It is no surprise that the possibility of a market “melt up” for the rest of 2019 is becoming a more common refrain among investors. After all, the unsettling volatility of the fourth quarter of 2018 is well within the rear-view mirror, and the first four months of this year have delivered ample gains with declining volatility. Although there are understandable reasons for this optimism about the future, two uncertainties risk being assumed away in this melt-up scenario, and they don’t relate to the trade and political issues that have persisted for so long and that investors feel comfortable sidelining.
The first four months of 2019 have seen a return of the 2017 realignment that comforts investors a great deal – that is, the combination of high returns, low volatility and favorable correlations.
Year-to-date returns for the S&P 500 totaled 16 percent as of April 18, while the VIX has fallen from a reading of 22 at the start of the year to just 12. Stocks markets outside the U.S. have also performed well: The MSCI World Index is up 16 percent this year; the Euro Stoxx 50 has risen 7 percent and the S&P/ASX 200 covering Asia has gained 11 percent. Moreover, and counter to what conventional correlation models would suggest for such a solid “risk-on” period, investors also made money in safe assets, albeit with a return of just 1 percent for the Bloomberg Barclays Global Aggregate Treasuries Index.
The primary driver of this highly favorable trio of metrics has been the historic dovish policy pivot by the Federal Reserve, which has significantly relaxed financial conditions and opened the way for other central banks to loosen policies.
With investors’ trust restored in the central banks’ willingness and ability to suppress financial volatility, including talk of a “Powell Put” as a follow up to the “Bernanke Put” and the “Yellen Put,” markets have found it easy to set aside a myriad of concerns, from trade and political tensions to persistently weak data out of Europe. Indeed, the markets celebrated the Fed's signaling of no rate hike this year and a termination of balance sheet reduction in September, and they also priced in a significant probability of a rate cut by the end of the year.
The argument for a melt up (involving a pile on by investors who don't want to be left on the sidelines during a market rise regardless of any change in market fundamentals) essentially extrapolates forward the impact of central bank liquidity support in the context of the notion of investment portfolio underexposure to stocks and the continued proliferation of index products. This is also known as the FOMO, or fear-of-missing-out, effect, and it goes something like this:
With investors confident that central banks have the markets’ back covered, low volatility gives them greater confidence to re-enter in greater size a market where they have remained underallocated after the trauma of the global financial crisis (and the overall feeling of economic insecurity that has persisted). This confidence will be reinforced by the strong performance of asset prices, along with the use of index products that generalize the rally. Dramatic headlines about soaring initial public offerings, such as Zoom Technologies Inc. and Pinterest on April 18, and continued corporate buybacks will add to the feel-good factor, creating a self-reinforcing dynamic that can take market indices well above their record levels.
Markets have been conditioned to treat the most cited risks to this happy scenario as increasingly temporary in their impact, and fully reversible in their price effects. These include trade tensions, particularly between the U.S. and China, as well as between the U.S. and Europe; political uncertainties associated with Brexit, other European political fluidity and Special Counsel Robert Mueller's report; and geopolitical tensions such as those between the North Korea and the U.S., and between Iran and Saudi Arabia.
Yet these are not the most important risks when it comes to the melt-up scenario. Instead, those have to do with the ability of a predominantly liquidity-driven rally to overcome two factors: a slow and uncertain handoff to the stronger global economic fundamentals required to sustainably underpin elevated asset prices; and the tricky policy balance that the Fed faces in the context of a divergent global economy in which the U.S. continues to be the notable outperformer among the advanced countries, the already considerable yield differential between the U.S. and Germany widens further, and the dollar strengthens.
The economic weakness of Europe was illustrated again last week by purchasing managers' index data that showed contraction for the euro zone aggregate, as well as the country measure for France, and a Germany stuck at a contractionary reading of 45. The Chinese data have been more encouraging, but there remain questions about the longer-term impact of a substantial stimulus effort by authorities, including potential contradictions regarding what’s needed to power the economy through the tricky middle-income transition.
By contrast, U.S. economic readings have been more encouraging. The jobless claim number released last week was the lowest in more than 50 years, providing further evidence of a healthy labor market underpinning consumption. And the bounce back in monthly retail sales has eased many concerns about a major economic slowdown notwithstanding slowing manufacturing. But good news for the U.S. economy entails a tricky policy challenge for the Fed.
The minutes of the last Open-Market Committee meeting confirmed that the Fed’s policy U-turn was influenced by concern that U.S. growth and inflation outlooks would be undermined by spillovers from weaker international conditions and volatile financial markets, as well as trade tensions. Especially with the brighter prospects for a China-U.S. trade deal over the next few weeks, and with the stabilization of the Chinese economy, these concerns have been eased considerably, opening up the possibility of Fed-induced volatility as central bankers try to guide later this year toward a less accommodating monetary policy than what’s priced into markets.
All of this to say that, without a better liquidity-to-fundamental handoff and a more market-savvy Fed, the prospects for a melt-up scenario could well dim through the year.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He 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.”
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