Tuesday 21 March 2017
Animal spirits or a biased leap in assumptions?
Tuesday 21 March 2017
A feeling of 'some things just don’t change' regarding current market sentiment was discussed at our first Macquarie Fixed Income and Currency team Strategic Forum for 2017. The willingness for consensus to run away with otherwise unrealistic scenarios, like the call of 'higher yields', and the regular start of year belief in the return to normal, despite the overwhelming evidence that this has been and will be challenging.
Are we seeing the same from markets in 2017? Is it just another leap in assumptions, like so many leaps in the last 8 or so years. Or, is the cyclical uptick and new U.S. administration really going to make this year different?
The lure of the crowd and animal spirits is strong, but the evidence might suggest otherwise.
Setting the scene
During 2016, our views, broadly described as the central bank 'contained environment' and the resultant insatiable chase for yield, panned out better than we expected. Albeit not perfectly - yes, we thought the US election could go the way it did, but we did not anticipate the overwhelmingly positive market response. Fortunately, we were nimble enough with interest rate positioning to allow our overweight credit positions to more than compensate and steer our portfolios to solid outcomes.
Like 2016, so far we've fared well in early 2017. The cyclical uptick that began around this time last year continues to benefit from the sentiment boost associated with the perceived 'pro-business' new US administration.
Reflecting further on the recent boost to this cyclical uptick, we believe it has been driven mainly by two assumptions:
1. US fiscal policy (at last) is coming. Our thinking here is that big statements suggest it is, but the details are to this point lacking, and
2. That this form of stimulus (fiscal) will work. However, with other forms of stimulus before it having failed to deliver the economic growth and inflation that so many were confident would arrive, we prefer to remain sceptical.
Cyclical uptick, but structural challenges remain
In light of this, we find ourselves asking;
Why is the overwhelming evidence of demographics, debt, dependencies on low rates and central bank support, and risks to global trade and de-globalization – so easily swept aside in favour of unmeasurable, emotive, simplistic and volatile animal spirits?
It seems counter to logic that so many believe in the “bond yields higher” narrative, and yet so few rationalize that even if it were possible, this would be a poor outcome. We wonder why those who forecast higher yields do not also forecast the resultant lower asset prices that would most likely result.
Why do economists default back to this-is-a-normal-cycle analysis (when zero, even negative rates, and trillions of QE suggests it's anything but)?
Indeed, how could inflation live with such high levels of debt? That is a question we are constantly intrigued by. Can it be anything more than cyclical and how could it take hold without the debt burden, which depends so heavily on very low rates, snuffing it out?
Thinking in action
We lean significantly on a preference for evidence based analysis, while appreciating that markets can and will run on stories and animal spirits (however wild they may be). We often hear 'don't under estimate animal spirits!' although we rather prefer not to under estimate the evidence drawn from deep research and analysis.
Recently we have acknowledged that credit markets are now exhibiting limited further upside in terms of valuation and have commenced reducing our exposures to markets such as High Yield, and in bond markets are more disposed toward accumulating duration believing waiting for higher yields may require much more patience than many market participants anticipate.
We are encouraged by the strength of this cyclical uptick, although with market valuations already pricing a very robust outlook, prefer to seek detail and evidence that this cyclical upswing can endure amid the well-known structural challenges.
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