As in the tale of the girl who ventures into the bears’ house, investors believe that the economy is neither too hot nor too cold, and inflation is neither too strong nor too weak. The central banks will thus be able to lower rates before the macro weakens, while prices continue to ease on their own. Grab the popcorn and enjoy the show. Why bother with superhero films? In this one, all financial assets are flying high. Stock markets have had their best first quarter for five years and credit spreads are narrowing. It’s a bad time for prudence, the villain of the story. Or is it not?
Speaking of heroes, this writer is in mourning, having lost two recently. At the end of November, we lost Charlie Munger, Warren Buffett’s loyal squire and paradigm of common sense (which is far from common, one wonders who gave him that name) in the world of investing. Among many other things, he argued that when enthusiasm dominates (currently the indicators are off the chart), it is difficult to find good prices (ergo, good returns in the medium and long term). A few weeks ago, Daniel Kahneman, the only Nobel Prize-winning psychologist in economics (author of one of my favourite books, “Thinking, fast and slow”), also passed away. He proved that the human species is far from rational, as was (is?) taught in economics courses, and that our brains are not designed to be good at investing. Now it is all about “FOMO”, or the fear of missing out on rises, whether they are understood or not. Financial assets have become disconnected from reality. Earnings are revised lower as stock markets rise, led by cyclical sectors, in anticipation of macro rebounds. Fixed income risk premiums are contracting, and issues are being oversubscribed like there is no tomorrow, but Europe is not growing, Japan and Britain contracted last quarter, and to say that China is languishing is to put it lightly. And geopolitical risk is hardly a reason to pop the champagne, either.
In short, there are only two possibilities: either reality moves towards what the markets are discounting, or the markets move towards reality. The former may be the case. The US economy continues to surprise all and sundry with its unusual strength. China seems to be gaining some momentum, and Europe will one day improve (fingers crossed). Inflation, by base effect alone, is correcting — although not as quickly as desired. The labour market, in the US and almost everywhere, is as robust as can be. What is off-putting about the “Goldilocks” narrative is that it doesn’t seem very sensible for central banks to lower rates in a mad rush. They risk a rebound in inflation, which would wipe out their credibility, and they would run out of “ammunition” for any worse times ahead. Suppose that, in spite of the above, they do cut rates: this is already discounted by current prices… However, if it turns out to be the latter, and the financial markets are faced with a reality different from the one they expect, a lot of people are going to choke on their popcorn. The villains will come out on top in that blockbuster.
Especially when being prudent doesn’t mean doing nothing and waiting for storms to come. Not investing at all in equities may prove to be foolhardy, specially if inflation does not recede. Being prudent means taking part in the opportunities (which there always are in all assets, it is just a matter of being a little more selective), and leaving room for those that may come. Particularly when they pay us while we wait, without having to take on much risk. This story’s villains don’t do too badly either. Their portfolios may earn less than those of the superheroes, but they get a good night’s sleep. If the fun continues, so much the better. If there is a storm after all, they will be able to fish in troubled waters.
Hopefully today’s financial markets are not living in the wrong fairy tale. Perhaps they should seek out a Magic Mirror, and ask who is the fairest in the land. They might be in for a surprise.
Date of report: April 10th 2024