Financial markets had a turbulent start to 2016. In the early weeks of the year there were steep declines in the prices of many equities and corporate bonds as concerns mounted over the significance and implications of falling commodity prices, especially for the financial system and the broader economy.
There were clear echoes of the trauma of 2008, and in combination with a move to negative official interest rates from a number of Central Banks, this dynamic was very supportive of government bonds, the “safety asset” of choice for many years now. Sovereign bond yields in the larger developed economies fell sharply and made new lows in many cases.
From mid-February there was a quite dramatic and equally surprising reversal of this price weakness in ‘riskier’ assets, with oil and resource assets leading the way and emerging market currencies appreciating. This was followed by a period of relative calm which RBA Governor Glenn Stevens referred to as having a certain ‘eeriness’ about it.
The calm felt fragile, because periods of turbulence such as that experienced at the start of the year can often have a persistent unsettling effect on market psychology. Many of the concerns that investors were focused on in the early part of the year were largely unresolved. At the same time there has been a growing sense that we have reached an ideological crossroads for policy in several key economies.
The uncertainty about which path will be taken and whether there is divergence in policy solutions between economies is damaging to market confidence. This has played a role in most of the recent phases of volatility and nervousness and it is likely that it will again in the period ahead.
Our thesis in the Episode team is that it is these emotional dynamics of the investing experience that lead to many of the wild movements seen in markets, and that shifts in how investors actually feel about taking risk can drive valuations to extreme levels.
So, if we are right about this, how would we assess the emotional make-up of investors today and what signals would we look at?
I wrote earlier this year of how conventional valuation signals are unusual and quite extreme, relative to longer run history or what we might expect. It suggests that within the investor community, there prevails a deep scepticism and pessimism about the durability of economic growth. In addition, investors continue to exhibit a myopic focus on the desire to avoid short-term loss with an intensity that did not exist in earlier decades.
These dynamics have intensified in the last twelve months as we have witnessed a capitulation on the idea that economies “will get out of the woods” and return to “normal” some time soon. In the period since 2009, this sub-conscious assumption that things would go back “to how they were before” underpinned investors’ forecasts. Importantly, “normal” meant the type of conditions that prevailed and “how things felt” prior to 2008. This persisted in spite of ongoing disappointment in certain economies, as markets assumed that the inevitable had merely been delayed and that the recovery process was just taking longer than usual.
By early 2015, however, this certainty of an eventual return to “normal” had shifted. Discussion of secular stagnation, the limits to the effectiveness of monetary policy and the burden of debt at the global level are a reflection of a gradual, or occasionally marked erosion in confidence about a return to higher levels of economic growth.
For many “normal” now meant a continuation of the recent weaker economic situation and trends. There is a suspicion that this might be “as good as it gets” – unless some more profound macro and microeconomic policy changes are forthcoming.
This deterioration and erosion in confidence in global economic growth can be seen in consensus forecasts. There has been a marked reduction in expectations for growth into the medium term over the last twelve months.
This extends to longer run expectations as well. There has been a significant decline in expectations for nominal GDP and this is significant for profits, interest rates and concerns over debt levels.
So where does all of this leave us as we assess the investment landscape and the outlook for returns from here?
Our assessment is that we have arrived at a pivotal and potentially critical moment in time, where a material change in investor thinking and behaviour is needed. The reality is that, with valuations at current levels, a continuation of existing attitudes and behaviour is highly likely to lead to disappointing and possibly very negative nominal and real returns.
The strategies that have been successful for the last decade are now priced to struggle. As ever, conclusions such as these, based on valuation signals as they are, do not tell us much about the immediate future. It is possible that current behaviours persist or even intensify, with valuations becoming even more extended. We have seen similar things before, where valuations become highly stretched and investors suspend all normal beliefs about the pricing of risk. Ultimately, though, gravity re-asserts itself and the results can be disastrous. We believe the time is near.