by Mohamed A. El-Erian
LAGUNA BEACH – This has been an unusual year for the global economy, characterized by a series of unanticipated economic, geopolitical, and market shifts – and the final quarter is likely to be no different. How these shifts ultimately play out will have a major impact on the effectiveness of government policies – and much more. So why have financial markets been behaving as if they were in a world of their own?
Apparently unfazed by disappointing growth in both advanced and emerging economies, or by surging geopolitical tensions in Eastern Europe and the Middle East, equity markets have set record after record this year. This impressive rally has ignored a host of historical relationships, including the long-established correlation between the performance of stocks and government bonds. In fact, correlations among a number of different financial-asset classes have behaved in an atypical and, at times, unstable manner.
Meanwhile, on the policy front, advanced-country monetary-policy cohesion is giving way to a multi-track system, with the European Central Bank stepping harder on the stimulus accelerator, while the US Federal Reserve eases off. These factors are sending the global economy into the final quarter of the year encumbered by profound uncertainty in several areas.
Looming particularly large over the next few months are escalating geopolitical conflicts that are nearing a tipping point, beyond which lies the specter of serious systemic disruptions in the global economy. This is particularly true in Ukraine, where, despite the current ceasefire, Russia and the West have yet to find a way to ease tensions definitively. Absent a breakthrough, the inevitable new round of sanctions and counter-sanctions would likely push Russia and Europe into recession, dampening global economic activity.
Even without such complications, invigorating Europe’s increasingly sluggish economic recovery will be no easy feat. In order to kick-start progress, ECB President Mario Draghi has proposed a grand policy bargain to European governments: if they implement structural reforms and improve fiscal flexibility, the central bank will expand its balance sheet to boost growth and thwart deflation. If member states do not uphold their end of the bargain, the ECB will find it difficult to carry the policy burden effectively – exposing it to criticism and political pressure.
Across the Atlantic, the Fed is set to complete its exit from quantitative easing (QE) – its policy of large-scale asset purchases – in the next few weeks, leaving it completely dependent on interest rates and forward policy guidance to boost the economy. The withdrawal of QE, beyond being unpopular among some policymakers and politicians, has highlighted concerns about the risk of increased financial instability and rising inequality – both of which could undermine America’s already weak economic recovery.
Complicating matters further are the US congressional elections in November. Given the likelihood that the Republicans will continue to control at least one house of Congress, Democratic President Barack Obama’s policy flexibility will probably remain severely constrained – unless, of course, the White House and Congress finally find a way to work together.
Meanwhile, in Japan, the private sector’s patience with Prime Minister Shinzo Abe’s three-pronged strategy to reinvigorate the long-stagnant economy – so-called “Abenomics” – will be tested, particularly with regard to the long-awaited implementation of structural reforms to complement fiscal stimulus and monetary easing. If the third “arrow” of Abenomics fails to materialize, investors’ risk aversion will rise yet again, hampering efforts to stimulate growth and avoid deflation.
Systemically important emerging economies are also subject to considerable uncertainty. Brazil’s presidential election in October will determine whether the country makes progress toward a new, more sustainable growth model or becomes more deeply mired in a largely exhausted economic strategy that reinforces its stagflationary tendencies.
In India, the question is whether newly elected Prime Minister Narendra Modi will move decisively to fulfill voters’ high expectations for economic reform before his post-victory honeymoon is over. And China will have to mitigate financial risks if it hopes to avoid a hard landing.
The final source of uncertainty is the corporate sector. So far this year, healthy companies have slowly been loosening their purse strings – a notable departure from the risk-averse behavior that has prevailed since the global financial crisis.
Indeed, an increasing number of firms have started to deploy the massive stocks of cash held on their balance sheets, first to increase dividends and buy back shares, and then to pursue mergers and acquisitions at a rate last seen in 2007. The question is whether companies also will finally devote more cash to new investments in plant, equipment, and people – a key source of support for the global economy.
This is a rather weighty list of questions. Yet financial-market participants have largely bypassed them, brushing aside today’s major risks and ignoring the potential volatility that they imply. Instead, financial investors have trusted in the steadfast support of central banks, confident that the monetary authorities will eventually succeed in transforming policy-induced growth into genuine growth. And, of course, they have benefited considerably from the deployment of corporate cash.
In the next few months, the buoyant optimism pervading financial markets may prove to be justified. Unfortunately, it is more likely that investors’ outlook is excessively rosy.