Submitted by Taps Coogan on the 2nd of October 2017 to The Sounding Line.
Mohamed El-Erian, Allianz chief economic advisor, recently spoke with CNBC and reiterated his view that economic fundamentals are lagging financial asset prices, creating a potentially dangerous situation for markets. Yet according to El-Erian, enormous central bank liquidity injections and the conditioning of investors to ‘buy the dip’ has made markets resilient to all but the biggest shocks.
“So we have a whole list of uncertainties, Kelly, but the key thing is you need them to materialize in a big way, because there is so much liquidity and so much conditioning of investors to buy on dips. So you have the big question mark, what happens if more than one central bank normalizes policy at the same time. You have questions about geopolitics. You have questions about nationalism in different countries and protectionism. But again I stress, you need a big shock in order to derail this market… The biggest vulnerability is that we have decoupled asset prices from fundamentals, and we’ve done that because of massive injections of liquidity, and because of investor conditioning, which has worked extremely well… So you do need quite a big shock, but the vulnerability is the gap between the fundamentals that remain sluggish and asset prices which are high.”
“Yes fundamentals are improving but asset prices have rushed ahead of that improvement. I think the key issue, and that brings in why this tax plan is so important, the key issue is to have economic policies out of Washington, out of European Capitals, that actually high and inclusive growth. That is what we need and that is what ultimately will make sure we get a smooth transition. If we don’t get those policies, then its a more questionable outcome.”
It is worth pointing out that, even with the Fed on track to begin reducing its balance sheet in October, the Fed will remain a significant net contributor to market liquidity as it continues to roll over most of the bonds on its balance sheet. Additionally, as we discussed most recently here, banks are maintaining over $2 trillion in excess reserves which, under the right conditions, could provide another large liquidity injection into financial markets.