consistent economic bright spot among advanced countries, is showing pockets of weakness.

Yet stocks in the advanced world have mounted an impressive recovery from the lows of August. Some, like the major US indices, have climbed back to within striking distance of their all-time highs.

The driver of this widening decoupling between asset prices and underlying fundamentals has shifted from overconfidence in central banks to hopes of a durable resolution of trade tensions between China and the US, the world’s two largest national economies.

Two types of dynamics are driving such behaviour. The first is the growing influence of algorithms coded to look for favourable trade comments from American and Chinese officials. Once they move the markets — as they inevitably do — there is a tendency for retail investors in particular to be pulled in.

Yet more than the occasional partial and ad hoc signal is required to sustain the upward moves in prices. You need both durable tension resolution and greater adoption of pro-growth policy packages at the national, regional and global levels.

Whether viewed from the Chinese or US perspective, the baseline on trade continues to point to a further escalation in tensions notwithstanding the occasional ceasefire. Meanwhile, the headwinds to growth coming from elsewhere only grow stronger. And do not look for global policy co-ordination to act as a counter. The last G7, with its distinct lack of a collective statement, let alone collective action, highlighted the poor state of multilateralism.

Economic concerns are particularly relevant for Europe where uncertain politics in the largest five economies continue to hinder the implementation of impactful pro-growth policies, be they structural or cyclical.

The more these countries slow — and they will soon be collectively at stall speed or in outright recession — the bigger the challenges for other countries and the greater the pressure on the dollar to appreciate. That increases the prospects of two other risks also under-appreciated by markets: a currency war on top of the trade tensions, and financial instability undermining economic activity.


Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge