Fundamental Force


(Photo: NN Investment Partners)

The emotions of markets have created an interesting spectacle in recent weeks. The impressive moves in equity space and record jumps in volatility were yet another expression of the fact that markets will always have mysterious features that are very hard to fully understand. Such episodes of misbehaviour have always been around and help us all to stay humble.

Still they should not stop us in our everlasting effort to diagnose what happens, and to learn and adapt when needed. In this case the diagnosis of a more emotional and/or technical nature of the correction was a reason to stay calm and adapt towards adding rather than reducing risk.

A key factor behind the willingness to stay open to risky assets is that the most fundamental forces that also drive markets remain supportive. Important to mention here is that this not so much stems from the fact that the global economy is in its best state in more than a decade. Yes, it helps. But markets have understood that very well by now and largely priced that new, constructive reality.

However, being the complex system that they are, markets are less driven by a gravitational force towards an equilibrium that is determined by the state of underlying fundamentals. With the inherent uncertainty in a complex system like our economy, it is close to impossible to determine what the end state will be. It is much more informative to assess in what direction the current journey is heading. Therefore, it is much more the direction of change in the new information about the underlying economy that causes that market to re-assess on which path the economic system is travelling.

Economic data surprises   

Source: Thomson Reuters Datastream, NN Investment Partners

The good news is that not only the state of the economy is solid, but it still seems to be improving for the better. Global economic data continue to surprise on the upside (see graph above), the earnings season was pretty impressive and corporate analysts continue to upgrade their expectations about future earnings growth in almost all regions. This week’s flash PMIs could always be the start of a different direction (they disappointed modestly to very high expectations), but can just as easily be more noise in the data rather than the start of new direction. Monitoring all the evidence in a sharp, fast and balanced way is how we digest all information, both fundamental and behavioural. And for now the fundamental side of the equation still sends a forceful message of strength and ongoing change for the better.

Part of that constructive story is what is happening on the inflation front. Fears of an undesirable acceleration in inflation and subsequent response from central banks might have been a trigger for the dramatic change in investor behaviour two weeks ago; it was not a credible fundamental explanation for a sudden derating in equity markets.


Short-term inflation trends in developed markets


Source: Thomson Reuters Datastream, NN Investment Partners

Actually, when looking at the underlying, more short-term trends in either inflation (see graph above) or wages it is hard to argue that something problematic is happening. Compared to the summer of last year, the surprising downward trends that occurred in H1’17 have reversed and core inflation metrics have rebounded to levels seen in 2016. Moreover, these levels are close to, but below 2% in both the US and Europe and actually a support factor for somewhat more healthy nominal growth levels going forward. Especially for risky or growth-oriented asset classes this is positive news as in the end they are all a (discounted) claim of future nominal cash flows. The stronger future nominal growth in income and earnings in the economy is, the more support there is for the price of these assets today. Only when supply side bottlenecks or uncontrollable expectations about future inflation start to create a risk of a strong central bank response, followed by a combination of weaker real growth and higher inflation (a recession or stagflation period) will the fundamental support for growth assets structurally disappear. A very serious risk to monitor closely, but on our inflation radar not yet a high-probability risk, given the actual evidence in labour and product markets.

Obviously, when we look through all the data noise and observe that the underlying reality about either investor behaviour or the direction of the economy is changing, we will adapt. The willingness to stay open-minded in thinking about the world and to keep flexibility to respond is of fundamental value to our investment approach. When such a moment will arrive we can never predict in advance, but we can promise to change our minds when the facts change. At this point, however, the fundamental reality keeps us tilted towards assets that benefit from a further strengthening in global growth.


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