- Stocks have started 2023 with a strong rally, but there are four big headwinds, Mohamed El-Erian warned.
- The top economist pointed to pressures stemming from China's reopening, depleted savings, sticky inflation, and the Fed's rate outlook.
Stocks have started off 2023 with a "breathtaking" rally, but that could be disrupted by a handful of headwinds still facing the market, according to top economist Mohamed El-Erian.
"Financial markets have started the new year in a buoyant mood, bolstered by an elusive alignment of stronger global growth prospects, falling inflation, and less hawkish central banks," El-Erian said in an op-ed for Bloomberg on Tuesday, referring to the recent drop in US inflation. Prices cooled to 6.5% in December, prompting expectations for the Federal Reserve to ease up on its rate hike policy.
The central bank already raised interest rates 425-basis-points last year to battle rising inflation, a move that weighed heavily on stocks and contributed to a 20% drop in the S&P 500. Markets are now expecting the Fed to tack on another 25-basis-points in February, another step down from the aggressive moves it made throughout 2022.
The prospect of softer rate hikes—and possibly rate cuts in 2023—have sparked an impressive rally, with the S&P 500 gaining 4% from the start of the year as investors ramp up their risk appetites and pour more money into the market.
But that upwards momentum isn't guaranteed, El-Erian warned, pointing to four major obstacles ahead that could set stocks up for more volatility.
1. China's reopening
While China's reopening could spur higher supply and demand, that growth could be threatened if there's an outbreak of COVID-19, El-Erian said. He warned that without widespread vaccinations, the death toll could be "significant," which could potentially weigh on markets.
"In addition to raising questions about the sustainability of the current policy approach, this also increases the risk of new mutations of the virus spreading from China," he said.
2. Depletion in US savings
Government aid doled out to households during the pandemic is largely gone, and many households are also strapped with higher debt. That could spell trouble for US growth, El-Erian warned, especially if strength in the labor market falters.
Fed officials have repeatedly pointed to the high job growth and low unemployment as reasons why the central bank needs to keep rates high. Officials currently expect unemployment to rise to 4.6% in 2023, more than a full percentage point increase from the current rate of 3.5%.
3. Inflation could be sticky at 4%
While inflation is coming down, prices could linger above the Fed's 2% target, El-Erian said, previously predicting that price growth would remain stuck around 4% as supply chain issues continue to rattle the economy.
The sources of inflation are still concerning, El-Erian said, as price pressures have shifted to the services sector of the economy, which is less reactive to Fed rate hikes.
El-Erian and other top economists have repeatedly warned of the dangers of 1970s-style stagflation, a scenario where prolonged inflation causes expectations of high prices to spiral out of hand. That could slam the economy with high unemployment, low growth, and a recession, he previously warned.
4. The Fed is still repairing its broken reputation and won't cut rates
Central bankers are still reeling from their mistake in 2021, when inflation was described as merely "transitory." That means the Fed will likely be hesitant to cut rates, despite investors' hopes that it could spur another stock rally.
"If central banks do indeed cut rates later this year, the driving force would be recession concerns, something that would also pressure households and corporates," El-Erian said. "I doubt that the Fed is as excited as markets are about this year's considerable loosening in financial conditions."
Recession fears are growing as signs of stress continue to show through the economy. Bank of America, Citibank, and JPMorgan are predicting a mild recession to hit the economy this year, though strategists say there's potential for a more severe downturn.