Major US indexes witnessed a decline this week despite domestic data showing a firming-up of the economy as US markets are in the middle of a technical correction, said Mohamed El-Erian, chief economic advisor at Allianz and the former CEO at PIMCO.
Also, stock fundamentals are fairly weak compared to prices. Risky assets are likely to come under pressure, and markets are likely to see choppiness as liquidity continues to be tight. But the good news is that the correction is somewhat less disorderly than it has been before, he noted.
With the S&P 500 P/E ratio at 15, which is way below the index’s historical highs; and 10-year Treasury yields hovering around 2 percent, Wharton Professor Jeremy Siegel believes the market is going to recover by the year end.
Asked if agrees with him, Mohamed said professor’s Siegel’s observation about P/E ratio is debatable because different people measure it in different ways and it raises fundamental questions about economic outlook. However, the interesting development has been how quick people have been to call for another round of quantitative easing/QE4. That indicates the market’s rally is not driven by fundamentals but confidence in central banks.
There’s an assumption the central bank will remain the market’s best friend for ever, which is unrealistic. It’s interesting to note people that are forecasting a correction are implicitly assuming another round of assets purchase by the Fed. But the threshold for another round of QE remains much higher than most people realize, he explained.
The Fed is likely to announce the end of asset purchases this month. Asked to comment on this major event, Mohamed said Janet Yellen is likely to reassure investors about interest rates and tell the markets that rates will remain near zero for an extended period of time. The Fed is unlikely to comment on QE4 unless economic conditions deteriorate sharply. Still, talks of another round of quantitative easing will be a tall order, he argued.
Asked if low interest rate for an “extended period of time” means rate-hikes by the middle of next year is pretty much off the table, Mohamed answered in the negative. The US economy is not doing badly, and the labor market has improved quite a bit. Any rate movement will depend a lot on the underlying economic data. The central bank has to strike a fine balance and keep in mind the issue of financial stability while taking into consideration the evolving economic data, which is a delicate trade-off, he observed.
Economist Paul Krugman thinks both Europe and China are vulnerable and hence scary. Since the US economy is not de-linked from global developments, it remains fragile. Asked if he agreed with Krugman, Mohamed answered in affirmative.
With the exception of the US and the UK, the global economy is slowing, and a strong rebound looks unlikely in near future. Hence, no matter how fast the US economy heals, it’s likely to face headwinds from overseas, which in-turn will encourage the Fed to hold rates lower.
The markets have priced-in low interest rates though there’s a debate going on about how low the rates will be. That debate is likely to continue for some time, even within the Fed, he concluded.
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