By Colin Moore, Global Chief Investment Officer
Colin discusses his outlook on the markets, the normalcy of market volatility and how behavioral finance plays a role in it all.
Q: What's your outlook for financial markets?
Colin: It depends on which asset class you're talking about. We have to remember that after the trauma of 2008, we've had 10 years of strong returns, particularly from the equity market. Our analysis suggests that future returns may be more modest than they've been in the last decade, and that's what we'd expect. You earn bigger returns early in the business cycle. You make a little less as you get closer to the end of the cycle.
One of the risks investors face is forgetting they need a real return from their money, which refers to a return above inflation. At the moment, there isn't much return for investors in simple bank deposits - you have to look at the stock market and some areas of the fixed-income market for returns that are higher than inflation.
The basic return from government bonds or Treasuries at this stage tends to be very similar to their current yield. If you buy a bond that's yielding 2.8%, I'm fairly confident that the return you're going to get over 10 years is going to be 2.8%. It's highly unlikely that you would get more than that, particularly when interest rates are rising. There's no great magic to that. In equities, if the economic cycle can be extended another few years and corporate earnings continue to grow, then there's a positive real return to be had from investing in equities. But it will not, in my opinion, be at the same level we've had for the last 10 years.
The questions I ask myself are: Will the return be as high? No. Will it be positive? Yes. But will there be more volatility in getting there? Yes, because as you move toward the end of the economic cycle, any change creates a natural level of uncertainty. If you can handle some higher volatility to get a real return over time, then you should stay invested in equities.
Q: Let's talk about the state of economic policy. Have things changed so much that policies and principles that worked in the past don't work today?
Colin: One of the big debates we have internally is if the established economic principles are still relevant. I believe they are. But the transmission mechanism from one event to another is often different. Meaning, the outcome will be the same, but it may take longer to get there or it may get there a different way.
For example, the Laffer Curve tries to link economic growth to taxation rates, and the theory is that lower tax rates will lead to stronger economic growth because more capital is invested in the economy than paid in taxes to the government. But we have to ask: How does the government use its money? If it's redistributed to people who spend it, then it might have a positive economic effect. In general, lower taxes do lead to higher economic growth, but there's a debate as to whether that growth will be enough to cover the loss of tax revenue and not increase the government's deficit further.
There's also a principle known as the Phillips Curve, which represents the relationship between employment levels and inflation and wages. Today, it appears to be taking longer for inflation to materialize even though we have relatively low levels of unemployment, and we would expect wages and inflation to be rising much more rapidly than they are. Is new technology the cause? Are people losing their negotiating power on wages because they can be replaced by machinery or artificial intelligence? There's a lot of interesting debate happening around new influences on the economy that could affect how these principles work. I believe the long-term cause and effect of the Laffer Curve and the Phillips Curve will turn out to be correct. It just may take longer to get there, or we'll get there in a different way.
Q: Let's talk about market volatility. What would be considered normal market volatility?
Colin: Yes, it's important to determine what's considered "normal." All financial markets have some level of volatility, and for the last 8-10 years, we've had too little. This can be dangerous because it lulls people into a false sense of security, and there are so many things going on in the world every single day, we need to expect some level of uncertainty. On the other hand, too much volatility would be an indication of chaos in the financial markets.
It may feel a little too high right now, but I think that's preferable to the environment of the last few years, when it was overly complacent. Ideally, there should be a balance between no volatility and too much volatility.
Volatility represents uncertainty, and behaviorally, people don't do well with not knowing what will happen. But the reality is you're not going to make much money when everything is predictable. The way financial markets work is more uncertainty means more rewards (otherwise known as a risk premium).
Q: You have a background and interest in behavioral finance. What do you find interesting about that field?
Colin: It's very important to understand the behavioral aspects of finance. I'd love to tell you that everything can be solved on a spreadsheet with a good formula, but it can't be. It's not that we can help people become perfect automated machines or that they'll never show any emotion again. But if you can't understand how people react as humans, then you're never going to keep them on track for their long-term goals.
When we think about volatility, we have to determine if investors are reacting to someone shouting "Fire!" when there really isn't a fire. In that case, it's our job to tell them not to panic. But on the other hand, if the volatility is justified by a fundamental change in long-term expectations, then it is our job to warn people so they can adjust their portfolios accordingly.
One of the common theories in behavioral finance is called recency bias. If someone's return last year was positive, they assume the return they'll get next year is going to be positive. They dwell too long in what's called positive momentum. Similarly, if you've had a few bad years, you'll probably assume that it will persist. But that's not true either. Recency bias is why we're hearing investors say the level of market volatility is too high - they have had several years of abnormally low volatility, and they expect it to stay that way.
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