Despite almost non-stop news coverage last week of the high likelihood and adverse implications of a U.S. government shutdown, the performance of stocks and bonds in recent days betrayed little evidence of investor concern.
Go back a little further and markets have shown a striking ability to shrug off political and geopolitical instability. Is it luck or do markets have a better handle on these issues than most experts?
In the last few years, investors have essentially ignored expert advice about a long list of political and geopolitical issues. They include what turned out to be misplaced warnings about:
- A referendum vote on Brexit sending the U.K. into recession and fueling a broader fragmentation of the European Union. As it turns out, there was no immediate economic shock beyond the inflationary passthrough of a weaker currency; and even that is being reversed as the pound has regained its pre-vote level. Meanwhile, the efforts for autonomy and independence by Catalonia and Scotland haven't posed a significant risk for further European disintegration, at least for now.
- The spread of a disruptive anti-establishment political tide in Europe. The presidential election in France was won by Emmanuel Macron, an energetic reformist. Elections in Germany resulted in the probable continuation of Chancellor Angela Merkel’s steady governing. Together, these developments bring a considerably higher probability that a renewed France-Germany partnership at the core of the euro zone could achieve progress in strengthening the regional architecture, policy coordination and effectiveness.
- North Korea’s brazen threats turning into something a lot more disturbing. The rhetoric has continued but hasn't been followed by actions. To adapt the observation made by Republican Senator Richard Burr in a completely different context, North Koreans “always enjoy looking over the cliff. But seldom do [they] jump.” Moreover, thanks to renewed talks between North and South Korea, athletes from both countries will parade and, in some cases, compete on the same team at next month’s winter elections.
- The election of President Donald Trump leading to economic disruption and a market sell-off. Rather than undermine economic growth and job gains, the first year of the administration has seen a continuation and acceleration. And, after just a very few hours of nervousness, markets have been richly rewarded for betting early on deregulation and tax cuts, as well as the possibility of an infrastructure program.
- Tensions between Qatar and other members of the Gulf Cooperation Council, as well as Iran-Saudi Arabia competition for regional influence, turning into broader regional shocks. The tensions exist, including via proxy wars in Syria and Yemen, but there has been no big regional flare-up or conflict.
In sum, these developments haven't derailed global growth and corporate profits, neither individually nor collectively. Instead, investors and traders have been validated, confounding the predictions of many political scientists who have many more years of study and experience of politics and geopolitics.
Some may be tempted to argue that pure luck could have played a role in the good market outcome. But there are too many incidents for this to be a compelling explanation. Indeed, a better one may lie in a combination of the following:
Markets' narrower focus: Unlike political scientists, markets focus on what disrupts a handful of specified risk factors, and do so with a considerably shorter time horizon. They also deal with what can be reasonably priced, leaving other issues -- such as the probability of whether an irrational North Korea will decide to translate nuclear threats into action -- mostly to the side.
Neighborhood effects: Investors have taken considerable comfort from a generally supportive economic and market environment that includes an encouraging synchronized pick-up in global growth, improved prospects for additional pro-growth policies, ample liquidity and high risk tolerance. With these factors in play, it takes a big shock, or a rapid accumulation of small ones, to dislodge market sentiment.
Backstop: The markets’ willingness and ability to look beyond immediate threats have been bolstered by the perception of considerable funding assurances from two sources. First, from central banks through the recent (repeated) history of comforting policy guidance and large-scale asset purchase programs that have turned these institutions into BFFs for many investors. Second, from cash-rich corporate balance sheets that encourage stock buybacks and higher dividend payments.
Political scientists can rest easier in the knowledge that markets don’t necessarily know their business better, but -- rather -- benefit from a combination of a narrower focus, a favorable context and a deep belief in a strong backstop. Political scientists should take these factors more into account when seeking to translate their political/geopolitical insights into market calls. Meanwhile, rather than completely dismiss what these experts have to say, investors should realize that it’s a question of a balance, which could evolve over time.
I experienced that latter directly almost 20 years ago when I transitioned from a policy/economic analysis role at the International Monetary Fund in Washington to a more market-oriented one, initially at Salmon Smith Barney in London. There were days when my astute colleagues trading the various markets would be keen to hear from me, betting that my insights would play out in price action. But there were also days when they would ask me to “come back later,” betting that whatever I had to say would simply be overwhelmed by market technicals.
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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