Stocks have established one record after another while economies have had to deal with another wave of COVID-19 hospitalisations and deaths that has surprised most in terms of intensity and speed of spread while complicating the journey to vaccine-induced herd immunity.Explanations
Chasing price action
Unless you are, as I am, a great believer in the overwhelming influence on markets of ample and predictable central bank liquidity, particularly from the Federal Reserve and the European Central Bank, it has been difficult to find a durable narrative to explain and predict this year’s exceptional price action in financial markets.
Indeed, rather than narratives leading market action, market action has led to a series of consensus explanations that often proved serially inconsistent.
I can think of several examples, including the three conflicting political narratives that were embraced widely by market participants in the middle of the year to “explain” consistently rising stocks: High prospects for the re-election of President Donald Trump with a lower-tax, less-regulation agenda; a divided government that would keep it sidelined and allow business to flourish unhindered by interference; and a blue (Democratic Party) wave that would result in huge fiscal stimulus that would significantly boost demand.
The dual liquidity phenomenon
This year investors experienced illiquidity in what are the biggest and traditionally the most liquid markets and liquidity in usually illiquid segments. Specifically, March will be remembered as the moment when even flows in US Treasury bonds, the benchmark of all global benchmarks, were disrupted sharply.
A few weeks later, the Fed’s intervention in markets, including surprise purchases of high-yield securities, injected liquidity far and wide and induced “cross over” investors to venture well away from their normal habitat.
By the end of the year, the deep belief in an everlasting “central bank put” has meant that, of all risks facing investors, those associated with liquidity have returned to being the most underappreciated.
The search for risk mitigation
The more central banks have succeeded in repressing market yields on “risk free” government bonds (and confronted investors with little to no income and adversely asymmetric price risk), the more investors have searched for new and more attractive ways to mitigate risk – so much so that a growing number of market commentators commented during 2020 on the prospective death of the traditional 60/40 stock-bond portfolio.
Many investors, and particularly those facing negative yields on government bonds, have ventured to other areas of the fixed-income market in an attempt to offset the risks associated with their considerable equity positions.
What started as purchases of short-maturity investment-grade bonds – on the correct premise that the Fed has put them under a protective umbrella with its own buying – has evolved to include debt with significantly higher default risk, such as high-yield and some emerging-market bonds.
Others have adopted more of a basket approach, adding gold, Bitcoin and other cryptocurrencies to what traditionally consisted just of government bonds.
The lack of emerging-market accidents
Emerging economies have found themselves in a perfect economic storm because of COVID-related disruptions. Because of the global economic “sudden stop” and the geographically uneven recovery that has followed, many have seen export revenues collapse, tourism earnings disappear and inflows of foreign direct investment evaporate, with some even facing the prospects of outflows.
Yet, with the exception of pre-existing condition countries such as Argentina, Ecuador and Lebanon, the vast majority of emerging markets avoided debt defaults and significant restructurings. Indeed, with liquidity returning quickly to financial markets, and with investors encouraged to search aggressively for greater yields, a record level of EM bonds was issued at exceptionally low risk spreads and overall yields.
Combined, and unlike what most have faced around the world, these five factors add up to a year that has given investors a great deal of what they could wish for – especially in terms of handsome returns with notably low volatility outside of a few weeks around March that seem to have been quickly forgotten.
They are also factors that speak to the dominant market influence of central banks, which anchors an unhealthy co-dependent relationship that most investors are keen to continue regardless of the declining benefits for longer-term economic and financial well-being, together with mounting collateral damage and the spread of unintended consequences.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include ‘The Only Game in Town’ and ‘When Markets Collide.’