10 min read 20 May 20
Summary: When we talk about market ‘episodes,’ we often mean periods where investors appear to give up on their own long term beliefs due to what prices are doing right now.
It is common to see correlated declines across range of apparently unrelated asset classes during these episodes, which was exactly what we saw in March. Such periods of heightened correlation can be highly revealing of the changing beliefs embedded in markets and how behavioural forces might be playing a role.
But it can also be the case that as the initial episode ‘unwinds’, the more divergent behaviour across assets can be just equally revealing as looking at periods of stress.
As we approach two months since the bottoms in many equity markets and this divergence begins to assert itself, what can we take away regarding investor beliefs today?
Sometimes it can be hard to look at charts of asset prices and see anything other than markets can be deeply inefficient. The March episode was a good example of this, particularly in parts of the emerging world.
As an example, in the course of two months the market has shifted its ‘decade long’ view on South African government debt from being worth just under 9.5% to close to 13%… and back again.
We can almost always find reasons to explain price moves after the fact. To explain the recovery: policy rates have fallen from 6.25% to 4.25% since the start of March (though they had not risen before that) and the Central Bank has intervened with bond buying. But it is hard to account for the nature of the round trip in a long-life asset, particularly given a look underlying South African debt dynamics, as our colleagues at Bond Vigilantes did recently. In many cases, it can instead seem that certain liquid areas of the emerging world become the first port of call when investors need to hid from volatility.
Just as emerging market weakness was an ‘obvious’ trend to expect in the March phase, there are many subsequent developments that also appear obvious with hindsight.
In many ways, first-level, rather than second-level thinking, seems to have been the right way to profit in the recent episode. Rather than needing to worry about what might have already been in the price, a simple preference for traditional safe havens and the ‘obvious’ winners from a pandemic has been sufficient.
Looking back, declines in global healthcare stocks appear puzzling, yet it almost seems that the market had ‘other things to worry about.’
Again, if we were to try to explain these moves, a return to prior levels suggests that what has been gained for these stocks only offsets the broader losses. But the nature of the price moves look inconsistent with such logic.
Of course the ‘obvious’ is often only revealed to us with hindsight…
Also falling into the ‘obvious with hindsight’ camp are technology stocks, and not just in the US. Both the Nasdaq and the Korean equivalent (Kosdaq) have unwound their March declines.
These stocks are perceived as having several benefits. Earnings are arguably more resilient to any slowdown in growth given their global reach and little or no need for a physical presence to build or distribute their products. On top of this near-term safety argument, the rise of working from home now and in the future also makes a good story for longer term profitability.
For those who had hoped that active equity management might offer greater protection from recession, or that value could outperform as it did during the bursting of the tech bubble, this represents yet another painful experience. Though as we have noted, it would be wrong to anticipate this period to resemble past recessions.
Bitcoin has seen some more news coverage of late, with hedge fund managers Paul Tudor-Jones talking up its prospects as an inflation hedge and the latest ‘halving’ taking place last week (does each halving make each Bitcoin less attractive from an ESG perspective?).
For all the challenges in valuing Bitcoin, some will have looked to recent behaviour to assess its potential to be a safety asset. It wasn’t immune to declines in March (not much was), but has recovered since:
One sample can tell us little about the characteristic of an asset, but many will be looking to see how it responds should we see a meaningful change to the inflationary regime in the post-lockdown world.
Not a loser in the sense that price has gone down, quite the opposite. Rather the difference from the cases above is that there hasn’t been reversion back to pre-February levels.
This is revealing if we consider that such rapid falls in yield can often reflect an episodic desire for safety. If this were true, then you might expect yields to rise again as the episode passes.
Instead yields have stayed low. The episode instead looks to have the very brief ‘belief free’ sell-off in March (circled below), and not the more meaningful rally:
This is in keeping with the pattern of behaviour for much of the last few decades. Even when government bond yields have fallen in periods of panic, they haven’t tended to revert back to prior levels. While the periodic rush to safe havens may have had a behavioural element, it looks like it has been a case for the ‘right thing happening for the wrong reasons.’ Ultimately the bigger behavioural bias has been an anchoring to old levels of yield and expecting a return.
What this reveals in the current instance is that, in spite of recoveries in equity markets, we should be very wary of suggesting that this reflects optimism about the global economy. Instead the very recent yield stability implies a belief that policy will need to be kept easy and very little concern about inflation (in direct challenge to the view that the recovery in bitcoin reflects expectations for higher inflation).
If we need further evidence that recent market behaviour should not be confused with optimism, we can look at the behaviour of banking sector stocks around the world.
There has been no sign of the recovery that we have seen in aggregate indices, and in particular technology related companies. Economic policy shifts will have an impact on this, but as with rates, it would seem that pessimism about the cyclical dynamic is still dominant.
If South African bond yields are an example of just how episodic the sell-offs in many parts of the emerging world seem to have been, Brazil presents a different picture.
Again, we can see the correlated depreciation versus the US Dollar in mid-March. But while other emerging market currencies have recovered, or at least stabilised, the Brazilian real has continued to weaken.
Would this have been different if the Brazilian central bank had behaved more like South Africa’s? Possible, but either way the lack of a recovery suggests that, rather than the purely episodic move indicated by the correlated sell-off in March, the recent independent weakness has more of an idiosyncratic, and possibly fundamental, element.
Like Bitcoin, oil is an area that has gained attention the period since March. This was heightened when WTI prices briefly turned negative April, but the ongoing geopolitical dynamic also lends itself to press coverage.
In the case of Brent crude, which didn’t suffer from dislocation to the same extent in April, prices are still materially below their February levels.
We have discussed before how the nature of demand and supply in the oil market can lead to wild swings in price, and how the lack of any sense of yield to act as a valuation ‘anchor’ can also prevent prices ‘snapping back’ after price action which might appear episodic on the surface. When it comes to commodities, the returns to identifying behaviourally-driven price action are frequently less assured.
The aftermath of an episode can provide indications of the extent to which market behaviour is becoming more closely related to fundamentals. We are still a long way from market behaviour looking ‘normal’ and market beliefs are still highly fragile against a backdrop in which the picture for earnings, defaults, inflation and policy is unclear.
However, the very re-emergence of diversification is often a signal that the nature of the opportunity has changed. What appeared to be an opportunity across almost all assets has given way to a need to be more selective and tactical.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.