Friday, August 13, 2010

Deciphering Today’s Violent Market Moves

Mohamed El-Erian
CEO and co-CIO

Why such a sharp sell-off in equities on Wednesday, together with a further rally in U.S. government bonds? I suspect that three U.S.-related drivers are part of the answer – one is obvious, and two, less so.

Tuesday’s FOMC statement confirmed what the high frequency partial data have been signaling for a few weeks now: the U.S. economic recovery has lost momentum. And Wednesday’s export numbers amplified the message given by recent employment, housing and retail sale reports.

Analysts are now downgrading their projections for Q3 (and 2010) growth, again and rightly so. Goldman and a couple of other banks did so a few days ago; others are following. This translates into lower top revenue growth for companies, and less rosy earning expectations. Of course, equity prices do not like this. Cisco’s numbers tonight will not help.

I would suggest that there are two other, less obvious factors:

As Rich Clarida and I recently argued in the FT, sharp risk-on/risk-off swings in markets are to be expected given the reality of today’s macro context.

A couple of weeks ago, Fed chairman Ben Bernanke called the outlook “unusually uncertain“. We went further, arguing that expectations of outcomes have evolved in an interesting manner – from the more familiar bell curve (a dominant mean and thin tails) to a much flatter distribution with fatter tails. In such an expectation world, short-term news can have a disproportionate impact on market valuations.

Perceptions of fatter tails – just witness the increasing talk of a double dip and deflation – also speak to the third factor behind Wednesday’s violent market moves: when you are potentially on the road to deflation, a small change in probability will have an amplified impact on markets.

Deflation traps are nasty. Once you are in one, it is really hard to get out. Policy effectiveness erodes very quickly; and the nasty politics of deflation further complicates the kind of effort required to get out of the traps. Just witness Japan.

So while deflation may still be the risk (rather than baseline) scenario for the U.S., a rise in its probability can cause quite an impact on markets.

Most likely, markets will remain nervous and volatile in the weeks ahead. We should expect further downward revisions in analysts’ growth, revenue and earning projections. It will take time for markets to adjust to the reality of a flatter expectation distribution and fatter tail. And the probability of deflation (which I have put at 25 per cent) will have an impact even though it’s not dominant.

And if you are still wondering on this last issue, ask yourself the following question: would you accept a lift from a person who has a one-in-four chance of getting into a really bad car accident?

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