It’s imperative to embrace flexibility and avoid dogma. Everyone can have cognitive biases; it’s important to identify them and not let them influence investment decisions. Importantly, encourage your clients to avoid ‘flat earth’ thinking when it comes to their investments.
GSFM recently hosted fixed income specialists Payden & Rygel, who addressed advisers around the country. The presentation took a different view to the general bond market approach; instead it looked at how to avoid ‘flat earth’ thinking and related this to the world of investment. In other words, how not to follow the wrong crowd and potentially risk the defensive portion of your clients’ portfolios.
As far as conspiracy theories go, flat earthers have been around for a long time. Eratosthenes, a Greek astronomer from Hellenistic Cyrenaica is said to be the first to discover the Earth is round, in 240 BC (or thereabouts!). Since then, the doubters have continued to argue, even now, that science is unable to prove conclusively that we do not live on a flat plane.
In fact, Google searches for ‘flat earth’ have spiked in recent years (figure one); although it may provide a source of mirth for some, many of the beliefs and biases held by so called ‘flat earthers’ can also be applied to some investors. When considering the underlying psychology, there are certainly parallels.
The characteristics that apply to flat earthers can be summarised as:
- Flat earthers find their view intuitively pleasing and rely on subjective experience – the earth around them is flat, therefore, the earth must be flat
- Flat earthers cherry pick their information, as opposed to applying any scientific method. They typically ignore the wide range of information available, especially where it conflicts with or criticises their view. In reviewing their beliefs, they would start with the assumption that the earth was flat and seek information to substantiate that point. Conversely, a scientific thinker would start with “what is the shape of the earth” and then work toward what it could be.
- Herd mentality and community formation spread and support the flat earth idea. Groups that subscribe to a dogmatic view tend to stick together and form a community; without outsiders to challenge their beliefs, they support one another and develop a herding mentality.
- Flat earthers appeal to pseudo ‘authorities’ within their community rather than objective data and analysis. The group begins to only listen to the voices in their community, their ‘authority’ figures and tend to block out the other voices around them, particularly if they are dissenting voices.
So how does this relate to investment?
It relates to commonly observed investor behaviour and herd mentality, which can easily infect investors and lead them – some of whom may be your clients – toward making poor investment decisions.
Imagine eliminating the words ‘flat earthers’ and replacing them with ‘naïve investors’: –
- Naïve investors find their view intuitively pleasing and rely on subjective experience – the markets around them are falling, therefore it must be time to sell. Conversely, the markets are at all-time highs, it must be time to buy.
- Naïve investors often cherry pick information and start with what they believe is right, rather than setting a broad purview; they may make a decision based on a select data set without considering the broader context.
- Herding mentality is common among naïve investors – people start moving in the same direction and a community forms. The same theme is reinforced in the newspaper, by talking heads on television, by finance podcasters.
- Naïve investors listen to the same voices which keep talking until it’s assumed their view is correct.
Examples of recent ‘flat earther’ macro views
1. “The end of the cycle is imminent”
Despite the ‘flat earth’ assertion that economic cycles have explicit lifespans and the end of the current cycle is imminent, this view has been repeatedly voiced in some quarters for the past six to seven years. Had investors believed this and acted accordingly seven years ago when that talk started, they would have missed out on a period of significant capital gain and income.
In fact, as illustrated by figures two and three, cycles do not move in regular average patterns; the US (and other economies) experience more time in expansion than recession. Since 1920, the US has been in expansion for 81% of the time. The obsession with calling a recession misses the fact that the US economy is expanding most of the time. Likewise Australia provides a good example, approaching 350 months of expansion over thirty years.
While there are recessionary risks, it’s not down to a single factor and it’s certainly not time related; conversely, Payden & Rygel believes there are many reasons the expansion can continue.
2. “Low inflation is a major problem”
It is possible to have growth without inflation – low inflation is not a new phenomenon. Although the Federal Reserve (the Fed) targets a 2 percent inflation rate, over time the average rate of inflation in the US has been 1.3 percent (figure four). Consumers don’t want higher inflation – and higher costs may result in less spending. Bond managers don’t want high inflation either; after all, inflation – like interest rates – can push up to bond yields, resulting in lower bond prices. High inflation seems to be more important for a government who wants to inflate their way out of debt than for the average person on the street.
3. “Central banks are propping up the economy and the markets”
While central banks and monetary policy are critical to an economy and markets, they are not the only drivers. However, flat earth thinking would have you believe that there’s a strong correlation between stocks and Fed’s balance sheet (figure five), so therefore, the Fed must be driving economic gain, especially in the sharemarket.
However, since 2014 the Fed has lowered rates, yet the trajectory of the S&P500 has remained the same…in other words, central bank action is not required to support markets (figure six). This is not to say that central banks don’t have influence – they do – but the idea that central banks control markets is incorrect.
4. “Trump, Tariffs, Trade Wars, Hard Landing In China, Brexit, Europe, etc.. will doom the global economy”
Tariffs are not a new phenomenon, China’s growth has recovered, and trade is more open today than ever before. Human ingenuity ultimately drives growth in the long run, despite hurdles that might appear.
There’s a range of influences on markets, which can be thought about in two parts; the measurable and the unmeasurable. The measurable – as illustrated in figure seven – shows that US consumer spending far outweighs the cost of tariffs to the US consumer (US$14 trillion to US$53 billion), so the cost of the trade war is relatively small.
From the Chinese perspective, 42 trillion Yuan is spent by consumers and government, the exports affected by tariffs are significantly smaller.
Of greater concern are the second and third order effects, those that cannot be measured. These might be decisions such as; do CEOs decide to not make deals because of the impact of tariffs on their business, or do purchasing managers change their orders because of the trade war? Are there other decisions being made (or not made) somewhere in the world because of fears generated by the global environment?
This potential impact on corporate earnings and growth is the larger concern; it’s the unmeasurable second and third order affects that can impact GDP that will be important.
Passive fixed income investing
A recent example of herd mentality is the huge growth in passive fixed income funds. Passive investing, replicating an index because it’s low in fees, is a flat earther approach to bond investing.
A passive fund managed against a global developed market government bond index (figure eight) would take on approximately 8.3 years of interest rate duration, which is a significant amount of interest rate risk. This might work for an organisation hedging a long-dated liability, it’s not so good for an individual investor.
At the same time, the average yield of the same universe is 0.94%; an investor is taking risk but not reaping the reward. If you then take the yield and divide by the duration, you get a ratio, the ‘break even ratio’. This indicates the number of basis points the market would have to move before you lose your return. In this case, the number is 11 basis points.
If you buy an index fund that replicates this index and the yield rises 11 basis points, you have wiped out your return potential (in terms of yield) for the year.
This relationship between yield and duration through time (lower left hand chart) has resulted in a much broader margin; in the early 2000s there was a 100 basis point cushion, and, in the 1990s, there was a margin of approximately 200 basis points. Currently there is a very thin margin for error in an indexed approach.
Figure eight also shows approximately one third of issuants have a maturity longer than 10 years. This helps the issuers wanting to issue debt at all time low rates – it’s not helping investors. Finally, more than 40% in countries in the index have a debt to GDP ratio greater than 100%.
It is a similar situation when you look at corporate bonds. The spread relationship is at all time lows, with a 16 basis point margin before the return is wiped out. As with government bonds, more than a third of corporate bonds are long duration, with highly indebted companies.
So, an index fixed income fund can be described as:
Buying bonds issued by highly indebted companies and countries, for a long period of time, at the lowest rates in history.
Who’s benefitting from this situation? The corporations and governments undertaking long term borrowing at incredibly low rates.
The concept of a debt weighted index does not work as an investment approach. When investing in an index fund you are consciously embracing higher exposures to the largest debtors.
Similarly, conventional bond funds are generally linked to an index with specific characteristics – duration (or interest rate sensitivity), exposures to debt and credit quality.
Having the largest exposure to the biggest debtor is counter-intuitive, hence the increase in absolute return, or unconstrained, bond funds that aren’t bound to an index. In the current environment, advisers should be thinking about how to position the defensive part of their clients’ portfolios in a time of historically low bond yields.
An absolute return approach to fixed income is better placed in such an environment because it:
- Removes the benchmark from the equation
- Can focus on companies/countries with the least amount of debt
- Can focus on lower durations issues
- Actively selects issuers that will add value to the portfolio
- Can embed additional yield for investors
- Focuses on positive returns.
It’s imperative to embrace flexibility and avoid dogma. Everyone can have cognitive biases; it’s important to identify them and not let them influence investment decisions. Importantly, encourage your clients to avoid ‘flat earth’ thinking when it comes to their investments.
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