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Audience

How can we respond to irrational market behaviour?

05/07/2018

Emotions can get the better of anyone. In financial markets, it happens all the time.

Investors use a range of financial models to value assets. They may typically refer to economic conditions, company profits or historic levels of returns. But when we observe investor behaviour, it is clear the price they are willing to pay for assets is influenced by many other factors.

Political events, media stories and shifting investor sentiment can all trigger significant market movements. Prices can rise or fall rapidly, with market commentators unanimously identifying a cause. When these events occur, we should always ask ourselves whether the underlying value of those assets has really changed, or if prices are being driven by fear and greed.

The investment environment of recent years highlights the inconsistent nature of global markets. In 2016, they were characterised by significant price swings, triggered by concerns over populist movements spreading throughout the US and Europe. In 2017, investors took political events in their strides. Reactions to Germany’s inconclusive election and uncertainty in Catalonia, for example, were muted and locally confined. 2018 has seen volatility return once more, with analysts citing trade war concerns and eurozone politics as among the causes for more recent widespread downturns.

Why did markets react differently to events over these periods, despite similar risks? It is not always possible to rationalise, but the broader environment clearly affects investors’ emotions. In 2017, political developments may have influenced markets less because underlying growth dynamics and sentiment were supportive. With greater uncertainty around monetary policy tightening and less synchronised global growth in 2018, sentiment appears more fragile.

We believe irrational and inconsistent market behaviour creates opportunities for active managers. Our starting point for any investment decision is our valuation framework, which we use to evaluate assets according to fundamental drivers of returns. We then look to see if current asset prices have moved away from what we consider ‘fair value’. If markets appear myopic or volatility seems unjustified, we will look to capitalise.

We call events such as these ‘episodes’. Sometimes episodes can play out over the short term, while at other times asset prices are likely to change over several years. We can observe numerous examples in recent periods.

Following the US election in late 2016, Mexican assets sold off rapidly over fears of Donald Trump’s intention to “build a wall” and renegotiate terms with fellow NAFTA members. This generated plenty of media attention, but we did not receive any information that could be used to re-evaluate the fundamental value of Mexican assets. The peso fell 20% between the US election result and January 2017, before recovering to pre-election levels over subsequent months as markets turned their attention elsewhere.

Figure 1: US dollar vs. Mexican peso

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The Mexican peso’s volatility following Donald Trump’s election as US president was a notable example of prices being driven by investors’ emotions. Data source: Bloomberg, 31 March 2017

Please note, past performance is not a guide to future performance.

More recently, we have seen political uncertainty drive Italian bond yields to multi-year highs. The situation in Italy highlights the challenges in identifying whether we are witnessing an ‘episode’, or indeed a fundamental change. Should Italy leave the eurozone, it would undoubtedly have profound effects on the single currency and European economy. But such a process would take a long period of time to unfold and the facts suggest it would be difficult to achieve. With prices shifting in response to short-term newsflow, it therefore seems Italian assets are being partly driven by emotional considerations, including memories from Greece in 2015.

Over the medium term, one could argue that European assets are still suffering from pessimism that has lingered since the financial crisis, despite its strengthening economy and the European Central Bank’s plan to end monthly asset purchases. If Europe’s economic recovery continues as data suggests, European equity valuations have scope to appreciate. Real yields on ‘safe-haven’ government bonds, however, look unsustainable.

Whatever the market environment, our aim to look past the ‘noise’ and focus on the fundamentals. New data, media headlines or even price moves may seem like useful information, but they do not always tell us about the future returns of an asset. We should resist seductive narratives that attempt to simplify the complexities of a situation or predict its outcome – in doing so, we stand a greater chance of making better investment decisions.

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

Juan Nevado is a member of M&G’s Multi Asset team

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