Originally published by Cuffelinks
Investor sentiment – the dominant feelings of participants inside investment markets – has a powerful influence on the prices at which shares, bonds and property are traded. But this sentiment is often wrong: recall the observation of Paul Samuelson, a famous and much-read US professor 50 years ago, that the US share market “has predicted nine of the preceding five recessions”.
It’s in the interest of investors to think about:
- the key features of prevailing sentiment
- whether those expectations are well-based
- whether sentiment is likely to change in the near future.
Here are two recent examples of how swings in investor sentiment had big effects on markets in 2016, and a thought on what the next big shift in expectations might be directed at.
Fears of a hard landing in the Chinese economy were overdone
In the early weeks of 2016, investor sentiment turned far too negative on China. Market commentary, along with the prices of shares, bonds, commodities and currencies, reflected a dire view of China’s economy. It was expected to soon fall into a deep recession and Chinese authorities would be powerless to avert the looming crisis. Most likely, it was thought, their policies, particularly regarding management of the renminbi, would worsen the situation.
The dominant investment position was to be short everything that could be affected by China’s hard landing – global shares, bulk commodities and Australian and ASEAN currencies. Little attention was paid to how ‘crowded’ those trades had become as so many large hedge funds had adopted positions that were in line with the prevailing sentiment.
The Chinese crisis turned out to be a false alarm, and an expensive one, especially for those who were late in taking positions in line with the prevailing market sentiment. Chinese growth slowed just a little, expectations of a recession abated and global shares recovered.
Brexit fears were also exaggerated
Another sharp change in investor sentiment followed the UK vote in late June to leave the European Union. The prevailing expectation, for a time, was that global growth would slump, shares would suffer sustained falls and the pound would take a battering.
While market positions were small when compared with the situation regarding China, expectations again turned gloomy. Sentiment soon focused, however, on how long disengagement from Europe would take, giving the UK economy time to adjust, and markets recognised the exaggeration.
Monthly statistics can mislead
A lesson for investors is don’t read too much into the monthly statistics such as the Purchasing Managers’ Index (PMI). The PMI is a measure of business conditions in a wide range of economies, both for each economy and for the main sectors of manufacturing and services. PMI data is based on monthly surveys of purchasing managers, who are asked if various aspects of their businesses are better or worse than they were a month earlier.
The problem investors face is in interpreting the summary results. Each month, the people who organise the survey deduct the percentage of ‘worse-than-expected’ results from 100; if the score is less than 50, the economy (or sector) is said to be ‘contracting’, whereas if the score is more than 50, the economy (or sector) is said to be ‘expanding’. Thus the Chinese economy was reported as contracting in the early part of 2016, and the same thing was reported for the UK economy in July. These assessments were the stuff of headlines and were given a lot of attention in broker and news reports. As Mark Tinker of AXA puts it:
“The mantra that a PMI above 50 means expansion and below 50 means contraction continues to be widely repeated and in my view is highly misleading. The PMI is a diffusion index and as such measures changes in expectations on a ‘compared to last month’ basis. Thus, above 50 means ‘better than last month’. If last month saw 7% growth (as it did in China) and this month’s reading is below 50, that does not mean growth will be negative. It means it is likely to be slower than 7%. Earlier this year, we saw headlines that ‘Chinese manufacturing is contracting’ when the PMI was below 50, yet it continued to grow, just at a slower pace. In truth it was because the market was looking for evidence to support its own (incorrect) pre-conception that China was in recession and as such it paid to be a contrarian.”
Monetary policy will not remain as friendly
For several years, the majority of investors have felt that interest rates will remain ‘lower for longer’ (in July and August the expectation seemed to shift to interest rates being ‘lower forever’). This view has been reinforced by the expectations that central banks would continue their accommodative policies and inflation would remain just about non-existent. The resulting hunt for yield has pushed shares and bonds much higher.
In my view, we’re now seeing the early signs of a major (and lasting) change in this sentiment, but there’s a lot at stake. As Allianz (DE:ALVG)'s Mohamed El-Erian observed recently, the extremely easy setting in monetary policy has “delivered to investors the dream team of high returns, low volatility and profitable correlations”.
There are four main reasons why monetary policies globally are unlikely to remain, in aggregate, as highly accommodative.
First, the US is well on the way to returning to full employment and inflation is likely to return to its target range of 2% and climbing. The US central bank will likely respond with timid and gradual increases in its cash rate, but still move ahead of the glacial pace of monetary normalisation that’s been the prevailing view in financial markets.
Second, the European Central Bank seems unlikely to move its cash rate further into negative territory, as market sentiment has been expecting. The earlier adoption of a negative cash rate in the euro-zone hasn’t delivered the hoped-for boost to spending – but has made it harder for banks there to borrow and lend, and weakened their capital positions. Also, stronger economic numbers from China, the UK and Australia suggest monetary policies in those countries will be eased less than has recently been anticipated.
Third, there’s growing recognition among policy makers that, as BetaShares’ David Bassanese puts it, “the global economy is as good as might be expected once you make allowance for slowing potential growth”.
Fourth, many countries (but not, as yet, Germany) are considering stepping up the role of fiscal policy, especially in increased infrastructure spending, to somewhat reduce the heavy reliance placed on accommodative monetary policy.
These are the consequences for investors:
- Shares and bonds are likely to be volatile as sentiment allows for, and often changes its views on, prospective increases in US and inflation rates moving higher.
- Equities and bonds may be sold off more than is justified at times, as happened in the US ‘taper tantrum’ crisis of May 2013.
- Even as monetary policies become slightly less accommodative, a lot of liquidity will still be sloshing around from the massive expansion of central banks’ balance sheets. The global economic recovery that’s been running at a modest pace since 2009, needn’t run out of puff.
- In my view, shares can cope with an increase in bond yields of up to a percentage point without tipping into a bear market, provided profits are strengthening. The current sell-off in shares, when it’s run further, could present a buying opportunity, whereas the current sell-off in bonds could mark the end of the longest and largest bond rally ever.
- There’s good common sense in the view that Allianz Group has expressed: “Rather than be determined by extraordinary liquidity injections, investment returns and the success of risk management will probably depend a lot more in future on economic and corporate fundamentals.”