Mohamed El-Erian

Has the Stock Market Established a Bottom?

The Jan. 4 monster rally in risk assets, which saw major US stock indexes surge by 3 percent to 4 percent and the “risk-free” yield on 10-year US Treasuries rise by 11 basis points, was a stark illustration of the power of a favorable alignment of the trifecta of economic fundamentals, central bank liquidity and technical factors. Whether markets have reached the bottom of what has been a brutal few months for investors is, however, a much more complicated and uncertain question.

The strong employment data released early Jan. 4 ensured a solidly higher open for markets. Not only did the economy create 312,000 new jobs in December, or almost twice the rate of consensus expectations, but wage growth also picked up (to 3.2 percent annually), and revisions bolstered the October and November jobs tallies. Concerns that the latest report would push the Federal Reserve into a more hawkish policy stance were offset by another encouraging component in the monthly data: a rise in the participation rate (from 62.9 percent to 63.1 percent), which indicated there is a further element of slack in the labor market

Shortly after the open, markets got a big push from Fed Chair Jerome Powell. Countering earlier concerns about the central bank being too rigid in its policy and insufficiently sensitive to economic risks, Powell signaled at a meeting of the American Economics Association exactly what the markets wanted to hear: The Fed would be “patient,” he and his colleagues were monitoring a broad sets of risks, all policy instruments were available for use, and therefore the central bank wasn’t on “autopilot” when it comes to reducing its balance sheet.

The favorable effects on asset prices of this alignment of fundamentals and liquidity was amplified by the reversal of disruptive technical dynamics. Instead of amplifying the markets’ fall, algorithmic trading and pockets of patchy liquidity turbocharged the risk rally at the end of last week; and the wide use of exchange-traded funds and passive products ensured that the upswing was broadly based among different sectors of the marketplace.

Yet this break in what has been a volatile selloff does not guarantee that a bottom has been established, at least yet. The three factors governing markets remain fluid.

Fundamentals: The strong jobs report, as important as it is in terms of confirming the health of household consumption, is dominated by current and backward-looking metrics. It does not counter the more worrisome forward-looking indicators that appeared in the weak ISM manufacturing data released Jan. 3. Nor do the fundamentals contain much information about the risk of spillovers from economic weakness in Europe and China (the latter highlighted by Apple’s earnings warning earlier last week), spillbacks from the recent market volatility, the scope for pro-growth measures, and the potential resolution of trade tensions.

Liquidity: The Fed's more market-supportive comments do not change what has become a more difficult reality for central banks as they confront policy challenges that are largely outside their control and that have turned the institutions from effective suppressors of volatility to inadvertent enablers. Moreover, the challenges facing another systemically important monetary institution -- the European Central Bank -- are even more daunting given the region’s more difficult economic, financial and political environment.

Technicals: Although more favorable market technicals could buy time, especially as they are the most likely to pivot first in a more durable fashion, this is far from assured. Absent a more permanent alignment between fundamentals and liquidity, technical factors are likely to remain unstable and largely unpredictable, creating the possibility over the next few weeks that investors will still use rallies to sell rather than buy, which would solidify a bottom-formation process.

It was natural for investors to applaud the Jan. 4 economic and policy developments and the encouraging market rally that was breathtaking in its magnitude and broad reach. However, it is far from certain that the good news signals a decisive end to the unsettling downward-trending price volatility. Caution is still warranted.