The last few months have been painful for investors with a range of equity indices crossing the emotive, but entirely arbitrary threshold that demarcates a “bear market”. At the same time, the narrative around the fundamental outlook has changed. Bearish views have proliferated and commentators espousing them received more airtime. But to what extent is this really warranted? Have markets been responding to this change in outlook, or has the outlook itself responded to markets?
From July 2015 to February 2016, Bloomberg’s median surveyed forecast for 2016 US GDP growth dropped by 0.4%. This may not sound like a drastic shift, but the distribution of forecasts is more telling. As recently as November, 77% of forecasters expected growth to exceed 2.5%. By February this stood at 14%.
As the selloff continued into 2016 and the sense of distress intensified, it feels like a US recession has become part of investors’ probability distributions in a much more meaningful way.
We highlight here how recession fears seem overdone and I don’t want to rehash those arguments in this piece. My point instead is on how quickly and easily beliefs shifted. The narrative has changed from ongoing recovery to genuine concern (sometimes panic) in a matter of months and perceptions of risk have skewed to the downside.
For our investment approach, the distribution of beliefs is often more important than the point forecast itself. We do not think that we can know better than everyone else what US GDP will actually be, but if we can observe others being overconfident – either positively, or negatively – then we might be able to say something about the chances of a surprise. Identifying biases in consensus views can provide investment opportunity.
These biases can take different forms. Sometimes forecasters allow the short term to have too much of an impact on their longer term views, more commonly they will exhibit anchoring in the face of persistent contradictory evidence. For example, investors and economists have taken a long time to alter their inflation expectations downward despite repeated lower than expected outcomes in the decades since the 1980s. A multi-decade opportunity in bonds existed, should this have been identified.
It is possible that we could be seeing something similar in China today. Expectations for growth have been disappointed each year since 2012 and yet forecasters have consistently predicted higher growth for the following year. Only in the latest 2017 numbers do we see a sign that the balance may have shifted away from optimism.
Rapid, meaningful shifts in expectations of this type are worth considering and I think behavioural biases are evident today. The perception of risk has increased due to asset price declines. Newsflow is selectively interpreted due to this negativity and a desire to rationalise the short-term price action. Commentators have fixated on stories like China, while we hear little about the general robustness of the US and European economies. Positive developments are overlooked, with negatives seized upon as confirming the new, bleaker picture.
It’s certainly plausible that the risks to US and global growth have increased over the past few months. But when objectively assessed it’s difficult to justify the extent of the narrative shift and capitulation in beliefs. Ill-considered and emotional changes in the perceived set of odds can indicate the direction of likely surprises. This is a potential opportunity.