Does this mean that there were no ‘episodes’ during the year? And does this lack of volatility mean that it was harder to generate returns through episodic investing?
As is often the case, it is necessary to look beyond US-centric market commentary; it would be wrong to say that there were no episodes in 2017. Moreover, episodic investing does not require short term volatility to generate returns. The below highlights a few of the shorter term episodes we saw in 2017, and how longer-term episodes can be major return generators.
In May, all Brazilian assets were hit by a corruption scandal involving President Michel Temer. The event was seen as significant for financial assets because it threatened labour and pension reforms which could improve the country’s fiscal position.
Episodes often involve markets focusing too much on the issue of the day, and ignoring the range of other factors that can drive markets. This appeared to be the case in Brazil.
The rapid decline in prices took place against a background of general strength in the global economy. At the same time, the very fact that prices were falling rapidly appeared to prevent investors from taking a longer term view. Ultimately, for those who were able to do so, this episode proved to be an opportunity for investors, and as we have noted previously, actually served to change the risk properties of Brazilian assets over subsequent months.
The Spanish market
While market responses to election results in the UK, France, and Germany were relatively muted, the Catalan independence vote has had a more lasting impact on asset prices. As we discussed in October, there hasn’t been the kind of contagion to other markets that tended to accompany European political events between 2011 and 2015. However, within Spain itself, there has been notable underperformance, as shown in the chart below by the equity market, which is down 9.6% since May.
As a result, Spanish equities market has gone from being on a similar valuation to the Italian market in the middle of the year to trading at a discount.
This divergence is not yet material, nor has it been accompanied by the type of rapid price action seen in Brazil. However, should trends persist a more meaningful opportunity could begin to emerge.
As an emerging market with a current account deficit, material pass through from currency weakness to domestic inflation, and relatively significant levels of US Dollar debt, Turkish assets have always seemed vulnerable to US policy tightening.
However, in 2017 there have been signs that more idiosyncratic drivers of return have begun to take hold. In November, there were sharp moves in Turkish bonds and the currency, with ten-year yields increasing by around 1% in a couple of weeks.
A combination of deep pessimism on the prospect for the Turkish economy, signs of unhelpful political intervention in economic policy, and knock-on effects of political developments in Saudi Arabia combined to paint a deeply negative picture for Turkish assets.
When such pessimism is combined with rapid price action it can be a sign of opportunity. As the chart above shows, Turkish bonds have recently recovered from the weakness of November, even as US short-rates have continued to rise.
Assessing whether price volatility represents an episodic investment opportunity is challenging at the best of times, when there is little clear sense of ‘fair value’ this is even harder. From an emotional standpoint, and looking at a price chart, Bitcoin bears all the hallmarks of a bubble.
Bitcoin looks and smells like an episode, but as I wrote recently, uncertainty about valuation means that it is any call in either direction is even more speculative than for other assets.
More compelling models of valuation are being created, including the use of ‘Metcalfe’s law’ to integrate network effects with supply and demand, but assessing how much demand is simply a function of prior price gains rather than a sustainable dynamic (or if this even matters) makes it very difficult to use these as assessments of future returns.
How do you generate returns when there are no episodes?
Although we often associate episodes with short term price volatility, the biggest opportunities created by human behaviour are longer term in nature. Major events can shape investor perceptions for years to come and create huge valuation signals which take just as long to unwind.
After the Asian crisis few wanted to touch certain areas of emerging markets irrespective of valuation or fundamentals. The tech bubble drove many developed markets to such expensive valuations that it would take years for them to recover. More recently, European peripheral bonds took years to decline from crisis levels.
We believe that the financial crisis has had a similar effect, with a preference for safety and aversion to volatility that has set up a major valuation anomaly between ‘riskier’ assets and the government bond market (and related fixed income assets). In the middle of 2016 Dave wrote about a pivotal moment, which suggested that this could be about to change, meaning a very different environment to that which we have been used to.
Backing such a theme, with an emphasis on long term valuation signals, still represents episodic investing even if shorter term volatility is less in evidence. In recent years, and particularly in 2017, there have been rewards to observing that this desire for safety was unlikely to be rewarded in the future. Now that the opportunity costs of avoiding risk are being felt, it remains to be seen whether the behaviourally-driven valuation misalignment between ‘safe’ and ‘risky’ assets will unwind even further.
* Although our definition of volatility might be revealing here. Average daily moves have been low, but we need to consider whether this is relevant. For those of a longer term disposition, a year in which many equity markets increase by 20% or more could be considered one of surprisingly significant variation.