Last week, global equity investors got a much-needed reprieve from volatile, loss-inflicting markets. But rather than signaling the start of a calmer market phase, this may well prove a prelude to renewed volatility in the weeks ahead.
After ending the last trading session of the previous week with a gain, global stocks got off to a good start last Monday. US markets went on to post their best weekly performance since November, as two days of solid market rallies were followed by relatively calm consolidation. Markets in Japan and some parts of Europe did even better, registering gains of 5 percent to 7 percent.
There were four reasons for this respite from an otherwise horrid start to the year:
Attempts by central bankers, especially outside the US, to reassure markets; stepped-up negotiations among oil producers aimed at stabilizing prices; the rush by European banks to avoid joining the set of unhinged market segments by coming up with measures including repurchases of their securities; and some, albeit limited, positive US economic news.
Yet none of these factors serve to significantly counter, let alone, overcome three much bigger and more consequential realities.
First, corporate earnings will be further challenged by continued signs of spreading global economic weakness and a persistent inability by governments to deliver the required policy responses. Last week, the Organization for Economic Cooperation and Development joined other international economic watchdogs in offering lower growth forecasts. It also noted additional risks.
Second, the continued ability of central banks to repress financial volatility is increasingly in doubt. The institutions that are willing to pursue such policies, particularly in China and Japan, are facing questions about their effectiveness. And more able central banks, such as the Federal Reserve, may not be as willing to do so, particularly given economic indicators suggesting that financial volatility has not contaminated economic activity and that wage and price inflation are starting to pick up.
Third, although a few days of market gains can force traders to cover their shorts, in this case, it does not seem to have triggered the return of the stabilizing role of long-term capital. Instead, it would appear from data about the flow of funds that markets still need to reprice considerably lower to find the anchoring inflow of significant patient capital.
Until these three factors change, occasional periods of market calm — and, thankfully, there will be some — are likely to prove frustratingly short. But this does not mean that investors should just reconcile themselves to passively riding roller-coaster markets that will likely create anxiety and may even force some, during large air pockets, to liquidate at the wrong time. Instead, investors would be well advised to consider adding a tactical component to their longer-term strategic and structural positioning.
Given the likelihood of a return of significant market volatility, periods of downward pressure will continue to be associated with price overshoots and undue contagion. For investors willing to stomach lots of mark-to-market risk, these gyrations will offer an opportunity to gain exposures at attractive prices to names possessing solid economic and financial fundamentals. And during the periods of upward retracement, these same investors will have the opportunity to accumulate cash, while continuing to upgrade the quality of their holdings.
Anchored by the notion of “buy and hold,” many long-term investors will naturally resist adding a tactical component to their investment approach. But failing to do so could also cause them to risk losing sight of a larger reality that volatile markets are now signaling increasingly consistently.
The world is experiencing policy and economic realignments that undermine two notions that have served “buy and hold” investors well in the last few years: that global growth, while low, remains relatively stable; and that systemically important central banks continue to be both willing and able to repress financial volatility and boost financial asset prices.
This paradigm is coming to an end. Moreover, what may follow is far from predestined, depending in large part on whether politicians are able to bring about the much needed hand-off from excessive reliance on central banks to a broader policy response. In the meantime, we all better get ready for the return of greater financial
Mohamed El Erian, a Bloomberg View columnist and chief economic adviser at Allianz, is chairman of Barack Obama’s Global Development
Council, ex-CEO of Pimco and author of “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse”