Investors’ incrementalism lays them open to ambush
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The writer is professor of business at Columbia Business School
Recent trading sessions have brought sharp gains in equity prices and notable declines in bond yields. These large swings are very much in keeping with the volatility witnessed throughout 2022. But, importantly, they are in notable contrast to the “incrementalism” that described much of the previous decade, dominated investors’ views and drove behaviour. Regardless of direction, many investors seem caught out yet again by the speed and vigour of market moves.
Expectations have dramatically shifted throughout the year in many countries. There have been wide gaps in economic and corporate performance, sharp changes in government policies and abrupt swings in the pricing of financial assets. Applying the usual metrics of volatility, such as standard deviation, is less interesting than a review of the underlying catalysts. The bottom line is this: widespread expectations this year that big changes might be afoot but would occur only gradually and smoothly were mistaken. The mathematical assumptions built into many models that changes would occur in small, regular increments were in error.
Incrementalism, both in government policymaking and portfolio management, had been fostered by several factors. For example, developed economies enjoyed decades of generally mild-mannered inflation and well-controlled interest rates. Monetary and fiscal policy adjustments were typically small and easily anticipated. Exceptions, such as around the global financial crisis or the early stages of the pandemic, were viewed as just that: exceptions.
Investors responded accordingly. Asset classes that performed well generally continued to do so, as did the investments within them; momentum was a powerful factor driving relative performance. Valuation tools became less helpful. In equity markets, investors gravitated toward the shares that had already outperformed and whose market capitalisations were therefore rising. Valuations became even more skewed. This was enhanced by capitalisation-weighted index funds and ETFs. But the underlying fundamental conditions have clearly changed, and incrementalism is no longer the winning strategy.
Consider the implications of the current willingness of central bankers to make large and repeated adjustments in policy rates in response to inflation. This follows governments’ earlier readiness to make dramatic fiscal policy changes in the face of the pandemic and in response to disruptions in both aggregate demand and supply. The longer-term policy implications, on prices, trade uncertainties, income distribution and so on, are still not fully understood. Big changes in sovereign currencies, and failures in some digital currencies and platforms, have policy repercussions. Added to the mix is international anxiety over military action, both threatened and real, in Europe and Asia.
Asset managers, as recently as early 2022, nevertheless assumed that they would be able to “time the market” because of their narrow focus on a few variables that were expected to stay within narrow bounds. Consensus forecasts were that interest rates would rise only modestly and gradually. Most fixed-income managers made only incremental cuts in their allocations and portfolio duration. Similarly, US equity managers assumed valuations would be only modestly and gradually impeded by rising rates, and there would be only a slight deceleration in the pace of earnings gains. This had implications not just for the overall asset class, but also the relative valuations of the fastest growing companies.
The 2022 declines in bond and share prices, the rise in the dollar and other adjustments occurred with a rapidity and ferocity that alarmed many market participants. Although the vigour of recent rallies is far more pleasant, it is nevertheless a reminder that moves can occur in big jumps. Indeed, economic history shows that this is the more common condition.
A divided US Congress offers little protection from volatility. The next increase in the federal debt ceiling is at risk. These periodic adjustments are a peculiar feature of US fiscal policy. Basically, Congress is asked to allow the Treasury to raise funds for activities that were previously approved and on which money has already been spent. Some Republican members have indicated that they plan to hold hostage key elements of approved Biden policies which address long-term under-investment in infrastructure and climate resilience. Investors may need to tighten their seat belts when Congress returns to Washington, especially if the conversation veers from policy needs to political gamesmanship.