It is quite staggering how much sentiment on the global economy can change. In the middle of 2016 asset prices suggested that we’d never see meaningful growth again, by the end of 2017 ‘synchronised expansion’ was the order of the day.
Today the prevailing argument is that the world is clearly slowing and that the removal of ‘excess liquidity’ (which seems to mean different things to different people) means prospective losses for all assets.
The question is whether it is these beliefs that are driving asset prices or the other way around? My sense is that prevailing market beliefs are driven by price action itself far more than many would like to admit.
Whether we want to believe it or not, the market is certainly making a call on the future, as opposed to what we are seeing in data today: most global growth metrics look relatively healthy but have clearly been slowing since the stellar levels of the start of this year.
However, in phases such as the current one it is tempting to ignore prevailing data and take our lead from what prices are doing. As I wrote in February 2016, it can be tempting to believe that ‘markets are telling us something’ (an interesting view, given that many active investors predicate their existence on a belief that the market makes systematic errors).
The problem is that letting prices lead us can mean constantly chasing the past, and being ‘whipsawed’ when the world changes.
This, probably more than anything else is what loses money for most investors and is arguably heightened by our emotions.
Fear impacts the way we make decisions and social dynamics (like markets) can spread and reinforce fear. These pressures are only compounded by our tendency to find pessimism more convincing than optimism and the scope for forced selling when infected by the volatility virus.
Arguably 2016 was the last time that markets were this fearful. In fact, despite the world being in a more secure place in terms of earnings and global growth today, some equity markets are now on cheaper valuations than they were then:
A shift in emotional dynamics
Such simplistic valuation assessments are not sufficient to understanding whether the market may be offering us an opportunity, it is also key to understand the nature of market behaviour. In this respect, the equity weakness of the last six months has been less suggestive of episodic investment opportunities. Price moves and de-rating have been gradual and differentiated across markets, suggested facts, rather than fear may be behind them.
Weakness in Asia and Europe and emerging market currency moves were relatively justified in the context of fundamentals and global rate moves, while the US had been immune due to the strength of earnings growth.
In the last month this has changed. Sparked by moves in US long rates, market declines have been both relatively correlated and rapid. Moreover, there are signs that it is price itself, rather than any ‘new news’ that is driving markets. Arguably, the fact that the US equity market has fallen in this phase explains why there is a greater sense of panic; in the Western world much market commentary is still very US-centric.
Correlation and diversification
While equity market weakness has been correlated, it is perhaps interesting to note that diversification has come from both expected and unexpected sources. Gilts and Bunds have rallied (modestly), but the currencies of Turkey, Brazil and Argentina have also delivered strong returns. This is, in our view, a reflection of our belief that episodes change the risk properties of assets.
The circularity of it all
It will be interesting to see whether the correlation patterns that we have been more used to assert themselves in this phase. On days of large equity falls, we have seen US Treasuries rally. Of course, there is a contradiction here, on a sustainable basis US rates cannot both pressure equity markets when they rise and rally on ‘safe haven’ effects when the stock market does fall.
Such inconsistencies can be resolved. Perhaps a recession is imminent and/or global markets are so expensive that they are set up to fall no matter what happens to rates (within reason). Trade wars and China slowdown still dominate many lists of investors’ biggest worries today and many view them as far more important than the path of US interest rates.
Many have made these arguments, and on weeks like this they seem more persuasive than they originally did. What is always important is that you are forming these views logically, and not based on what prices have just done to you.