Valentijn van Nieuwenhuijzen, Chief Investment Officer at NN Investment Partners
Markets are behaving in ways that might confuse some, but actually should look familiar to most. The world is full of uncertainty and we love to discuss the forces behind it. However, we should never forget that uncertainty is not unusual and realize it is harder than you think to find the arguments that show that uncertainty is currently unusually high. Hurricanes, geo-political conflicts, clouded policy outlooks and potential shifts into new economic regimes have been around in almost any decade since the Second World War. And in the first half of the 20th Century the world actually was almost certainly more uncertain than in any period that followed thereafter.
The experienced observers will indeed have noticed that markets are not suggesting that much has changed recently or that huge uncertainty lies ahead of us. This is no proof of the absence of uncertainty, but that is no reason to ignore it either. History shows that although markets occasionally fail to anticipate shocks and crisis, it happens much more often that high profile pundits cry wolf over a crisis that never arises.
Therefore, it is important to note that the evolution of markets so far this year is not very dramatic, with only modest returns in most asset classes and a continued down-drift in underlying volatility trends. This market landscape of high absolute valuations is visible in multiple places, but at the same time relative risk premiums are mostly at or above long-term averages. Only in credit space do spreads (over government bonds) look tight compared to history.
Zooming in on the core drivers of markets – the underlying macro fundamentals, the policy and political outlook, and the behavioural trends – helps to understand this ecology. To start with the latter for a change, it is important to acknowledge that the rising popularity of “passive” investing and algorithm trading, in combination with strong QE and regulation-driven flows into bond markets might well have created investor behaviour that depresses the underlying trend in market volatility. And from a more short-term perspective, cautious sentiment and persistently high cash levels of active money managers are likely to also have dampened to potential of market turbulence to jump and/or persist.
From a more fundamental perspective, it is probably crucial that although the global economy is in its best state in a decade and corporate earnings in their strongest recovery since 2009, we have yet to convincingly pass the “reflation” mark. The hope of global reflation fuelled markets in the second half of last year, but during 2017 it gradually became clear that the productivity and inflation pillars of this story are still missing. Without these elements nominal growth in the global economy will not be able to break the upper-end of the range it has trading in for the last three years. Real growth-oriented assets like equities actually need that breakthrough to be able to start trading at a lower risk premium. Or, in other words, to trend higher for yet another one to three years. In the meantime, many investors will still see income or yield-generating assets as the safer bet. After all, the strong underlying economy keeps the risk of defaults and dividend cuts low, while limited additional growth is needed to still reach their return targets.
And finally the uncertainty over the outlook for inflation, for which many of the traditional models of analysis seem impaired at this point, puts another limit into the ability of risk premiums in bond and equity markets to come down. Especially because it feeds into uncertainty over the behaviour of central banks going forward. On top of all this, the (geo)political risks are obviously not completely ignored by markets either, and the combination of these uncertainties largely explains why risk premiums in both government bond markets (compared to cash or T-bill rates) and equity markets (compared to bonds) are not low from a historical perspective.
To some extent this is all more of the same we have been seeing for most of this year or even longer. It is still important to note what these factors at play are, however, as it helps to better understand why the market behaves as it does. And what are the levers that might force it shift it behaviour in the future. With the current diagnose, we stick with a diversified and modest risk tilt in our asset allocation stance, as the fundamental backdrop creates better return prospects for fixed income spread products, real estate and commodities than the lower yielding part of fixed income markets. Meanwhile, hope of more convincing reflation is not lost, but to override the potential political and policy shock-risk, we need more evidence of rising inflation and productivity trends to emerge. Let’s hope this is eventually how the markets evolve into a new regime.