Friday, November 25, 2016
Old behaviors will have to change in new environment
"New eras are cut short by the financial behavior they reward and condition," -James Grant.
Too much of anything is not good thing. Or, as stated by Herbert Stein, "If something cannot go on forever, it will stop." All investment strategies fail or fall out of style at some point. The financial conditions and the behavior that the markets have rewarded over the last few years may be ending with the election of a new US president and the coming elections in 2017.
With inflation expectations rising and the likelihood that there will be more deficit financing from either tax cuts or more infrastructure spending along with a cut in the amount of regulation, we are seeing revisions in interest rate expectations. It seems as though the equilibrium interest rate will be headed higher, or at the least, the level of rates have bottomed. This is an important change in regimes because it means that behavior that has been rewarded - the reach for yield, may end. Now there may be some good opportunities in fixed income, but the tailwind of having Treasury benchmark yields moving lower seems less likely, so yield chasers have to be more picky.
Current financial behavior or assumptions for how to make money will be cut short. The behaviors rewarded in the past may move to the opposite alternative. Perhaps, the best description of the new market regime will be more two-way flows with expectations. Yield chasing will be up for discussion. Inflation will likewise be up for discussion and not a far-away thought in a deflationary world. Some of the rewards and conditions that may not be in favor for 2017 include:
• Yield chasing will not automatically be rewarded, rather there will be a need to find value in fixed income. Two-way markets in fixed income will make buyers picky.
• Utilities and high dividend payers may be suspect. Buying risky yield substitutes also will not be automatic.
• Leverage may be out. In a rising yield world, financing has to be selective especially if growth is not guaranteed.
• Yield curve premiums will be back; term, volatility, and inflation premiums to name the majors.
• Banks will be more attractive if there is slope in the yield curve. Steeper yield curves more profitable.
• Inflation protection will be rewarded with a need to look for inflation not deflationary assets.
• Commodity investing will be rewarded, just not through an index. This switch will be at odds with the long-term trend since the Financial Crisis.
This is not a set of predictions for 2017 but rather a view on investor behavior if there is a shift in asset performance. Behavior responds to pain and gains, and if there is pain with yield chasing it will stop.