If I am correct in my analysis, this results in caution for those expecting the Fed to effectively bail out the weaker segments of the credit market, like high-yield bonds, and of equities, like emerging markets. Moreover, the risk of triple-B rated companies becoming speculative grade is high, and the Fed will be hesitant to increase its own credit exposure to them. These so-called fallen angels have, and in some cases still are, taking on more debt at a time of declining actual and future earnings. That becomes a balance-sheet and income issue that the Fed can do little about.
Thus, the only way investors would be protected in these circumstances would be through the government rather than the central bank. In other words, this is a bet on government bailouts on terms that are favorable to financial investors. It’s not a wager that I would be comfortable in making or advocating.
Rather than view the Fed’s unquestioned commitment as a signal to buy across the financial markets, investors should focus on specific senior sectors and high-quality securities. It is another reason to trade up in quality by sharply reducing credit and equity exposures to those companies at high risk of default or downgrade below investment grade.
Remember, in making the policy bet in this environment, it is particularly important for investors to distinguish between liquidity risk on the one hand and credit and equity risks on the other. And in following the Fed, investors need to keep in mind that the central bank is committed to ensuring smooth functioning for senior segments of the financial markets. It does not seem willing, and may even not be able, to support income and balance sheets for the more junior ones.
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. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include "The Only Game in Town" and "When Markets Collide."