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El-Erian: 5 Facts About the Market Selloff

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The 7% rout that compelled China to halt stock trading on Monday, along with sharp losses in European and U.S. markets, marked an inauspicious beginning to the new year for investors.

Here are the five things to know about the implications of the selloff for 2016 and beyond:

1. The two main causes were renewed warning signs about the health of the Chinese economy and a new flare-up of geopolitical tensions in the Middle East, which intensified concerns about the strength of fundamentals underpinning financial asset prices. Specifically, these signals highlighted the fragility of a global economy that has yet to develop sufficiently robust growth engines. They also were a reminder that markets are vulnerable to geopolitical stresses that extend well beyond nation-states and can involve non-state actors whose disruptive behavior is hard to predict, let alone control.

2. Investors followed the initial large and precipitous falls in equity prices with buy reactions that were consistent with years of repeated conditioning. In China, the government stepped in again with measures to stabilize market sentiment; and it did so even as it had been planning to phase out its previous intervention. In Western markets, some private stock purchasers came in looking for bargains, following an ingrained pattern created by years in which “buy the dip” strategies have proved quite profitable.

3. This response reflects market expectations of subsequent liquidity injections from two sources: exceptional central bank policies, including large- scale asset purchases (or quantitative easing); and companies deploying their cash holdings via stock buybacks, higher dividends and merger and acquisition activities. Yet as reliable as these reactions have been in the past, their immediate applications are more uncertain today. After the December rate hike by the Federal Reserve, the systemically important central banks are now on divergent paths. Specifically, the Fed is easing off stimulus policies while others — including the Bank of Japan, the European Central Bank and the People’s Bank of China — are likely to accelerate such measures. Meanwhile, the immediate deployment of company cash is hindered by the approach of the quarterly earnings season, when corporations tend to be less active. 4. This is unfolding amid growing uncertainty about the sustainability of the path the global economy and markets have been on for the last seven years. At a minimum, this confluence of factors entails a lot more volatility in the year ahead. As I postulate in my soon-to-be-published book, “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse,” central banks could find it a lot harder to continue to borrow growth and financial returns from the future by relying on experimental measures. Two outcomes are possible within the next few years: This path will either give way to a more comprehensive policy response that will provide a sustainable lift to fundamentals, which would validate financial asset prices and push them higher; or this approach will succumb to its growing internal contradictions, leading to asset price declines, contagion and create new asset class correlations that will challenge even the most diversified investors.

5. Nothing is predestined about these two medium-term outcomes. Much will depend on how policy makers and the private sector respond in the months to come. Regardless, investors need to be a lot more nimble because they will be navigating increasingly volatile markets. The age of financial volatility repressed by central banks is ending.

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