In his testimony to Congress on Tuesday and Wednesday, Chairman Jerome Powell confirmed that the Federal Reserve has undertaken a dramatic policy pivot, opening the door even wider for other central banks to also adopt more dovish stances.
The shift increases the risk that many on Wall Street could slip back into the comforting belief that renewed central bank support is sufficient to ensure another round of meaningful stock market rallies around the world. Already, the MSCI World Index has rebounded about 16 per cent since its Dec. 24 low, and for understandable reasons. Going into last year, extraordinary liquidity injections and ultra-low interest rates had pushed up stocks dramatically. But investors shouldn’t view the recent monetary policy pivot as a green light for piling on risk assets as a whole. Instead, they should focus on three important qualifiers that favour domestically oriented US securities, both stocks and bonds, and seeking greater credit quality and liquidity.
Fed officials cited international economic weakness and spillovers from disrupted financial markets as reasons for their decision to end both their repeated signalling of additional interest rate hikes and their autopilot approach to balance sheet reduction, according to the minutes of the January Federal Open Market Committee meeting. Powell repeated the new patience-flexibility mantra in his congressional testimony. A growing number of other central banks in both advanced and developing countries have taken the same line, sharing similar global growth worries and/or wishing to avoid an appreciation in their currencies.
Importantly for investors, this central bank policy reversal concerns the two other systemically important institutions whose policies also have had a disproportionate impact on market valuations and volatility (though to a lesser extent than the Fed): the European Central Bank, which has started indicating that it will delay the already signalled first hike of its currently negative policy rates and that it may restart loans to banks under targeted long-term refinancing operations; and the Bank of Japan, whose governor, Haruhiko Kuroda, has said he is more open to expanding stimulus measures.
These developments have understandably reignited risk appetites, boosted markets and given investors hope for a renewed round of the exceptional 2017 mix of high returns, low volatility and unusual correlations that lifted every asset class. No wonder an increasing number of market strategists are now inclined to recommend an across-the-board increase in risk taking, both domestic and global.
Yet that reaction may be premature for three reasons:
The bottom line for investors is quite simple: Although central banks are again adding to the punch bowl rather than taking it away as they were threatening to do in 2018, this is not a green light for the sort of generalised risk taking that greatly rewarded investors in 2017. Rather, it’s a call for a selective approach that favours the stocks of domestically oriented companies, US stocks and bonds relative to European ones, and a general increase of credit quality and liquidity.
Mohamed A. El-Erian is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”