Commentary on Political Economy

Monday 16 August 2021

Why Only a Huge Shock Will Deter Risk-Taking Investors

Conditioned by the Fed and three new mantras, investors are anchored in the expectation of never-ending stock index records.

By Mohamed A. El-Erian

16 August 2021, 18:00 GMT+8

“Never fight the Fed,” is still working for the stock market.

“Never fight the Fed,” is still working for the stock market. Photographer: Michael Nagle/Bloomberg 

When I began to work directly in financial markets in 1998, after 15 years at the International Monetary Fund, I remember being particularly struck by the conviction my new colleagues had in two often-repeated mantras: “Never fight the Fed” and “the trend is your friend.”

Such deep-rooted conviction not only informed their views but also influenced their trading and longer-term portfolio positioning. That conviction has not diminished in any way since then. Indeed, it is strongly in play now and has given birth to three other mantras that now roll off the lips of market participants just as easily as the other two.

Investors have been richly rewarded for adhering to the two long-standing mantras. Stocks, as measured by the S&P 500 index, have registered 48 highs this year alone as the Federal Reserve has remained extremely supportive of asset prices. It has maintained emergency-level measures — including $120 billion of monthly asset prices — despite the receding of the worst of the Covid-related economic and financial fallout and mounting concerns about excessive financial risk-taking.

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The power of this market conditioning is not new. Excluding a few blips, including in March last year, they have been in play and building ever more momentum since the global financial crisis. Indeed, stocks have generally done extremely well during this time, and unsurprisingly so.

The Fed’s continued strong repression of bond yields, both directly and indirectly, has done more than push investors to take more risk elsewhere in search of higher returns. It has fueled the other three mantras I mentioned earlier: TINA (“there is no alternative” to risks assets); FOMO (“fear of missing out”); and “buy the dip” in markets regardless of its cause.

The strength of this combined phenomenon was in clear evidence last week. The S&P registered four records despite headwinds to its three supportive macro themes: high and durable growth; transitory inflation; and a Fed that will continue to surprise on the dovish side.

Global economic activity is facing new Covid-related challenges as the delta variant drives infections and hospitalizations higher in more countries. The risk to demand was highlighted on Friday by the sharp drop in U.S. consumer sentiment as reported by the University of Michigan. This came ahead of next month’s scheduled removal of the incremental unemployment insurance benefits that have helped boost household income and savings.

There is also a renewed Covid-related risk to supply as more global supply chains become disrupted along with transportation. Such disruptions add to concerns about inflation in the pipeline, an issue highlighted by Thursday’s considerably hotter-than-expected producer price index numbers, dampening the relief that came with the previous day’s consumer price index report, which showed inflation not accelerating from already elevated levels.

In addition to such growth and inflation headwinds, more Fed officials signaled last week their greater inclination to begin an earlier taper of monthly asset purchases. This risks leaving the most important voices in the Fed — Powell, Vice Chair Richard Clarida and New York Fed President John Williams — more isolated, highlighting the challenges facing FOMC unity.

Yet none of this got in the way of those four S&P records last week, something that won’t surprise most behavioral scientists.

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Given the deep conditioning of markets, and its positive reinforcement by financial rewards, a huge shock to market psychology — such as a serious policy mistake, a big market accident or a combination of both – would be needed to shake investors out of a mindset that has served them incredibly well so far. It is a mindset that is immune to lots of bad news. Indeed, it allows for the immediate reframing of such bad news into good news — for example, the greater the headwinds to the economy, the higher the likelihood of another round of stimulus measures from the Fed. No wonder skeptics, particularly in the hedge fund space, have lost the appetite to challenge ever rising markets.

Investors are not alone in embracing a one-sided approach. Officially, the Fed appears to continue to think too little about two-sided distributions of potential outcomes and the related need to consider insurance for both tails of this distribution.

Looking at recent developments and prospects, many economists tend to caution about the wide range of possible outcomes. That’s not where investors are. Anchored by two long-standing mantras, and their three more recent derivatives, they are strongly inclined to stretch even more for high returns, continuing to position their portfolios for much more than 48 records in 2021. 

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