In search of a narrative

Nobel Prize winning economist Robert J. Shiller describes narratives as a simple story or easily expressed explanation of events that many people want to bring up in conversation or on news or social media because it can be used to stimulate the concerns or emotions of others, and/or because it appears to advance self-interest in his book Narrative Economics: How stories go viral & drive major economic events[1]. Recognising narratives is an important part of seeing through market noise and focusing on the fundamentals.

What has been the dominant narrative?

From our view, the dominant narrative has been “markets are dislocated from the real economy”. This narrative has been the investment consensus since March. This story suggested a correction needed to happen. Investors that missed the equity market rally since late-March have clung to this story.

What is our view?

We think financial markets now are not so dislocated from the real economy (Chart 1).

Chart 1: The recovery in the S&P500 is broadly in line with the recovery in the manufacturing PMI.

The unprecedented amount of monetary and fiscal policy support unleashed on the global financial markets has clearly supported equity market valuations. That is intentional. The US Fed (and other global central banks) want financial conditions to improve, financial wealth to increase, and for both of those to eventually support the economic recovery. Low rates for longer are largely priced in equity markets. We think an earnings and economic recovery is not. The global economy is recovering from a very deep recession. The rate of improvement in global labour markets has been astonishing. There is limited evidence that households will materially change their spending behaviours in the wake of the pandemic. A durable, sustainable recovery is underway. And that will be positive for future earnings.

Why have markets corrected?

The correction narrative has thrown up several potential drivers:

  • Tech sector stocks have run too far without justifying the valuations, and needed to correct.
  • Investors are sitting on significant gains since March and are choosing to book profit.
  • The US has failed to agree a further fiscal stimulus package, worsening the outlook.
  • Markets are throwing a tantrum because further stimulus has not been forthcoming.
  • Chinese-US tensions are a significant risk and markets are not reflecting that.
  • The outcome of the US election is a binary event and could result in a market sell-off.

Some or all of these may have contributed to the correction. But trying to build a cohesive narrative to justify a small near-term equity market drawdown is not especially helpful (Chart 2).

Chart 2: The recent correction is small even compared with a short history.

How have we reacted?

We focus on the medium-term outlook rather than short-term market wiggles. In 2019, our medium-term outlook was for a recession and equity market drawdown in 2020. Our view was that equity markets were disconnected from the economy then (Chart 2). Our portfolios were positioned to protect against that. In March, April and May 2020, our medium-term outlook changed to expect no further recession over the medium-term. Our portfolios repositioned to reflect that view. Our view has not changed over the past few weeks. At current market pricing, we think global equities are moderately attractive. And we have upgraded our conviction in that view over the past month. The increase in conviction reflects the following observations.

  • The Fed’s change to an average inflation target will leave rates at low levels for 5-10 years, supporting our expectations of low cash rates for an extended period.
  • The Fed’s commitment to average inflation through the cycle means inflation would be allowed to run hot for some time. We expect that will allow real and nominal yields to gradually sell-off for longer maturities.
  • Higher longer-dated real yields could help steepen the yield curve, a necessary condition for financials and cyclical/value stocks to rally over the next five years. That will support equity risk-adjusted returns over the next five years.
  • We are closer to a vaccine for Covid19, with several vaccines in late stages of trials.

Look through the noise

Markets are noisy and volatile. It is easy to get swept up in a narrative. But long-term investors should look through the noise. Focus on the fundamentals. And the outlook now remains a positive outlook. Investors should stick to their process. Embrace diversification. If you are able, engage in repeatable, defensible dynamic asset allocation. If dynamic asset allocation is not an option, then do not be tempted to implement knee-jerk reactions. Our monthly Asset Allocation Review considers a range of asset returns and outlooks over the medium-term. Reach out to our Portfolio Advisory Service to find out how we can assist you with managing the upcoming investment challenges. Data Source: Bloomberg LP, Oreana Financial Services [1] Robert J. Shiller. 2019. Narrative Economics: How stories go viral & drive major economic events. Princeton University Press, Princeton, New Jersey. Access our Portfolio Advisor page for further information.


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