Portfolio manager Piet Viljoen reflects on how, judged in isolation, markets may appear irrational right now – but may be better understood after evaluating the incentives at play.
“Mother, do you think she’s good enough for me?Pink Floyd
Mother, do you think she’s dangerous to me? Mother, will she tear your little boy apart?
Ooh, aah, mother, will she break my heart?
Hush now, baby, baby, don’t you cry
Mama’s gonna check out all your girlfriends for you
Mama won’t let anyone dirty get through
Mama’s gonna wait up ’til you get in
Mama will always find out where you’ve been
Mamma’s gonna keep baby healthy and clean
Ooh, babe, ooh, babe, ooh, babe
You’ll always be a baby to me”
The song “Mother”, off the Pink Floyd album “The Wall”, is about an overprotective mother. A mother who will do anything to keep her baby safe from harm. Mothers being who they are, this is not uncommon. Mothers will mother. However, taken too far, this can have negative psychological consequences for the baby in question.
Today, it could be said that central banks are “mothering” financial markets. Central banks are saying to investors: “You have nothing to fear, nothing to worry about.” And this has real consequences for investors, and the way they should be managing their affairs.
As Howard Marks said recently: “When it comes to investing, we are actually concerned with one thing: dealing with the future. Yet it is clearly impossible to know anything about the future. You can’t predict, you can only prepare.”
Preparation is all about managing risk. Risks include not only asset prices going down, but also going up.
To understand how to manage risk, one has to understand what drives the market’s behaviour. And to understand behaviour, one has to understand incentives. Judged in isolation, in terms of one’s own value system, markets can appear irrational, and just plain wrong. But markets are seldom wrong. The market’s behaviour is much better evaluated in the context of the incentives at play.
So let’s examine the incentives and resultant behaviour:
Since the Financial Crisis of 2008, central banks have been pulling out all the stops to suppress volatility in markets, lowering risk free rates, controlling the yield curve, and reducing credit spreads – and saying that they have almost limitless powers to carry on doing so. Risk premia have evaporated. Interest rates are at or close to 0% in many markets around the world.
Central bankers are saying to investors: “Come on in, the water’s fine.” And if – heaven forbid – something bad should happen, mother is always there to help her baby.
In a free market, Adam Smith’s invisible hand (i.e. prices) do a reasonable job of allocating resources. Prices are the signalling mechanism that balance supply and demand. In a controlled economy, where prices are set by bureaucrats, misallocations happen instead. Rent controls cause housing scarcity, food price controls cause food scarcity.
In the market for risk, interest rates are the price that guides the allocation of capital. In their endeavour to make markets “safe” via controlled low interest rates, central banks are incentivising large increases in debt. Companies are borrowing to buy back stock, governments are borrowing to bail out companies who bought back too much of their stock, and central banks are borrowing to bail out governments, who bailed out too many corporates.
In true millennial style, no one loses. Everyone gets a prize!
In their efforts to de-risk markets however, central banks have ended up inhibiting price discovery. Markets have become voting machines, rewarding the most popular choices; not weighing machines, rewarding the most valuable choices.
At the same time that central banks have smoothed the waters, so to speak, markets have also been democratised, and are now freely accessible to everyone. Ostensibly, this is a good thing. On the one hand, investors can now access index funds at 0% fees, and traders can transact in stocks for 0% commission. Unsurprisingly, participation in markets is increasing, and flows into the market are dominated by non-discretionary buying.
Given the confluence of all these “nothings”: zero interest rates, zero fees and zero commissions, we need to ask: Is the price for the popular choices today a fair price? Will we look back in 10 years’ time and say the popular choices were good choices? As a sanity check, we might also want to ask: What were the popular choices ten years ago?
This is why “nothing” worries me. Specifically, my worry lies along three axes:
- An overly indebted financial system will weigh on long-term growth prospects, and can create a deflationary environment, with dire consequences for economically sensitive assets and positive implications for nominal assets.
- As the old saying goes, “Don’t fight the Fed”. Due to money printing, markets can easily “melt-up”. In markets, popularity is contagious.
- All governments have been notoriously bad at repaying excessive debt – it is always the course of least resistance to inflate it away. With dire consequences for nominal assets, and positive consequences for real assets.
Risk is like energy, it tends to be conserved rather than dissipated. Despite the central banks’ best efforts, it doesn’t go away, it just hides in different places.
Investing is not about avoiding risk. Investing is about building a portfolio that can benefit from certain risks, protect against other risks, avoid ruin, and make it easier (but not too easy!) to stay the course. If we can do that, we don’t need to be mothered, and nothing need worry us.