Balancing Behaviour

 (Photo : NN investment partners)

(Photo : NN investment partners)

Optimism is on the rise. And it is not hard to see why. The global economy hasn’t been better in more than a decade with growth more balanced and synchronized than seen in a long time. And inflation remains well-behaved, while policy and political risks seem lower than in recent years.

After a decade of depressed expectations that followed the credit crisis of 2008, it might still feel strange to some, but households, firms and investors seem to shaken-off their pessimism. Optimism amongst all of them has jumped recently to multi-year highs.

In a complex system, full of continuous feedback loops - like our global economy - this certainty bodes well for the near-term outlook. In our economic system broad-based upward trends in regional, sectoral and sentiment dynamics feed on themselves and create ongoing positive surprises and a higher than normal robustness in the business cycle. As a result, it is not surprising that expectations about economic and earnings growth are being upgraded by almost everybody. It also explains why many investors have a constructive stance on risky assets and positive return expectations for 2018.

It might not be a full-fledged Goldilocks environment yet (wage and productivity growth are too weak for that), but after all the economic and political traumas of the last decade it remains hard to escape the sense that it all is too good to be true. At least, it should never lead to complacency and therefore it seems wise to reflect a bit on risks that could be lurking around the corner of these great economic times.

Next to often discussed inflation, policy and political risks, it seems that also investor behaviour will need close monitoring in 2018. Solid economic outlook and rising optimism itself can actually be a potential source of market instability going forward. Not often have outlooks on the global economy and preferences of investors on where to place bets in financial markets been more concentrated than currently. Economists and strategists, both in the public and private sector, have a widely shared belief that we will see another strong growth year in 2018. And amongst investors, a remarkable consensus is found on how to allocate capital with equities, especially in cyclical regions (Europe, Japan, EM) and sectors (Banks, Tech, Industrials, etc), being by far the most popular and government bonds being very disliked.

The fundamental reasons for these views are very solid, but from a markets’ perspective this creates a more fragile backdrop. Even if the fundamentals are solid at some point the marginal buyer disappears if all active players in the market are already positioned for this fundamental strength (or risk, in the case of bonds). With many sentiment indices, technical metrics and positioning indicators at extremes, a modest shift in thinking or flow dynamics can easily create substantial downdrafts in the most liked parts of markets. Equally, short squeezes are more likely to pop up in bond markets with bond yields at the upper end of their recent trading ranges, extreme short positioning in futures markets and strong “underweight” positioning in bond portfolios. Whether it is inherent profit taking by some investors, a rare disappointment in economic data or a poorly phrased comment from central bankers that triggers such a reversal is impossible to know in advance. The only thing to “know” is that a higher level of fragility in markets can make the size of a market move that follows substantially larger than it would be otherwise.

It seems hard to see how such a market correction would really derail the underlying recovery, but the bout of volatility that follows can still impress many. Although probably a temporary phenomenon, the behavioural extremes that have become more visible in recent weeks have been a key motivation for us to tactically reduce both our positive stance on equities and our negative stance on bonds recently. Given that the fundamentals are what they are (strong!) the adjustments have not eliminated our risk-on stance. However, we choose to navigate with a less aggressive stance through the more fragile environment we observe today. Once investor sentiment and behaviour normalized again we might well look for new opportunities to add risk again.

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