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Turbulence Ahead as U.S. Flies Solo

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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It is tempting to come up with complicated reasons for the unusual and outsize moves in financial markets in recent days, including a sharp appreciation of the dollar, large volatility in stocks and precipitous drops in European government bond yields.

Yet the simplest explanation may well be the best one: The U.S. jobs report Friday confirmed the multidimensional decoupling taking hold in the global economy. The resulting divergence in prospects for economic performance and monetary policy -- in the U.S. and across countries -- has consequences for prices in the bond, equity and foreign-exchange markets, both in relative and absolute terms.

QuickTake Monthly U.S. Jobs Report

Despite sluggish wage growth, the persistence of strong employment increases confirmed that the U.S. economic recovery continues to broaden and that it's highly probable the Federal Reserve will start an interest rate hiking cycle by, or at, its September policy meeting.

As a consequence, U.S. equity markets are no longer being powered by the twin engines of an improving economy and hyper-stimulus monetary policy. Instead, a tug of war is playing out between the influences of the economy's fundamentals and probable policy decisions. The result is higher price volatility as rather small changes to expectations -- in either direction -- result in large market moves.

The decoupling isn't limited to the U.S. economy. The report showing strong employment in February added to the international divergence. This is particularly true of the systemic differences between Europe and the U.S.

Both economic performance and the outlook for central bank policies reflect this growing divergence. In response, the euro has taken another notable leg downward, to levels last seen 12 years ago, spreading volatility to other currencies and beyond. The Mexican peso is at a record low versus the dollar and, in the case of Brazil, the disruptions to the marketplace are amplifying existing investor discomfort caused by less supportive economic policies.

Even the government bond markets in advanced countries aren't immune to the impact of divergence. As European yields are pushed lower by the European Central Bank’s large asset-purchase program, their U.S. counterparts are confronted by complicated competing forces. They are pressured downward by collapsing European rates, but they are also driven higher by the U.S.'s stronger economy and expected Fed rate increases.

It will take some time for all these forces to play out and be reconciled. The net economic consequences are two-fold, torn between assisting orderly global rebalancing and inducing what has been called “volatile volatility,” which undermines growth and heightens financial instability.

In the meantime, investors would be well advised to remember these five points:

  • With the U.S. as the only non-crisis country willing to tolerate the appreciation of its currency, there is little in the short-term that is likely to counter the relentless march of a stronger dollar. That means the euro won't be the only currency to experience a notable depreciation. This phenomenon will be widely shared across the foreign exchange markets.
  • The currency moves are likely to overshoot -- particularly when it comes to emerging markets -- going well beyond what is warranted by fundamentals. These excessive movements are likely to drag down other emerging market segments, such as local rates, to levels that will eventually offer compelling value for longer-term investors with an institutional appetite for volatility.
  • Despite the record levels in some maturities, short-term forces will continue to favor a widening yield differential between the U.S. and Germany. But there is an arbitragable limit to this gap, and we are getting closer to it.
  • Heightened equity market volatility accentuates the attractiveness of a stock-selection approach that emphasizes not just solid corporate fundamentals but also high cash generation. In the meantime, the generalized market beta trade -- investments that rely on the returns of the market as a whole -- will be challenged.
  • For those who insist on market beta, Europe offers more compelling valuations than the U.S., provided investors can hedge the currency risk in a cost-effective manner.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net