An important element of our process is having a sense of the prevailing bias or consensus beliefs. That is particularly important when it results in crowding and when there might be unintended correlation in portfolio positions
An important element of our process is having a sense of the prevailing bias or consensus beliefs. That is particularly important when it results in crowding and when there might be unintended correlation in portfolio positions. Judging consensus beliefs is not an exact science. Positioning data can help. However, it is often the case that extremes in beliefs and positioning are accompanied by asymmetry in valuation. There are also cyclical (tactical) and secular considerations. The latter will clearly be a more persistent influence on asset class performance.
In the immediate aftermath of the 2008 crisis, an important behavioural effect on investors was “volatility aversion” or the desire for assets with perceived stability (low standard deviation) of cash flow and returns. That also likely contributed to a reduced investment horizon (or time frame) and the emergence of risk parity and volatility targeting strategies. Within equity it encouraged demand for companies with low volatility factor characteristics (less cyclical and often the opposite of the “value”). In a world where trend growth was perceived to be lower, it also encouraged demand for companies with strong secular growth. Those characteristics often overlapped with the “momentum” factor (the technology and communications sectors have often been a large weight or more than 40% of the momentum factor index in the United States).
There was also a correlated belief in the rates markets. Through the 2008 crisis and in the immediate aftermath, fixed income markets still expected that the Fed Funds rate would be positive in real terms. While the crisis caused a deep recession, the assumption was that rates could mean revert to pre-2008 levels. However, as Gerard Minack noted last week, the European crisis, double-dip contraction and the post 2012 weakness, forced markets to lower the decade-ahead outlook for rates. A negative real Fed funds rate has been persistently priced since 2011. By mid- 2016, the prevailing bias was that this was a permanent state. However, it was probably not until the pandemic that markets lowered the end-decade forecast for the Fed funds rate from lower-for-longer to lower-for-ever.
From a behavioural perspective, the correlated belief that rates are lower-for-ever has encouraged some extreme valuation anomalies and positioning in markets. The most notable is in assets with long duration, whether that is in fixed income or equity with cash flows a long way into the future (stocks based on hopes and dreams). It has also likely encouraged investors to take on short convex positions. That is, sell volatility in all its forms and allocate capital to “carry” related strategies in the credit and fixed income markets.
For investors that could prove a monumental mistake. It is plausible that the pandemic could mark a secular trend change. The pandemic was the catalyst for a shift to fiscal-led cycle management that could lead to higher through- the-cycle real interest rates. To be fair, some of my former colleagues at M&G in London argued that this process might have started in mid-2016 around UK Independence. However, just as the prior decade showed how long it took for permanently lower rates to be embedded in consensus beliefs, the end of lower-for-longer will not happen overnight.
Tactically, the Economist Cover this weekend suggests that there is elevated fear that shortages in the global supply chain will lead to more persistent inflation. Stated differently, the consensus belief has started to doubt the “transitory” thesis put forward by central banks and others. The big picture point for markets is that if inflation becomes more persistent that is likely to force a major change in markets everywhere. Most notably it will underline the point that fixed income provides as hedge for equity in recessions, not inflationary episodes.
Ordinarily, the Economist is an excellent contrarian indicator. Once the story or theme has made the front cover it is likely well appreciated and priced into positioning and sentiment. That might be true in segments of the energy markets. However, at the current level of real and nominal yields it is probably not priced into fixed income. Neither is it priced in the equity or volatility markets that could be most affected by persistent inflation and a sharply higher discount rate.
Tactically in the very short term, while the September employment data on Friday in the United States was disappointing at a headline level. Upward revisions to the prior months, lower unemployment and higher wages suggest that the Federal Reserve probably remains on target to commence normalisation away from emergency policy conditions in November (liquidity withdrawal and eventually higher rates next year). In a regional context we would also expect liquidity and growth conditions to improve again into year end. That probably sets up another phase of higher yields and outperformance of value and cyclical equity. If inflation becomes more persistent and there is a secular shift in rates next year that could prove disruptive for a number of correlated positions and lead to a phase of higher cross asset volatility. Where is the greatest volatility?: follow the leverage.
Disclaimer
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