A majority of economists questioned Powell’s unscripted remark. From an economic, institutional and market perspective, it would have been much better for Powell to stick to the script given to him rather than venture into a statement that Larry Summers, the former Treasury secretary, described on Bloomberg Television as “analytically indefensible” and “inexplicable.” Yet having gone unscripted, Powell’s analytical slip served as a spark for markets that have been conditioned by years of huge and predictable Fed liquidity injections.
It should come as no surprise that markets are so sensitive to any hint of a return to the uber-stimulative, liquidity-abundant policy regime. Yet high and potentially sticky core inflation greatly limits the Fed’s ability to pivot back to such a regime any time soon.
There is a better way to think about July’s contrast between the market and the economy, one based on the view that asset prices are sensitive to three general influences: fundamentals, including the economy’s impact on corporate earnings; technicals, including the amount of overall liquidity in the system, cash in investment portfolios and general level of risk-taking; and relative valuations, be they historic or intra-asset class. The latter two influences drove the July rally in the face of deteriorating fundamentals.
Given the amount of liquidity that has been injected in recent years, a lot of it is still sloshing around. The level of cash holdings by investors has been high, and the willingness to take risks is still considerable once a green light flashes on.
All this comes when equity valuations have become more attractive, with some particularly prominent individual stocks, albeit a relatively small set, trading at strikingly cheap levels. Stocks have also benefited from the widening market belief that, with the economy slowing so rapidly, bond yields had fallen in the last month and a half to levels that are notably less attractive, especially with such high inflation.
This is not to say that fundamentals will have no influence going forward. A lot will depend on the answer to two questions: How sticky will inflation be on the way down, and how deep will the possible recession be, neither of which can be answered yet with a great degree of confidence.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of The Only Game in Town.