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The one equation investors need to understand the world today

Atlantic piece has it at top as: 4 Global Transitions/4 Global Experiments = 1 Unusual Market

Confused about the markets? Don’t be. All you need is the above equation to understand the recent past, the present and what may lie ahead. Let me explain.

Five years after the financial crisis, the global economy is attempting four major, multi-year transitions. Each is consequential; and, together, they speak to historical re-alignments.

  1. The first transition is from assisted growth to genuine and more inclusive growth, especially in the West;
  2. Second, from central banks purchasing financial stability to economies developing more lasting structural stability;
  3. Third, from tired China-US relations and a financially-fragmented euro zone to new regional and global economic arrangements which re-align incentives or, at the very minimum, reduce current tensions; and
  4. Fourth, from increasing social inequality and political dysfunction to institutional, political and social renewal.

Each of these transitions is complex and uncertain. Put them together—as is the case today—and the result is, to use Chairman Ben Bernanke’s insightful formulation, “an unusually uncertain outlook.”

Clearly, there is a lot at stake for both current and future generations. So, given the material downside of failed transitions, governments and central banks are reluctant to leave the steering wheel to unfettered “market forces.”

Yet they lack immediate solutions. Even if they had them, their execution ability is far from perfect. They also lack proper tools, comprehensive historical frameworks, and trusted analytical models. Meanwhile, the advice they get from professional economists is all over the place. And, after the 2009 peak, global policy coordination has been reduced to ineffective summits and largely ignored communiques.

Accordingly, the world is engaged in four historic and unprecedented policy experiments:

  • China, where the new leadership is managing a shift from an increasingly less-potent mercantilist growth model to one based on internal demand, while seeking to deliver it while maintaining high growth rates;
  • Europe, where governments (with the help of the European Central Bank) are trying to complete an imperfect economic union in the midst of a recession, alarmingly high unemployment (especially among the young), analytical disagreements and political tensions;
  • Japan, where the new government of Prime Minister Abe has embarked on the country’s boldest post-war economic experiment, deploying the “three arrows” of highly unconventional monetary policy, aggressive fiscal expansion and (still to come) fundamental structural reforms; and
  • The United States, where the Federal Reserve is trying to deliver growth and jobs using partial and imperfect measures, and doing so without the proper support of other policy agencies that are paralyzed by Congressional dysfunction.

At the most fundamental level—and this is a critical point—the basic objective of these four experiments is to assist the economic and financial transitions by bringing to today the reality and the anticipation of tomorrow’s growth.

Realizing this, markets have aggressively front run tomorrow’s financial returns. Why? Because that is what markets always try to do. At times it works and at others it does not.

Given both the depth of the four transitions and the extent of policy experimentation, we should expect this configuration to create a large disconnect between prices and the underlying fundamentals—and it has.

So much for the past and present; how about the future?

The current disconnect is fine as long as two conditions are met: pragmatic policy experimentation continues for a while AND it succeeds. Then, and only then, would higher growth and stronger corporate top line revenue growth validate market prices and enable them to go higher.

The first condition is highly likely to be met. Lacking what they perceive as a better alternative, governments and central banks have no choice but to venture even deeper into unfamiliar policy territory, and to stay there for quite a while notwithstanding mounting costs and unintended consequences.

The second condition is much more uncertain. Success is needed at multiple levels. Internal and external coordination is far from easy. And the political system complicates rather than facilitates the process.

What should individual investors do? That depends on three key issues: how they assess the future convergence between currently-sluggish fundamentals and artificial pricing; existing portfolio positioning; and overall risk tolerance.

From those that have entrusted their pensions and investment to PIMCO, and having benefited from the considerable market rally, we believe that it is best to gradually reduce risk exposures over time; and to do so especially for companies and sovereigns that lack both solid balance sheets and exposure to solid growth.

This may not be the time to sprint away from risk. But it is the time to walk away, and do so in a measured and disciplined manner.

Mohamed A. El-Erian is CEO and co-chief investment officer of Pimco, the world’s largest bond investor, and author of When Markets Collide.

This originally appeared at The Atlantic. More from our sister site:

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