199. How to benefit from irrational investor behaviour

30 June 2022 (pre-recorded 15 June 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re considering investor behaviour – both rational and irrational – when it comes to market news and headlines surrounding internet rates and inflation.

Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today I’m joined by Steven Andrew, the Elite Rated manager of the M&G Episode Income fund. Steven, thank you very much for your time today.

Steven Andrew (SA): Hello Ryan. No problem at all.

[INTERVIEW]

RLA: Now, it’s been a pretty volatile year so far in 2022. We’ve seen some big swings in markets in the recent months. We’ve moved from the growth stocks, to so-called value stocks, tech stocks in particular seeing their price fall significantly. Is this rational investor behaviour or is something slightly strange going on here?

SA: It’s a really good way of framing it. Is it rational investor behaviour? It usually is rational to be perfectly honest with you. Markets are usually quite sensible things. They look at what’s in front of them, and then they give you a price for the risk they want to attach to that. And what markets have been experiencing and what we’ve all been experiencing is the real aftermath of the post-COVID phase, where we’ve gone from, we need to move from emergency settings for lots of things, to normal, whatever that is. Normal settings for lots of things. And in navigating that journey, particularly as the cost of capital changes – so particularly as US rates go up and the market tries to guess where they’re going to go next – really is a big challenge for, not only for risk assets, but principally for the reevaluation of that safety asset as well.

So, we’ve really had, as you say, it’s been a challenging time and you could really think of it as…so where are we? We’re in the early summer, hopefully early summer. At the start of the year, the Federal Reserve was being characterised as being, not even behind the curve, they were off the curve. They weren’t attending to the curve. The curve was doing its own thing without it. Then the Fed joins the party. So, then the Fed joins that conversation that says, okay, well, we’re with you here. We recognise that there’s no need for the emergency status, but the market was haring away saying, “you need to get rates up quickly”. Now the narrative going along with that was the whole inflation thing, and growth was coming in quite powerfully alongside that. So, the journey really, if we leap forward to today, or through that journey, it’s been one where firstly, the markets led the Fed, then the Fed caught up, and now it’s the Fed leading the markets. So now the market’s all ears to hear what does the Fed say should happen next?

So that has been rational in a sense, but we need to really kind of, as asset allocators, you take a big step back to say, well, in a multi-period sense, you’ve got two jobs really, in a multi period sense, where are the opportunities being thrown up here in this volatility? Are there opportunities that we can build portfolios with? And then at the same time, are there levers that we need to be pulling at the overall risk picture? Do we need more or less risk? And it’s not to say that markets are necessarily irrational, but usually what we’re saying when we’re pulling that risk lever is we either, we either want to participate in what the market’s currently doing, or we think it’s going a little bit too far.

So, in that sense, that’s been the nature of the journey, I think, throughout the start of this year.

RLA: Yeah. Thank you. Because it just seems that investors are reacting to every decision and hanging on every word of central banks, particularly the US central bank. Is that sort of, is that rational behaviour or should people be looking at sort of corporate fundamentals or something like that?

SA: Ultimately it isn’t rational behaviour, of course, because no individual, regardless of their job title, has any control over what ultimately is going to happen next. You can control certain individual variables of that. And the variable that the Federal Reserve gets to control is this interest rate. Which, if you compare it still to past, well, to the experience just of my working lifetime. So you, you compare it over the past 30 years in essence, then this used to be a really big number. And now it’s a really small number. It used to move in big steps and we would laugh at the prospect of moving in 25 basis points, because that was just hilariously ineffective, to now we’ve got these minuscule steps that we’re moving in. And yes, we may see bigger steps now emerge from the Fed with 50, 75 [basis points]. These are much more like we were used to in the past and, while they can have some effect on some things – so they do change something quite material in the real economy, if you are a certain kind of category of player in that.

So if, for example, you’ve got an enormous mortgage in the US, that’s about to come up for refinancing and you took it out at 3% using the long run reference rate for Fannie Mae mortgages when you took it out, and then those rates doubled pretty much, you’re at 5-5.5% now and it’s still heading north. You’re going to feel the pain of that. So, there is a real economic impact of that and that does permeate its way through the real economy.

But when markets are fixated on these big macro variables, I think you’re right to observe that it might not be fully rational and it’s certainly not fully encapsulating the genuine complexities that goes to drive earnings, to drive economic activity for particular sectors or companies, or even the  fortunes of nations in terms of where their unemployment or inflation go.

Janet Yellen put this really well when she was in her final days as Chair of the Fed, and these were the almost the rose-tinted times of pre-COVID, and we weren’t… didn’t have all this disruption and seeming chaos to deal with. She felt that it was, the environment was such that she could acknowledge that the Fed really didn’t know what they were doing. The Fed really didn’t. She was on her way out and said, you know what, when you look at the pathway that inflation has followed, when you look at the pathway that we’ve taken interest rates and where growth has then been, it’s not clear to us what there’s any demonstrable link between those things in terms of what we can and cannot control.

So, the policymaker really has a heavy hammer that it can only really use effectively if it wants to apply it heavily. The tinkering thing, the fine-tuning thing, isn’t really in their control, because other stuff comes in and out. The inflation that we’ve been experiencing is the result of some big, unpredictable shocks. You had the Russian invasion of Ukraine. You had COVID. You had the corresponding cascading through the global economy in a very coordinated way. The supply chain crisis, the bottlenecks, all of that’s going to mean something for some time. So being able to say, I know what we’ll do, we’ll raise rates by 50 basis points and that’ll sort it all out, kind of misses the mark.

So, it’s important that, as equity investors, as fixed income investors, we try and really focus on how much I’m being charged for this asset? What sort of risk is built into that asset’s return profile? And then how does it interact in the portfolio? And one of the challenges with that, that we’ve had this year and markets at large have had, is the positive correlation between both equities and bonds. So, equities and bonds are both doing the same thing and falling.

So, the power of diversification has essentially been non-existent outside of going short stuff or owning lots of cash. Which as a long-only investor is obviously a bit of a challenge in terms of one’s timing of the market. So, finding realistic diversification, both in the moment and as a delivery mechanism for things like income, which is what pertains to the main fund that I run, then it is really, there are two-fold challenges, really in terms of the composition of the portfolio.

RLA: Thank you. And given we’re talking about your portfolio, you tend to invest in more unloved areas, but one area that has been unloved for many years is UK equities, you’ve only got around 4.5% in your fund. Do you think that they’re unloved for a reason?

SA: Usually when things are unloved for a while there’s a good reason. I guess that’s the challenge. We might contrast – I’ll tell you what we could contrast it with, or at least compare it with to some degree is the holding in Japanese equities because we could, and I’m certainly not drawing any parallels from any other sense, in terms of the Japanification of anything in that way… The UK has a different sort of setup to its economy in that way, both socially and economically, but the parallels from a “this is a really unloved and hated area”, the Japanese equity market was an unloved and hated area for a long period of time.

And places get this reputation from investors because they don’t make lots of money in them and that they can be a bit dangerous if you own them at the wrong time. And then they suffer the winds of change that are out with whatever the corporate sector’s doing. So, you have this combination of some perhaps not so energetic, domestic production of earnings, while you have an externalised vulnerability to what’s going on. So, you’re fully engaged in the global economy and markets, while at the same time, your domestic base isn’t firing on all cylinders. So, we could draw those sorts of parallels with the UK and certainly and Europe as well, to be fair. But also with Japan.

Now, with Japan, we’ve got 9-10% in Japanese equity right now. And that’s in areas where earnings are showing themselves to be improving. Now they’re improving from a not particularly great base, but they are on a steadily improving path and being fairly strong relative to that valuation. Now with the UK, when we’re trying to get that balance and build a decent size of exposure, we’re not really getting the same sense of durability of those earnings. So, it’s not something that we felt appropriately expressed in the portfolio.

Not to say that I’ve got, as you say, I’ve got a holding – if I’m owning some of it it means I like it to some extent. It just means that I’m not, I don’t wish that to be the primary determinant of the behaviour of the aggregate portfolio because it really is a mix between making sure that the risk allocation at the top level is such that when the market decides who wins, is it risk that wins? Or is it safety that wins? When the market decides that the portfolio behaves well in that environment, while at the same time constructing the portfolio in an ongoing, durable, sustainable way, sustainable in its kind of dictionary meaning of being able to be sustained over a long period of time.

RLA: Okay. Maybe sort of turning to areas where you’ve got a bit more weighting in. I’ve noticed you’ve got a fair bit in the US and in emerging market government bonds. What’s the sort of rationale behind these positions and how will they fair, particularly in a world with as we discussed higher inflation, potentially interest rate rising and usually a negative for bonds.

SA: Yeah. These are two important areas and again, it highlights… So, the first topic there, US equity, really highlights the need, as I see it, for a really focused element of your exposures, really. So rather than observing the US equity market at large, to be an attractive place because it fundamentally isn’t, it’s fundamentally, or at least has been it’s on its way to being better valued, but it was fundamentally overvalued in terms of its richness relative to its peers, relative to its own history. And so in that sense, you are then participating more in a price game than you are in an investing game. So, what you really want is to be investing with a margin of safety in some of these assets, if indeed they are to be homes of capital on an ongoing basis.

So, it’s important when we differentiate between what each holding is doing. So, what are these holdings doing? They’re either there because they’re generating a fundamental return in a multi-period sense. So we’re buying them at a good price. We’re looking at their earnings or their future cash flow stream, if they’re bonds or whatever they might be. And we’re happy for them to continue to meander along. So, we’re not really going to touch them very much.

Then there’s another aspect of really the character of exposures that we’re after, which is how do these exposures interact with the other types of risk in the portfolio? And how do they interact with things that aren’t risk, things that are the opposite of them? So, things that are US treasuries, for example. So, the example here that I would give, so when we think about US equity, we don’t really think about US equity. We’ve been thinking about US banks in that sense. So that over the past year, probably longer, has been our focus.

As macro-oriented investors you’re really thinking about that global interest rate cycle. You’re really thinking about how the market is situating its risk disposition to say is everyone huddled in one place here? Is everyone’s expectation in one place here leaving us vulnerable, leaving the market vulnerable to a surprise in one direction or the other? So if we can observe a clustering in the market’s own beliefs about rates, are we at peak Fed hawkishness, for example? Are we complacent that rates don’t need to go higher? In that, what’s the interaction between bank equity because banks benefit if rates are going up and growth is good, and what’s the interaction of that and US treasuries? So, the banks has really been a lever that we’ve been pulling over the past 12 months.

And it’s been interesting over the past six weeks. And interesting here is a euphemism for pretty horrid, because bank equity’s been rubbish and rate expectations have been deteriorating. So that tells us something about how the market is in, tells us something, things are getting worse. So, the price has been falling and that’s not been a great and positive experience for the portfolio, which it was up until about six weeks ago. And the reason for that might, it tells us something and it tells us that the market is more fearful about growth than it is about inflation.

And the reason it fears inflation is only because it fears growth, it fears rates going up. So the higher inflation goes, the more the markets fear the Fed, and which again goes back to what I said at the beginning in terms of who’s leading now? The Fed is leading now. The Fed has got control to say the market believes us when we say we’re going to chase down inflation, because if inflation rises, we look like we’re going to be more hawkish and correspondingly if inflation starts to peak, the market will breathe a big of relief, not so much because of an inflation belief, more because of its growth impact belief. So, the focus on where we’re owning that equity is really key.

And without wishing to kind of go on too much in one batch here, the emerging market government bond area has always been an interest for the portfolio in the sense that you do have that multi-period characteristic that says these are giving us some high comparative yields. And if we can find them in an environment where the currency isn’t expensive relative to my base currency – so relative to my sterling – are these currencies expensive or are they cheap? Can we find good opportunities there that we don’t need to hedge the currency back? We’re happy with those exposures and, in that sense, we’re happy to own a multi-period sentiment in emerging market sovereign bonds. We have been scaling them more through the first half of this year.

So, they did really, really well in the first quarter. We scaled them back – happily enough, that was then a positive contributor to the portfolio, both in the first quarter. And then subsequently as they then fell, having scaled them, we didn’t participate quite as much as that. We’re looking at them again now. We haven’t decided to add to them quite yet. The environment still feels very noisy from a global interest rate backdrop, but it’s certainly an area where they have absolute validity in the portfolio. And it’s something that I would really expect to be a powerful driver of returns going forward.

RLA: So that roughly brings us up to sort of what we’ve seen so far out this year where we are today so what’s your outlook for markets going forwards? Do you think things will get worse before they get better? Or we sort of round about peak fear at the moment?

SA: Well, it’s funny. I mean, I thought we were at peak fear about a couple of weeks ago, and then it turned out we were peaking again! So ,bear that in mind when we say what I think is going to happen next! For me, in a broader sense, in terms of what the main thrust of things would be. So, if we imagine a conversation in six months’ time, that’s oftentimes a good psychological way of distancing ourselves from the emotion of the minute, to say, well, let’s imagine a client conversation in six months, and we’re trying to explain ourselves, given what has happened, what do we do today, given what has happened?

So, what we see is that the market currently has some relatively extreme interest rate expectations being led there by the Fed. So, they’ve been led by the policymaker to adopt a view that’s quite aggressive from an interest rate perspective. There has already been a real economy reaction to that, both in the money supply data in the US, the M2, which has fallen back very quickly. But in a more everyday way in that increase in the mortgage rate. So the mortgage rate has gone up super fast, and that in the past has been a pretty good guide as to what happens in the housing market, as it’s understandably an area that is heavily financed by debt, rather than people having the ready money to hand to go and buy a house. So, in that sense, it’s a super sensitive area of the economy to that interest rate. It’s not necessarily hitting the inflation target in any way, but it’s slowing demand down.

So, I do think that market attention in this way is going to become ever more focused on a recession, on then how do we get out of this particular bear market from an equity perspective? There’ll be the interpretation of the occasional rally as either a turning point or an opportunity to sell a little bit more.

I do think that the bond [market] is funny. The bond area now feels like a more straightforward call than the equity area. The bond area feels like you are close to the end of the road from a curve sense. I see no reason why the curve can’t invert further, because the Fed will probably keep raising interest rates and the market’s going to be pressured into observing the downside of growth. We’ve got still some appreciation of where is the downside going to take us from an economic momentum perspective? And, all the while, and I think when we look back on this period in however many months, years’ time, when we are fully clear of the post-pandemic era, because we’re not, we’re not in some areas we’re not even out of it yet. So, when China restarts fully its economy, that again will have a big splash in the data.

The interpretation of the data really has been very thoroughly contaminated by the on/off massive stimulus soaking the economy in money, then trying to withdraw some of it, and then trying to rebalance the supply and demand thing so that you don’t get crazy inflation. All of that is a consequence of switching your economy off because of the global pandemic. So, we’re still living through that.

So, I think it’s wise, as hard as it is, it’s wise to continue to bear that in mind and not think that the future holds more of the same. We can very easily fall into these lazy assumptions that say we are now in a world of dot dot dot, whether that’s high rates, high inflation, low growth, whatever it might be. We don’t know where we are, but we still know we’re somewhat disconnected by the experience of the pandemic. Going forward, bonds look like they might give us greater clarity. I think there’s still some work to be done on areas of the equity side. So, I would say the balance has tilted more away from equities towards bonds in that short run sense.

RLA: Steven, that’s been brilliant. Given us some real food of thought. Thank you very much for your time today.

SA: No problem at all. Thank you very much for having me.

SW: M&G Episode Income is a multi-asset fund that uses behavioural finance to find pockets of value and invest against the herd, rather than following it. The name “Episode” refers to those periods of time when investors’ emotions cause them to act irrationally. To learn more about the M&G Episode Income fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.