Deeply ingrained beliefs can be hard to dislodge -- and especially in markets when they have led to high investment returns over a prolonged period. That can encourage certain behaviors to last even in the face of contradictory indicators; and it may take a very large set of inconsistent data for behaviors to change.
This tendency -- underpinned by what behavioral finance calls “belief perseverance,” “confirmation bias” and “attitude polarization" -- could be one of the reasons that financial markets have confidently brushed off what has been a growing list of developments that otherwise would have resulted in higher volatility. It includes just in the last couple of weeks:
The particular beliefs I am thinking of relate to the trifecta of economics, finance and politics, and they have been extremely profitable for investors and traders. Specifically:
While all three are fluid -- and, I would argue, quite uncertain and less predictable -- developments so far haven’t been enough to reach a critical mass, either on a standalone basis or in combination. As a result, most measures of market volatility remain very low and extremely well-behaved.
As to the next few weeks, this market calm would be upset unfavorably by signs such as:
Adding to the outlook’s fluidity, the risks are not just in one direction. Thus, markets would respond well to progress in detailing and implementing the Trump’s administration pro-growth measures relating to tax reform, deregulation and infrastructure, as well as dovish central bank statements out of Europe and Japan.
Then there are the longer-term issues that I discussed in prior articles and that also carry the risk of higher market volatility. Endogenously, the low-volatility market regime faces a potential headwind because of currency appreciation that is too strong and would slow growth, pressure corporate earnings and fuel protectionist rhetoric. Exogenously, markets may find it increasingly harder to be shielded from the cumulative adverse effect on the economy/politics/institutions of growth that has been too low and insufficiently inclusive.
Over the next few months, the markets’ faith in its three beliefs -- stable economics, low financial volatility, and politics that does not adversely affect either of these -- is likely to be more seriously challenged by the possible further accumulation of contrary data points, thus increasing the potential for a tipping point. And if it takes a long time for this to happen, the greater the likelihood that these cyclical contradictions could be accompanied by larger secular and structural ones.
Yet the consequences don’t necessarily have to be dire for markets.
Yes, one cannot ignore the potential for downside risk in which low growth gives way to periodic recessions, artificial financial stability yields to unsettling volatility, and the politics get so messy they result in disruptive economics. Depending on the timely response of politicians, however, there is also an upside in which growth is higher and more inclusive, financial stability is genuinely anchored, and politics improve and enable better economic governance.
With such a bimodal distribution of outcomes ahead, it’s good that we are learning more about which indicators to watch and why.
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 View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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