PLACE FINANCIÈRE & MARCHÉS — Marchés financiers

NN Investment Partners

Value for money

 (Photo: NN Investment Partners)

(Photo: NN Investment Partners)

Not too much news on the state of global markets. Macro numbers remain strong, politics remain noisy and investor risk taking is building on the back of the equity market rally. Still, no broad-based signs of excessive optimism visible as fears over political shocks lingers.

Investor cash levels remain high and investor sentiment has come down from its elevated levels at the start of the year. That is not to say it’s easy to identify investment opportunities in markets. The balance between fundamental, political and behavioural factors is shifting continuously. Moreover, valuation metrics look confusing and some are wondering if a reflating world economy translates into a regime shift that makes investment tools less reliable in providing guidance for the rest of the year.

These days finding value for money in financial markets is somewhat similar to overcoming feelings of vertigo while walking on a very reliable suspended bridge over a spectacular canyon. The rational part of your mind might tell you that you can safely cross while enjoying the view, but your intuition will warn you for the unusual (and therefore threatening) environment around you. This is what many investors have experienced in recent years when looking for safety in their investment portfolios as interest rates on savings accounts and in bond markets dropped to unprecedented lows.

Short term interest rates have completely collapsed and this period even drifted into negative territory in Germany and Japan over the last two years. Having to pay for somebody else somebody else holding your cash does not (and will never) feel normal and distorts the mental picture on where investment value can still been found. With short term yields drifting to their extreme lows, it was not surprising that also longer term yields trended down and created a perception of poor value for money to many potential bond investors.

Again nothing surprising here because people’s expectations get anchored by both historical observations and theoretical dogma. Hardly anybody of the current generation of savers and investors (outside of Japan at least) has either experienced equally low levels of interest rates or was educated in economic or finance theory that explains the behaviour of global bond markets in recent years. With rational expectations (and behaviour) of agents in the economic system and fully competitive markets, interest rates were not supposed to fall below zero (because rational people would start hording cash) and markets were supposed to reflect the most likely nominal growth trends into bond prices more clearly.

With growth and inflation trends (summarized in nominal GDP growth) in both the US and Europe recovering from their Credit Crisis collapse in recent years, it is understandable that a classical analysis of bond markets is tilting many to the conviction that longer term interest rates “should” be more in the 2% - 4% range than some of the close-to-zero numbers that are still visible in Europe. Moreover, with US nominal GDP growth hoovering close to 4% for the last 5 years it is not difficult to see why some argue that US yields should be closer to (if not above) 4% than the current 2.5%.

The new reality is however that we have learned to take more into account than just future expectation of nominal growth trends to understand the behaviour of (bond) markets. Unconventional Central Bank policy (QE and negative interest rates most notably) are not effectively arbitraged away by “rational” market participants, savings desires of the private sector do not adhere to (rational) intertemporal optimization assumptions, regulatory incentives drive financial institutions (banks, pension funds, insurance companies) away from optimally diversifying their assets and persistent behavioural biases of investors create themes and price drifts that cannot be explained by classic economic or finance theory.  

So where does this leave us in thinking about markets, value and opportunity? At least with a conclusion that uncertainty is the only certainty and that betting big on Big Ideas on how the World should work is not an advisable strategy when taking decisions. Being open-minded, eager to learn and able to adapt is much more sensible.

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