Excessive central bank support may create zombie markets disconnected from fundamentals: Mohamed El-Erian

Central banks can’t protect investors from default risk, says Allianz Chief Economic Advisor.

We have seen the markets see a marvellous turnaround; one that has left most people agape. How do you really rationalise the kind of spectacular move that we have seen recently?
It has been a remarkable recovery; one that has surprised many people and one that is really disconnected from realities about economic and corporate prospects. There are two reasons for that. One, the market has embraced the V-shaped recovery and is looking through the inevitable short-term difficulties facing both the economies and companies. But it has also stumbled into another very supportive narrative which is what I call the win-win. It does not matter if you are wrong on the V-shaped recovery because central banks and the Federal Reserve in particular have done things in scale and scope that were unthinkable including buying higher bonds. So the market has this win-win mentality and that has driven us much higher than anybody anticipated and decoupled us completely from the underlying fundamentals.

The markets are now pretty much holding the Fed hostage. Are we looking at much further longer term impact because at the moment markets are definitely on their own high?
Every time we get in some or other correction, it tends to be a sharp one which shows you there is really a very big gap between valuations and fundamentals. The Fed and most central banks do not want financial instability to cross contaminate the real economy. So they will do whatever it takes to try and regress financial volatility and they have done that. The market has been conditioned to expect that and when the market does not get what it requires, you get a sense that markets are holding the Fed, the ECB hostage.

It will take a major shock; either a policy mistake or a market accident like a capital impairment situation. One thing that central banks cannot have from investors is default risk. So be careful not and do not fall into the trap of the false because in that case your mistake is not recoverable.

Where do you feel the central bank has gone wrong? For the longest time there have been complaints they were not doing enough and now it that they are just doing too much?
Central banks have the flexibility to respond quickly but they respond quickly on the assumption that they will be able to hand off the policy burden to somebody else. The reality is that they have ended up carrying a heavier burden. I particularly disliked the Federal Reserve buying high yield bonds. By going too far, you risk three things. One you risk massive mole as if you are encouraging excessive risk taking and we have seen that not just on the investment side but we have seen a record issuance of not just investment grade bonds but high yield bonds. There has been a mole hazard element. So we have seen excessive risk taking which I worry about.

Secondly, by supporting markets in a way that is disconnected from fundamentals, you not only encourage zombie companies to eat away the viability and dynamism of an economy but also zombie markets that no longer price risk and that is an issue for the longer term. Finally, you encourage misallocation of resources. So I worry that what the markets are gaining now which is real and incredibly satisfying, which is very high returns, comes at the cost of future lower returns and more financial volatility. Excessive support from central banks may create zombie markets disconnected from fundamentals