Managers will have to be dynamic and selective in responding to shifting market conditions as investor sentiment is changing quickly, according to M&G’s Stuart Canning.
Some market commentators have described the bull market as ‘the most hated in history’ but the longer it goes on, the research analyst said, the more likely investors are to change this perception.
In October 2016, M&G head of macro and equities investment David Fishwick warned that the market was approaching a pivotal moment in investor psychology and asset pricing.
“[This was] a capitulation in any sense that the global economy would return to ‘normal’ and arguably a peak in investor desire for safety, drawdown protection, and ‘uncorrelated’ returns,” Canning explained.
This shift in sentiment has set markets up for the type of investor behaviour since, with strong returns from risk assets and a cost to seeking safety, he argued.
However, the research analyst warned that in 2018 the world feels very different and investors should not expect these conditions to last in perpetuity.
Source: M&G Episode Blog
“In the fourth quarter [of 2017] there were more signs that investors are looking forward to the possible returns that could be generated rather than looking first and foremost to preserve capital in the short term,” Canning said.
“Within the space of 12 months we have gone from a condition of deep despair to one where markets are being described by some as euphoric.”
As such, in the last quarter risk assets generally delivered strong returns, with European equity markets being one of the few exceptions.
The strong final quarter returns meant that the S&P 500 finished the year having delivered positive total returns in every single month.
Performance of indices in Q4 2017
Source: FE Analytics
Meanwhile spreads on US high yield corporate bonds reached their lowest levels since 2014, another example of investors looking further up the risk scale.
Canning noted that “intuitively it makes sense that if investors are very optimistic about the future – and this is embedded in prices – then they are vulnerable to disappointment”.
However, he added that it can be difficult to gauge sentiment through any form of data and is judgement call on the part of fund managers.
“Those who were around in the tech bubble say that the environment then was more like Bitcoin today: it became a topic of discussion at parties, a source of bragging rights, and drew those who had never invested before into the market,” he said.
But the stock market does not feel the same to today as it did during the tech bubble, he said, with the consensus remaining one of scepticism.
“There seems to be more commentary suggesting that everyone else is euphoric than commentary which is optimistic itself,” Canning noted.
“It is common to see ‘dual time horizon’ outlooks along the lines of: ‘the market will go up for a little bit more but is overvalued and so must ultimately fall below where it is today.’”
There is a similar belief in Bitcoin, with investors suggesting it is a bubble but unwilling to short it just in case they are wrong.
“It is a common human reaction when our expectations have been confounded by price to think it is temporary,” he said.
This is not the same as peak euphoria, said Canning, which some believe we are heading towards, as that tends to arise when investors become resigned to the new norms.
“Consider how those calling a stock market bubble in the late 1990s ultimately came to be laughed at before the crash came, or how those who had been speaking about bond bubbles were far less vocal by the middle of 2016,” the research analyst said.
The problem for fund managers, however, is that you don’t need euphoria for a market to crash, as 2008 proved, Canning explained.
This is why we must not lose sight of valuation and from this perspective, said the analyst, the most important story of the fourth quarter is arguably the continued rise in two-year Treasury yields.
“In so far as these yields represent a risk-free rate they are crucial as a bedrock for the valuation of all assets. In 2017 rising rates did not pressure other assets, even at the long end of the US yield curve,” he said.
Source: M&G Episode Blog
“This is because, although investors have been confronted by the reality of strong macroeconomic data, there is still a belief that rates will have to stay lower over the long term, and that Treasuries can play a diversifying role in a portfolio.”
He added that this could be due to the expectation that the ‘goldilocks’ scenario of strong growth and low inflation that characterised 2017 will persist.
“I would contend that it also reflects a belief that strong data around the world is temporary. The ‘secular stagnation’ thesis has been tested but not abandoned,” Canning said.
Overall, market sentiment is changing quickly, but signs of euphoria are still tempered by scepticism about the longer-term prospects of markets as reflected in the shape of the yield curve and the levels of equity risk premia around the world.
However, if the belief that global growth is more sustainable does take hold then that could lead to opposing forces at work, he said.
“We could well see euphoria intensify but also increase as cash rates begin to pressure those assets that have been the most direct beneficiaries of the low-rate environment. Investors will have to be dynamic and selective in responding to these dynamics,” he added.