One of the many oddities that characterised last year’s trading in financial markets was the extreme volatility as investors switched rapidly, and seemingly erratically, from ’risk on’ postures to ’risk off’. Inevitably that same fitful kind of behaviour is likely to continue into 2012.
The volatility and investor mood swings could be explained by relating it to the levels of uncertainty and risk in the macro environment, with the eurozone on the brink, the US still struggling to generate a modicum of growth (and in a presidential election year) and question marks about the sustainability of China’s growth.
Those issues are, obviously, the backdrop for what has happened and is happening in markets.
Credit Suisse’s Australian equity strategists, however, have approached the question of investor behaviour from a different direction.
In a paper issued this week they make the point that the markets are in an "incredible state of flux" because they appear to be pricing in inconsistent outcomes.
Their starting point for that conclusion is that all asset classes are expensive, at the same time.
Normally, in threatening global times, investors rush to the safe havens of US Treasuries and gold. They’ve done that.
They’ve also, however, pushed up the price of equities and, at various times, commodities, which are normally the vehicles for investors chasing growth. The Credit Suisse analysts say that, relative to their long-term average, the S&P 500 is trading at a 25 per cent premium. Given the very lengthy bull market that preceded the financial crisis, which may have inflated that average, that premium could be understated.
The basic point the analysis makes is that the traditional safe havens have been made expensive – are generating low returns – because central banks have pumped so much cash into the system and it has to find a home. With the safe havens too crowded, the cash has spilled over into equity markets, pushing them up.
It was a feature of last year, and remains one entering 2012, that there is a massive amount of liquidity, created by central banks in the US and Europe, that has been parked with those banks at negative real interest rates rather than deployed in something more productive and higher-returning. That’s a measure of how fearful banks and other institutions have become.
The 'risk on’ trades occur whenever there is a smidgeon of good news, or a period where there has been no new bad news as investors try to capture positive returns, however briefly.
Conventionally equities ought to do well when interest rates are low, both because of the yield differentials but more particularly because the discount rate for future cash flows that drives net present value calculations is lowered and therefore valuations rise.
The Credit Suisse analysis, however, makes the point that the bond yield/earnings comparisons aren’t the only factor in valuations because the growth outlook also matters. There aren’t many people who think the outlook for 2012 is for meaningful growth anywhere in the developed world. Governments, corporations, investors and households are all behaving defensively.
If one accepts Credit Suisse’s conclusion that all the key asset classes are expensive despite, as the paper says, the internal inconsistency of safe haven asset classes and growth asset classes being expensive at the same time, the critical question becomes what happens if and when there is a reversion to the historical norm?
One would suspect that in the near term it could lead to more and more extreme volatility around even lower base levels of returns, with equity markets probably continuing to be the most vulnerable of the asset classes unless and until there are clear signs that the Europeans have regained control of their parlous economic and financial positions and of some growth returning in the US economy.
There is, of course, something of a ‘chicken and egg’ conundrum in the situation, given that the liquidity sloshing around the globe won’t be deployed productively and help generate growth until the level of eurozone risk to the global economy and financial system subsides and the US demonstrates that it is on a sustainable growth path. It will be quite some time before investor behaviour resembles anything we’ve come to think of as normal.