- In the short run, simple narratives can form to explain changes in security prices and complex market movements.
- These narratives can contribute to market volatility — the 30% plunge in oil prices in the first quarter of 2016 was viewed as evidence that global growth was weakening.
- This year’s market swings have created an opportunity for investors to reassess their portfolio positioning, ensuring it matches their long-term risk and return objectives.
In the long run, security prices are set by fundamentals, interest rates, cash flows and growth rates. In the short run, however, narratives can sometimes form to explain price changes. Often, these narratives can be self-reinforcing and shape belief states that swing much more rapidly than changes in actual fundamentals. The year is still relatively new, but it has certainly provided its share of excitement as two powerful short-term moves offset each other, bringing markets full circle in just 12 weeks. Narratives regarding the price of oil were a key contributor to the recent volatility.
Pre-February 11 narrative: Plunging oil prices signal rapidly deteriorating global economic conditions
Two distinct narratives played out in the first quarter of 2016. First, oil prices plunged more than 30%, fueling fears that global growth was weakening rapidly. While oil had been in a bear market since the summer of 2014, the velocity and magnitude of this year’s decline threatened the health of many emerging market economies as well as many energy companies’ balance sheets. The deteriorating price of energy company stocks and bonds bled into other sectors as investor expectations for global growth faded in lock-step with collapsing oil prices.
Investment-grade and high-yield spreads spiked while equity valuation levels fell sharply to levels that implied a reasonably high chance of a recession (see left side of circled area in Exhibits 1-3). Investors were becoming more risk-averse and fearful of an imminent recession due to the narrative that lower oil prices were the result of rapidly deteriorating global economic conditions, rather than continued excess supply and/or emotional selling.
Exhibit 1: Investment-grade spreads have roundtripped since year end
Source: Columbia Management Investment Advisers, LLC, March 30, 2016
Exhibit 2: High-yield spreads have roundtripped since year end but still show signs of risk aversion
Source: Columbia Management Investment Advisers, LLC, March 30, 2016
Exhibit 3: Forward multiples have roundtripped since year end and are near recent highs
Source: Columbia Management Investment Advisers, LLC, March 31, 2016
Post-February 11 narrative: Surging oil prices signal reduced risk of deteriorating global economic conditions
Saudi Arabia’s announcement on February 11 to freeze crude production in order to shore up oil prices may have turned the first narrative on its head. Oil has rallied sharply since, leading to one of the more dramatic and bullish shifts in credit spreads and investor risk aversion in years. Risk assets rallied sharply in the ensuing six weeks, bringing markets and risk metrics roughly back to levels where they started the year (see right side of circled area in Exhibits 1-3). Since mid-February, the story has been retold: the surge in crude prices indicated a reduced risk that global growth was deteriorating, making it safe to wade back into cyclical/lower quality stocks and high-yield bonds. Interestingly, value stocks have been outperforming growth stocks since oil bottomed.
Narratives leave investors whipsawed
Investors who followed the two narratives above rather than fundamentals were whipsawed. Essentially, key risk indicators have returned to their levels at the beginning of the year, prior to the increased volatility and steep plunge in asset prices. While the “easy” money has been made off the bottom, there are still pockets of undervalued industries and style factors that present compelling opportunities for equity investors. However, improving earnings will likely be necessary to drive broad equity indices higher from here, unless investors wish to rely on further multiple expansion beyond current above-average levels.
Conversely, fixed-income investors seem relatively risk-averse despite the bond rally, with spreads still much wider than normal. High-yield spreads are still at above-average levels, discounting principal losses that may not be realized. This dichotomy between fixed-income markets and equity markets has persisted for much of the past year and may be solved if the Fed can raise rates successfully later this year without spooking investors or affecting the economy’s growth trajectory.
Avoid narratives and follow fundamentals
So what lesson can we glean from the last several months? Long-term investors should maintain a disciplined philosophy and process, resisting the urge to rely on simple narratives, which naturally form to explain complex market movements. As we noted last fall, these occasional roundtrips in security prices and risk metrics provide investors with an opportunity to reassess their portfolio positioning, ensuring it matches their long-term risk and return objectives.
© Columbia Threadneedle Investments
© Columbia Threadneedle Investments
