As markets were experiencing sudden turmoil a month ago, I suggested five simple, readily available quantitative indicators that could help investors assess whether that bout of extreme volatility would be a transition to better-anchored financial markets in the medium-term.
These measures can be a partial proxy for evaluating the health of a much-delayed and critical transformation for financial markets: ensuring a shift toward better fundamentals that underpin what has been predominantly a liquidity-driven outcome for the trifecta of market valuations, volatility and correlations.
This change would coincide with investors' move away from their faith that liquidity injections from non-commercial players (particularly central banks, which also provide comforting policy guidance) will continue to repress any and all bouts of volatility.
While it’s still early, here is where we stand on the metrics now that markets have rebounded and the Nasdaq is back at a record high:
Volatility: Instead of reverting to its unusually low levels after the dramatic spike, volatility (as measured by the VIX) has mostly traded in the suggested 15 to 20 points range needed for a healthy market reset.
U.S. Yields: The yield on 10-year bonds has traded between 2.81 percent and 2.95 percent, well within the suggested reset range.
Yield Differentials: U.S. bonds have remained within the suggested range versus 10-year German government bonds, which serve as an important benchmark for European rates.
Correlations: The correlations between risk assets and risk-free ones have tended to revert to their historical (negative) level, though not yet on a consistent basis.
Currencies: The DXY index has shown more two-way movements in the last few weeks, trading in a range of 88.7 to 90.6.
Although these are early days still, there have been encouraging signs of the potential for a healthier asset price reset, despite some recent challenges, including the inconclusive outcome of elections in Italy, and market uncertainty about U.S. trade policy and economic management. Yet the underlying strength of the U.S. economy has been an important driver of progress.
The jobs report for February, released March 9, presented a vivid illustration of this. Going beyond a “goldilocks” snapshot of the labor market, it contained positives for both the demand and supply sides of the economy, as well as for the policy outlook.
The large size and diversified nature of the improvement in job creation were important reminders of continued economic dynamism that is increasing the possibility the U.S. economy can leave behind too many years of a “new normal” involving low and insufficiently inclusive growth. Concerns that this may lead the Federal Reserve to increase rates more aggressively -- that is, four or more hikes in 2018, instead of the three signaled earlier --- were eased by muted wage growth and, more encouragingly, a solid increase in labor participation as previously discouraged workers were drawn back to the labor market.
Markets were also heartened by the tariff carve-outs for Canada and Mexico that the White House announced March 8, together with signals that other exemptions could be considered in the context of concrete steps toward fairer trade. This helped dampen concerns about stagflationary trade wars.
The economy and markets need to continue to build on all of this, including by making further progress on pro-growth structural reforms around the world, more balanced demand management in some advanced economies and greater efforts to strengthen the regional economic architecture in Europe. Remember, it's not just the markets that are transitioning back to a more normal set of conditions for expected returns, volatility and asset-class correlations. This shift coincides and interacts with two other transitions: in policy, with the move away from excessive reliance on unconventional monetary policy, and in the underlying drivers of higher and more inclusive growth.
For now, there is around a 65-35 probability that all three transitions will be navigated ably, though with bumps along the way. And these are important historical transitions that speak to economic, financial, institutional, political and social well-being. If they are mishandled, the global economy would not revert back to the new normal of the aftermath of the financial crisis. Instead, it would most probably be victim to more periodic recessions, unsettling financial volatility, greater global trade tensions, and more complicated politics at both the national and regional levels.
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, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."
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