Via Mohamed El-Erian for Bloomberg
Risk assets across the globe, despite already high valuations, have recovered impressively from a sell-off triggered by concerns about a North Korean nuclear attack. In doing so, they have again highlighted the extent to which traders and investors — highly confident about the environment they operate in (be it economic, financial or institutional) — have developed endogenous stabilizers. And while there is a limit to the effectiveness of these stabilizers over time, disrupting them in the short run would require deeper and more sustained adverse shocks, be they internal or external. Over the longer term, however, they cannot obviate the need for a handoff to more sustainable engines of value creation.
Having been sold off last week in the midst of a spike in the widely followed VIX and lots of talk about a long-anticipated price correction, risk assets have recovered yet again as many stock indices resume their march toward another set of records. While helped by North Korean leader Kim Jong Un’s temporary pullback on firing nuclear weapons toward Guam, the recovery started before such a signal. And it persists despite yet another intensification of political noise in the U.S. that inevitably drowns out and delays any legislative progress on pro-growth policies.
The recovery in risk assets has a lot to do with a “buy the dips” mentality that is now deeply ingrained in markets and that, repeatedly, has proven highly remunerative. It is underpinned by four related beliefs held by a very wide set of traders and investors and supported by high-frequency data and other recent signals:
- A Goldilocks global economy in which prospects for relatively stable nominal gross domestic product have been enhanced by a fall of the threat of material slowdown that has occurred without materially increasing the risk of an inflationary outbreak.
- Supportive central banks that continue to show considerable caution when it comes to both raising interest rates (recent examples come from the Bank of England and the Federal Reserve) and tapering large-scale balance sheet purchases (see: European Central Bank and the Bank of Japan).
- Continued migration to passive vehicles, including exchange-traded funds, which dull stock differentiation and provide consistent overall support to markets.
- Strong performance of corporate profits, which also helps to bolster companies’ cash holdings and expands prospects for dividend payouts, stock buybacks and mergers-and-acquisitions activities.
Because of this multifaceted configuration, it will take a big and sustained external shock to shake investors out of what has become a comforting, self-reinforcing “buy the dips” conditioning. The same is true when it comes to possible internal disruptions, be they indications of a less robust global economy or a policy slippage.
Over the longer term, however, there is a limit to how far this conditioning can decouple asset prices from fundamentals. But, as already illustrated, it is a limit that extends beyond what many traditional valuation approaches and models suggest, especially historically based ones. It is an elongated, enjoyable journey for traders and investors. But like all journeys, it needs to give way to a sustainable destination. And a necessary condition for this involves a greater policy effort to promote higher and more inclusive economic growth.