NN Investment Partners

Fear Fear Itself


(Photo: NN Investment Partners)

It’s funny how the mind works. First we fear secular stagnation, then we worry about central banks tightening policy. First we fear lack of productivity growth then we worry about job destruction from technological disruption. First we fear political shocks impacting markets then we worry about the lack of volatility in markets.

It is almost as if we always want to be worried about something. If the market is already in turmoil we always have illuminous benefit of hindsight to explain why this is. Even worse, the reasons used often help to build the fear that the problems will last.

On top of that, it now seems that calmness in markets also spooks people as it is perceived as complacency by investors. And obviously if risks are overlooked the likelihood of a problem around the corner is only rising. Although the latter is true if risk are overlooked, it seems equally feasible that there is still a lingering crisis-trauma in our minds that continuously asks ourselves why not to worry? And once we start looking, it’s not that hard to find a reason if both situation A (high volatility/lack of productivity growth) and the inverse of situation A (low volatility/technological “disruption”) are perceived to be justified reasons of concern.

The hot topic of the day is the record-low level of expected volatility in the US equity market as embedded in the option market (and expressed by the well-known VIX index). Meanwhile, also the expected volatility of the US bond market (Move index) has drifted to the lower end of the range seen over the last 3 decades. Obviously these are interesting observations, but before drawing conclusion from it for global investors, they need to be balanced with other metrics that describe investors’ risk appetite and behaviour. What stands out then is that the positioning of investors is still not very aggressive. Cash levels remain above long-term averages, exposure to both bond and equity risk in active investor portfolios not aggressive either, and the risk premiums that investors demand in capital markets are mostly at or above average. Global equities still offer a relatively attractive premium compared to government bonds, while bonds themselves roughly offer an average compensation for risk compared to cash. So neither of the core assets in financial markets seem to reflect complacency about the uncertainty that the future always offers to investors.   

Still, one could argue that not enough compensation is offered for the remarkably uncertain future of this time. And one could be proven right. However, it is actually much harder that it might look at first sight to prove this point on the back of the behaviour of the underlying economy or the policy and political backdrop. On many metrics the current economic and profit recovery is the strongest and most robust one we have seen in at least a decade. Moreover, the behaviour of the economy has been remarkably stable is recent years. Therefore, both the direction of change and the observed volatility in the underlying fundamentals give limited reason to the view that markets are mispricing fundamental risks.

On the policy and political front there is more than enough potential risk factors to point to - tax reform in the US, tightening of monetary policy, conflict in the Middle East or with North-Korea, just to name a few - but an honest perspective on the past learns that these types of risk are around most of the time. Brexit, the Euro crisis, the invasion of Crimea by Russia, the fiscal cliff in the US and the Lehman collapse are maybe most present in people’s minds. Also in previous decades similar events have either happened or came close enough to happening to spook investors. This does not prove that future policy or political events will not move the market down substantially, but it does suggest that the market is not more complacent than average about such probabilities.

As always it therefore remains crucial to stay on guard to quickly respond if needed to a shift in market behaviour, but it should also not be overlooked that there is actually a good reason not to worry too much. For investor there is an important cost to pay for worrying too much and it is called “opportunity loss”. Many of the reasons for caution available today have been available in recent years. Those investors that have been guided by fear over those years might not actually have lost money, but have certainly “lost” the opportunity to do substantially better for themselves or their clients.

In a world where investment returns are more difficult to find than ever, a lack of willingness to exploit opportunity accumulates to a bigger investment problem that most of the current fear factors can ever create on their own.

Also for investors it holds that the only thing to really fear is fear itself.

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