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El-Erian: Markets Are Sprinkled With Lots of Fairy Dust

“Financial markets sure did well in the first half of the year, despite an unexpected share of economic disappointments, policy misses and geopolitical drama. They will need better news in the next six months to sustain that performance, and if they succeed it is unlikely that they will repeat those same, broad-based gains.

At the start of the year, few expected the U.S. economy to shrink by a stunning 2.9 percent in the first quarter, Russia to annex Crimea, and Iraq to fall victim to a sectarian insurgency — all of which served to amplify the challenges facing already-weak economies.

More predictable was the series of policy slips such as disappointing progress on Japan’s “third arrow” reforms and a persistently unbalanced macroeconomic stance elsewhere that relied excessively and for too long on monetary tools alone.

Yet you would be hard pressed to point to many markets that suffered any meaningful consequences. Rather than sell off, global equities have gained, as have corporate bonds, commodities and emerging-markets securities.

Historically, such broad-based gains would suggest that the global economy is improving. Not this time. Instead, analysts spent much of the first half not only lowering their growth estimates for 2014 but scaling back their assessment of even longer-term growth for a number of countries — including the U.S.

The answer to this puzzle is found in yet another asset class that did well in the first half — government bonds,including those issued by Germany and the U.S., the benchmark risk-free assets. The fact that government bonds rallied in the first half of the year speaks to the continued influence that central-bank policy wields in financial markets.

Motivated both by long-standing concerns about sluggish growth and newer worries about price deflation, the European Central Bank joined others in committing to a more stimulative monetary policy over a longer period of time…..”

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