EL-ERIAN: The ‘Bad News Is Good News’ Trade Has Limits

Picture: Reuters

With equity markets continuing to bet that bad economic news is in fact good news – a strategy that has worked very well in this period of hyper-active central banks – investors should also not lose sight of two important qualifications: valuations matter, as does the effectiveness of the ultimate policy-economic handoff.

Markets have rightly interpreted this morning’s disappointing growth data out of Europe as implying more dovish policies from the European Central Bank. And with the deeply embedded mantra that central banks are the markets’ best friend (and they certainly have been), European equity markets rallied on the poor economic data, providing a favorable context for the US market open.

This “bad news is good news” strategy has worked well given the commitment of central banks to use asset markets as a way of attaining their economic objectives. But there is a limit to how long it can be divorced from the question of the ultimate effectiveness of unconventional policies. And this issue becomes even more important as the gap between (high) valuations and (sluggish) fundamentals widens.

The strategy needs to be more than just a market bet on the journey. It also requires that the valuations of risk assets be eventually validated by the policy-induced destination. Yet, rather than converge towards such an outcome, the world is getting further away.

Mohamed A. El-Erian is the former CEO/co-CIO of PIMCO. He is Chief Economic Advisor at Allianz and member of its International Executive Committee, Chair of President Obama’s Global Development Council and author of the NYT/WSJ bestseller “When Markets Collide.”

Follow him on Twitter @elerianm