Markets 'completely ignored' Powell's balanced inflation remarks and are not pricing in key risks, Mohamed El-Erian says

• Markets are dismissing inflation risks after Powell signaled rate hikes may slow, Mohamed El-Erian said.
• But inflation is likely to stay sticky next year, and there are still credit and earnings risks for stocks.

The rally in stocks shows that markets "completely ignored" some of Powell's remarks on inflation, according to top economist Mohamed El-Erian, who warned that investors may not be pricing key risks into the market.

"The market did not hear his balanced remarks. And they were balanced," El-Erian said in an interview with CNBC on Thursday, referring to Powell's speech at the Brookings Institution a day earlier, where he signaled that the Fed could slow the pace of rates hikes as soon as this month. Officials are likely to deliver a 50 basis-point hike in December and potentially pause rate hikes in early 2023, according to a number of Wall Street forecasts.

Powell's comments sparked a strong rally in stocks, with the Nasdaq Composite gaining 4% on Wednesday afternoon. But El-Erian, who has been critical of premature stock market rallies in the past, said that Powell's comments may have given the market a "major, terrible charge," as it could lead investors to ignore key risks to stocks.

For one, while inflation i on the downtrend, it could remain sticky at 4% next year, due to ongoing supply-chain issues and changing globalization dynamics. Investors aren't pricing in that possibility, as well as possible headwinds from credit and corporate earnings.

"So the marketplace is saying inflation risks are over. The market isn't focusing yet on credit and earnings risk, and that's because … there's no sign of a recession," El-Erian added.

His worries have been reverberated by other market commentators. Morgan Stanley's top stock market forecaster Mike Wilson warned that stocks could fall 26% to 3000 in the first half of 2023, as earnings expectations were still 20% too high. DataTrek warned of an even steeper 29% drop if an earnings recession takes hold of the market.

While a recession is still avoidable and may not be as severe as 2008, the risks of a downturn are still "uncomfortably high" in the US, El-Erian said, and there's still a chance a downturn could be painful. If the US does tip into recession, the Fed is unlikely to bolster the economy with more liquidity out of fear of reigniting inflation.

He urged investors to avoid assuming that an incoming downturn would be short and shallow. That could be similar to the mistake Fed officials made in 2021, when central bankers dismissed rising prices as "transitory" before it spiked to 40-year highs.

"Don't fall into the trap of saying, 'it will be short and shallow.' Because if we do fall into a recession, there is a high risk it will not be short and shallow. So keep an open mind, and let's not repeat the mistake of last year, when we all embraced transitory inflation," El-Erian said.