Lean into markets to avoid getting sucked into recency bias
Financial news isn't the most confidence-inducing of things at the moment. Doom and gloom make for good headlines. But investing only for doom and gloom can be a kind of risk in and of itself.
"The important thing to understand is that 'tail risk' events happen, and when they happen they're priced," observes Andrew Papageorgiou, Head of Bank Capital and Corporate Capital at REALM Investment House.
It doesn't have to be about abandoning your investments altogether. Rather, it's about taking a measured approach.
"It comes back to thinking probabilistically about things... what you've got to accept is that the unknown unknowns always make up the largest proportion of potential outcomes."
As Andrew explains in this wire, you want to "lean in, in environments where those known knowns become knowns and are priced."
Can central banks be trusted?
Let's speak to central bank credibility in the first instance. It's fair to suggest that the level of confidence from the market towards central bank activity and central bank primacy and central bank efficacy is probably pretty low. You've got to remember that before the COVID calamity, there were 10 years, there were central bankers, did everything they could to normalise levels and rates of inflation when they were facing the spectre of deflation.
Despite their best efforts, despite their prognostications and their best learnings, they weren't able to deliver. COVID hits and lo and behold, we find ourselves now faced with the opposite problem or the problem at the other extreme.
There'd be no real reason or incentive markets to really throw themselves into or to believe the central bank narrative entirely.
Look, the reality is that why would you? The study of economics and certainly inflation, it's not built on any axioms. We're talking about theories that are very often untested. We find ourselves at a point in the global monetary narrative that is unprecedented in many ways. As a consequence of that, it's not surprising that the market finds and has to take a view its own way. You're seeing that right now certainly in places like Australia, for example, and places like Europe where there is a fundamental disconnect between what the markets are saying in certain instances and what central banks are forecasting. Then in certain places like Australia, for example, there's a further disconnect with rates.
Around rates specifically, there's a further disconnect between what market participants are saying and forecasters are saying, for example. Then the central bankers are almost irrelevant in the discussion to some degree.
Here in Australia, of course, we had the Reserve Bank step away from their protection of the three-year bond in November of last year. They're now likely to raise rates a lot sooner than what had been anticipated.
So generally speaking, as far as the RBA's concerned, you've got the markets almost looking past them and looking through them. Really, that's where we find ourselves. We find ourselves in a position where the market is starting to look through all of this its own way and perhaps putting less stock than has historically been the case of central banks.
Can investors be overly fixated on tail risk?
I think the nature of a tail risk is by nature, you can look as much as you like and you're not going to see it right through. You wouldn't have been looking for COVID. You wouldn't have been looking for Fukushima, for example, during the tsunamis. You don't ever look for these things. They just have a way of coming and finding you.
The important thing to understand is that they happen. They happen. When they happen, they're priced and they're reflected. So in reality, again, it comes back to thinking probabilistically about things. It's not important or the onus isn't on you to actually be able to predict exactly what ends up killing you, what it is, exactly what it looks like. What you've just got to accept is that the unknown unknowns always make up the largest proportion of potential outcomes. That's really what it comes down to. So from an investor standpoint, there is a level of compensation that is generally fair for credit risk all things being equal in a normal environment. That level of fair compensation tends to be very low if you're dealing with a recessionary environment. That level of compensation tends to be very high if you're dealing with Goldilocks environment where everything is going right.
There is a rate that is fair and reasonable.
What you've got to be focused on is ultimately, the current rate you're receiving, what kind of forward outlook does it reflect?
So for argument's sake in mid 2021 to late 2021, credit markets were delivering your credit spreads, which were speaking to an environment that was almost perfection. You were being paid next to nothing for taking on default probability or risks of liquidity around credit or risks of market volatility. Now, without knowing anything, you could make the value statement to say that at those levels, you are not being compensated for the risk you were taking. That's the interesting thing about buying in a really weak market, about being a little bit contrarian, because even though you might be taking a level or a price of compensation that might not necessarily compensate you fairly for things deteriorating further, you have to take a view on how bad things can get.
The reality is, as you can see it, you can observe it in option markets and spread markets, there's a reversion back to some type of long-term average, because there's only so much negative energy that can be maintained in the same way that any market run has to eventually run out because you run out of buyers.
Any sell-off has to end up slowing down because eventually, you run out of sellers. By the same token, if a company goes broke, it goes to zero and you don't get your money back. You've got to have your eye on investing in assets, in sectors that are money good, that have the ability to absorb an environment that becomes more uncertain. The level of compensation you're looking for really just needs to reflect a balanced set of risks, and that's the important fact. From our perspective, the contrarian approach we take leads us to want to lean in in environments where those unknown unknowns become known knowns and are priced.
Think about the forward-looking statement the market makes when it presents a very high-volatility number.
Think about the forward-looking statement the market makes when it presents a very high level of credit spread compensation for the risk you take. If you are buying a 10-year corporate credit security that's trading well above its long term average, you're actually receiving compensation for potential default probability that's well above what has historically been the case.
The same would even relate to bonds right now and interest rate securities when you're buying a 10-year bond right now. Here in Australia, you're buying at about 3.1%. If you look at inflation-linked bonds, that would point to the inflation assumed by the bond market sitting at around 2.5%.
If you are buying a long-term interest rate product, I'd much rather be buying it at an inferred inflation level of 2.5% or 3%, rather than buying it at an inferred inflation level of one or 0.8%. But this is the whole thing.
There is always a recency bias in markets. Momentum's a real driver. You have to think about why people pile into buying some of those securities when they're presenting much lower levels of compensation when the spectre of the unknown is always there.
The spectre of the unknown is always there. But getting back to the original statement of what is of concern, look, ultimately, as soon as something is of concern, it is being seen, it is being priced. So by virtue of that, it becomes less of a worry, and that would be whether we're talking about Russia and Ukraine and people starting to put in factors around neon gas or vegetable oil or oil and gas and what it means to market. All these things are starting to be priced. They're being priced in inflation models, in inflation estimates. The bond markets are starting to reflect these.
So yeah, sure, they're risks, but they're risks that are known knowns to some degree and they can start to be reflected. The stuff that should really worry you, you're never going to see it coming. It's really just about investing in discipline and looking through cycles.
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