The recent market turmoil shows the inherent weakness of financial markets being supported by easy-money policies, said Mohamed El-Erian, the former CEO of Pimco and now a member of Allianz International executive committee.
Low interest rates and asset buying creates a wealth effect in markets, sparking investment and good enough fundamentals to justify valuations.
But look out for any bad news. When it was reported earlier this month that German industrial production dropped 4 percent from July to August, it led to a string of downward growth revisions, El-Erian said Thursday at the CFA Institute’s Fixed-Income Management conference in Huntington Beach, Calif.
“So suddenly everybody questioned the fundamentals,” he said.
Also this month, the major central banks “went on a multi-track” path, El-Erian said, with the Federal Reserve and the Bank of England easing off loose-money policies while the ECB and Japan do just the opposite.
“So we saw an 8 percent move in major currencies, which got translated into equities because a lot of equity investors do not hedge currency risk,” he said.
In addition, many people expected the ECB to “go full QE, and they didn’t,” highlighting the conflict between the ECB and Germany over quantitative easing, El-Erian said.
Don’t blame the central banks for inflating assets, though.
“Each year [since the financial crisis] it’s been up to the central banks to step in and compensate for lack of policy responses,” El-Erian said.
Central bankers are limited to influencing financial markets with “imperfect instruments that were meant to give [politicians] time to get their act together,” he said. “I don’t expect anyone anticipated that the political system would become so polarized. … I don’t think [central bankers] would have ever forecasted that they would still be in this [monetary stimulus] business four years later.”
Politicians need to address structural reforms like immigration policy, corporate taxes, infrastructure investment, income inequality and the debt overhang, he said.