Why are Markets Not Reacting Negatively to Bad News?

Stock markets hate uncertainty - or so we're taught. But the last year has seen considerable political uncertainty and markets have rallied. We speak to Newton's Iain Stewart

Emma Wall 10 May, 2017 | 9:25AM
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Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm jointed today by Newton's Iain Stewart to talk about market uncertainty.

Hello Iain.

Iain Stewart: Good morning.

Wall: So, over the last year we've had several macro results, which have resulted in the markets doing the opposite of what we might expect, Brexit. For example, Donald Trump and indeed even this week, Macron being elected, so stock markets in France and across Europe fall when we think they would be positive. So why are we in this environment now where markets seem to do the opposite of what we expect?

Stewart: Yeah, I think, its, what we think it's because of continued support from central banks. So, as you're aware, we've used a lot of unorthodox mandatory policy over the last few years and that’s been expressly designed to support markets and to inflate them. Because its kept going on, investors have become conditioned to that. And in fact, I think they almost anticipate that if there may be something bad going to happen then the central banks will come in again or maybe even inject liquidity ahead of it.

I think that was probably what we saw through 2016, the lows there. There was a huge ramping up in the aggregate asset purchases, which is another way of saying money printing by central banks and that allowed markets to breeze through some of these what one might have thought were sort of calamitous events.

Wall: And how do you invest in that kind of backdrop. Do you assume that it will carry on going forever more? Or do you have to take a difficult pillar at some point and think, central bank is going to stop propping this up?

Stewart: Well, we're investing for absolute returns, so we're really not keyed into thinking about what the stock markets are doing. We're trying to invest for our investors in a target return basis, relatively a little bit incremental returns. And our approach is to try and balance the return that we can get from risk assets with capital preservation. So, if we can incrementally get a bit of return, but if markets are weak, we don't capture all of that, then we can make up a better return in the long run.

But really, we think that the sort of euphoria that we've seen in our markets as a result, we think of excess stimulus. Mix is very cautious, so we are very hedged, perhaps too early, perhaps we're being cautious too early. But we do think there is a lot of tensions building and low volatility is quite often followed by periods of high volatility. So, that would give us the opportunity we think to invest on a better basis for our investors in the long run.

Wall: Because we have seen incredibly low volatility. I mean, one of the first things I was taught when I first started covering investment was markets do not like uncertainty.

Stewart: Yeah.

Wall: And yet, markets have been pretty sanguine about uncertainty over the last year. So, do you think actually this is giving people false hope, and we should be prepared for a lot more volatility in the short to medium term?

Stewart: Well, yes, I think we will agree that we will have volatility in the longer term. And in a sense you are right that high levels of valuation, which imply high levels of certainty, are coinciding with very low levels of volatility.

In fact, levels of volatility that were last seen in 2006, for example, and that was the period where investors were starting to believe that, as Gordon Brown said, there was an end to boom and bust. And so that gave them the confidence to put in more gearing to lever more, to add more debt. And in a way we've got a similar situation now, we think debt growth is very rapid, particularly in some of the developing economies like China. And that low volatility encourages it. So, inevitably, if some of those debts go bad, which they can often do at the end of a cycle, then the volatility that we'd expect will come aboard.

Wall: So, Gordon Brown said end to boom and bust in 2006 sold-off all our gold, followed by market crash and gold price rallying. Is that what you are predicting?

Stewart: No, we're not predicting that at all. You know the market clearly chime but they don't repeat in that sense. But I guess what it's suggesting is that it probably is still a boom/bust cycle in our minds, because we don't see that underlying economic activity is really responsible for the sorts of levels of prices that we've got in financial assets. So, some sort of readjustment of that would make sense. And then that gives us an opportunity to invest with better expected returns because the higher the price that you pay for an asset broadly the lower return you can expect on it.

Wall: Iain, thank you very much.

Stewart: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar