By Mohamed A. El-Erian
Week in and week out, three hypotheses invigorate and sustain the stock market rally. The three are valid. Yet their longer-term implications may be far more complex than most investors fully appreciate.
Equity markets believe in the "Fed put," or the view that the Federal Reserve will increase its monetary policy stimulus in response to any (and all) meaningful decline in risk assets.
This dynamic is reinforced by the revealed preference of the Fed. It is also consistent with the institution’s policy objective – that of enhancing economic growth and job creation by pushing up financial asset prices and thus reviving animal spirits and triggering wealth effects.
Second, market participants also have reason to believe that the steadfast focus of the Fed forces other central banks around the world into more accommodating monetary policy.
The ongoing U-turn by the Bank of Japan, a central bank that long held the view that the collateral damage of prolonged unconventional monetary policy exceeds the benefits, is just the latest example of a "Don’t Fight the Fed" mantra that applies both within and outside America’s borders.
Then there is the "kick the can" hypothesis, or the view that even unusually dysfunctional political systems, be they European or in America, repeatedly find ways to avoid outcomes that would be really disruptive to markets.
Consider this week’s last minute drama on the Congressional fiscal sequester. The likely outcome – a deadline lapse that, rather than trigger a technical default or deep spending cuts, would be followed a few weeks later by a clumsy compromise on a continuing budgetary resolution (another Band-Aid government funding vehicle) – would certainly not be pretty, but it would be effective in avoiding a big shock to risk assets.
Now, each of these hypotheses is understandable and valid. Yet, for two inter-related reasons, their sustainability is subject to complexities that many may well underestimate: increasingly unstable internal dynamics, and a handoff process that is far from assured.
Let us consider each in turn.
The longer the Fed maintains its unusual policy activism, the higher the costs and risks. This reality was vividly illustrated in the minutes of the last Fed policy meetings released last week, with several officials referring to the rising probability of both direct and indirect damage.
As I argued last week, this does not mean that the Fed will abandon any time soon its current policy stance. It won’t. But it does mean that the overall impact on the economy – and, consequentially, companies’ top line revenue growth and their ability to contain non-wage costs – is indeed uncertain.