Some surprises feel more surprising than others. When events have binary outcomes, like an election result, you can instantly and clearly compare what you believed beforehand to what actually happened. These are “shocks.”
When something changes over time on the other hand, like the oil price, the growth of an economy, or an interest rate, our beliefs evolve with it. As a result, we frequently forget just how surprising the final outcome is relative to our starting point. All the usual behavioural biases – hindsight, confirmation, myopia – come in to play.
This year is likely to be characterised as a year of surprises because there have been a number of shocks. However, while investors need to worry about these, it is often the latter form of surprise that is more important to returns.
Here are a couple examples of huge surprises this year that are less salient but have been just as important as Brexit, Trump et al. to an investor’s returns this year. The chart below shows implied interest rate expectations in the US roughly twelve months ago.
At the start of 2016, the view was that by 2020 the Fed Funds rate would be somewhere near 1.4%. The Fed had just tightened but growth was expected to remain low, largely due to international headwinds.
By the middle of the year however, this had changed dramatically. In January and February of 2016, much of the talk was of an imminent global recession based largely on the effects of the oil price. The asset price response and media coverage was brutal.
By June, futures implied that the Fed Funds rate was expected to stay as low as 0.6% until 2020.
Six months later and rates are already higher than that. Meanwhile the US equity market continues to make all-time highs. The shift over twelve months from calls to “sell everything” to debating the merits of the reflation trade is profound.
These have been huge shocks to the consensus: what many believed at the start of the year had been exploded by the summer, and then again by Christmas. However, they receive far less coverage because human psychology tends to be drawn more to “shock-type” surprises, and – through hindsight bias – to downplay evidence that we have been wrong.
(Un)surprising changes to what matters to investors
We are often surprised without knowing it, and this can be illustrated by looking back at how the topics of the day change over time. The chart below shows the most popular topics at the Financial Times Roundtable in December 2015; note the focus on growth, China, Oil, commodities, and Europe.
Fast forward one year and we can see how things have moved on. Note: Trump, Brexit, policy, and Trade. China is still an issue, but oil and commodities no longer feature.
We should be more surprised that what actually matters for markets is often very different from what we had expected. Moreover, these types of surprise happen every year, not just in 2016. Fortunately, this can create opportunities for investors, it is what we believe creates episodes in markets.
Generating returns out of “shocks” versus other surprises
Anyone who made money out of correctly guessing the results of 2016’s key surprises – the UK’s ‘Brexit’ vote, the US presidential election, the Italian referendum – probably did so by visiting their local bookmaker rather than in financial markets.
Even if we had known the outcomes in advance, price responses were not what may have been expected. For example, in the run-up to the US election most commentary suggested that a Clinton victory would lead to a “relief rally” in risk assets, while a Trump win would mean “risk off behaviour”. In fact, following Trump’s victory equities did well and government bonds were weak.
However, focusing on other less eye-catching potential surprises to the consensus can be more profitable. If one had observed that consensus beliefs in the middle of the year represented a huge shift in attitudes with little change in data one could have exploited the unwinding of equity and fixed income episodes over the rest of the year. When market pricing suggests overconfidence about the future, there can be attractive returns on offer.
The good thing about 2016 is that we have all been made aware of how surprising the world is. Investors should expect to be surprised, and take steps to guard against our own certainty. It is when the market is overconfident that investment opportunities arise.