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Is the market wearing rose-tinted glasses?

As this first quarter ends, spring has arrived in Jersey, with blue skies, warmer temperatures and gardens bursting into life. Notwithstanding the warnings about climate change, it is very human-like for us to be optimistic about the summer ahead. This is because our brains have a built-in optimism bias. It is why we believe we will live longer than the average, our children will be more intelligent than most and we will be more successful than our peers. But, by definition, we cannot all be above average.

Most of us go through life with a selective ear for the news we take in. We hear the good more than the bad, the flattering more than the insulting. Moreover, we update our beliefs in a way that reflects that bias. In the general population, it is estimated about 80% to 90% of us behave this way, leaning towards an optimistic view of life. We are less anxious about the likelihood of unpleasant events: cancer, burglary, internet fraud, missing a flight, divorce etc. There is, however, a cost to this rose-tinted view of the world. To ignore bad news can be dangerous. It can make us overconfident, perhaps even reckless. It might leave us unprepared for a natural disaster, naive to the dangers of contracting disease, or oblivious to the warning signs of financial problems ahead.

Can we control our optimism bias?

Researchers have found that reducing or eliminating the bias is incredibly difficult, with attempts leading to little change and, in some instances, actually increasing the bias. However, scientists at University College London have discovered people who are stressed or anxious are better than more relaxed individuals at incorporating bad news into their existing beliefs, while still responding normally to good news.

In their experiment, half of the 35 participants were told, at the start, that they would need to deliver a speech on a surprise topic in front of a panel of judges after completing a task – something that would elevate the stress levels of most of us! The other half were told they would complete an easy writing assignment at the end of the study. For the task, the participants were asked to estimate the risk level of various threatening life events, such as being a victim of domestic burglary or credit card fraud. They were then told the real risk – either good news or bad news depending on how it compared to their estimate. Later on, they were asked to provide new estimates of what they thought the risks would be for themselves.

As expected, the participants who were not stressed internalised the good news better than the bad. Researchers found these participants continued to underestimate some risks even when being told the threatening event was more likely than they thought. The opposite applied to those who were stressed or anxious.

The researchers believe their findings help explain how people benefit from a generally optimistic way of processing information. Under threat, a stress reaction is triggered which increases our ability to learn about hazards; this being a good thing. In contrast, in a safe environment, it is biologically wasteful to be on high alert constantly, leading to the conclusion a certain amount of ignorance helps to keep our minds at ease.

Why write about this now?

Our October 2013 VFTD was titled ‘The optimist sees the doughnut; the pessimist sees the hole’. Based on our findings above, it would seem the majority of us spend our time in the doughnut camp. In the investment world, we suspect the ratio is dictated by the asset class being managed; equities is a business typically run by people constantly optimistic; bondies tend to temper their enthusiasm, constantly looking for what might go wrong.

Interpreting market news flow and distinguishing the good from the bad is part of our everyday. Recently, it has been very interesting to contrast the reaction of financial markets to announcements by the Fed in Q4, 2018 and Q1, 2019. We will all remember the Fed raising rates in December last year, in the teeth of a sharp market correction. It was the fourth rate rise of the year and the accompanying message was to expect two more through 2019. A rally in late December, was further boosted by a significantly more dovish Fed following their January meeting and Q1 has continued to be a strong positive quarter for risk assets.

Many would have expected this optimism to continue, post the March Fed announcement, when it indicated no more rate hikes this year and also advised it would complete its balance sheet roll-off program at the end of September; 3 months earlier than scheduled. Surely, this was good news and reasons for optimism? This is not how bond markets interpreted it. Post this announcement, the ‘real’ yield on the US 10 year Treasury (UST) Note has fallen to just 0.56%, a level not even reached during any part of the 2008/2009 Global Financial Crisis. Equity markets wobbled for a couple of days, but they are not signaling anything like a recessionary environment.

It is not just the US markets sending contradictory signals – falling yields are a global phenomenon. Today, there are circa US$10 trillion equivalent of government bonds trading with a negative yield. Last week, Germany auctioned 10 year bonds at a yield of -0.05%. Investors who bought these and hold them to maturity are guaranteed to sustain a loss.

Which asset class is right? Or based on our introduction, which market participants’ are too relaxed and which too anxious? Are some assessing the economy through rose tinted spectacles?

Current market behaviour tells us two things:

  1. The global economy has an interest rate ceiling which has likely been reached.  There is simply too much debt out there; as a share of GDP, it is now three times what is was in 2000. There are two debt pools which have risen significantly. The first is US corporate debt, leaving the borrowers disproportionately vulnerable to even the smallest rise in servicing costs. The second is China – across both the financial sector and state-owned-enterprises (SOEs) – where the debt binge continues. Moreover, in complete contrast to 2008/2009, Chinese households are today even more levered than their US counterparts.
  2. We have entered a period of fiscal indiscipline. Many governments around the world are ratcheting up spending to try and keep their populations happy. Fiscal deficits as a share of GDP are rising – about 3% – reversing all the good work of the last few years. Rising government spending means more debt is being issued, leading us in a vicious circle back to point 1.

Implications for markets and portfolios?

Twice during the day we penned this VFTD, two seasoned and respected investors forecast that the nominal yield on the 10 year UST Note will be revisiting the cycle lows of 1.3%, very possibly in 2019; this after the yield has already collapsed 100bp from last year’s peak. If this were to happen with the next 12 months, then the total net return will be roughly 15%. Perhaps this is reason for optimism and explains what is meant when they say bonds have more fun?!

With $9 trillion of debt, US corporates are understandably raining back investment in order to reduce leverage and try to protect their credit rating. However, this may be too little too late and it seems inevitable that defaults and downgrades will accelerate from here (see chart below).

Credit agencies are reportedly already under pressure not to cut ratings; although many BBB companies should already be classified as high yield, based on their leverage ratios. In the past 10 years, the BBB bond market has exploded from $686 billion to $2.5 trillion, an all-time high. In other words, 50% of the investment-grade bond market now sits on the lowest rung of the investment-grade ladder. Consider the implications if just a third of these issues became fallen angels – this would swamp the high yield market, which is currently “just” $1trillion in size. The economic fallout would be significant, hurting jobs, growth and earnings – not good news for the equity market.

For portfolios this means acknowledging we are late cycle and paying particular attention to asset allocation, ensuring those traditional hedges – duration and gold – are firmly in view. In equities, we need to be tilted towards regions, styles and sectors better insulated from slowing growth. In credit markets, following the recent rally, the risk reward is now fading. As a team, we are all for leaning towards the optimistic view of life, however, as portfolio managers it would seem prudent that, despite the spring sunshine, we should not be wearing rose-tinted glasses.

Julia Warrander and Russell Waite

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