Today, investors have a unique opportunity to observe the spreading of a real virus alongside the viral nature of financial markets and the real economy. As Nobel Prizewinning economist Robert Shiller points out in his book, Narrative Economics: How Stories Go Viral and Drive Major Economic Events, “stories and images are created around new economic events”1. In some cases, these stories are memories of the past and their spreading can have major implications regarding economic and financial markets.
The Covid-19 crisis has thrown up a sequence of images from the past (pandemics, wars, the Great Financial Crisis) that have pushed central banks (CB) and governments to act in unprecedented ways (in terms of magnitude and speed of action). This has defined the current ‘day after’ narrative.
Financial markets have adapted to this new narrative, pricing in the rosiest scenario of a ‘day-after renaissance’, but more will be needed in terms of fiscal and monetary support to sustain the recovery moving forward. The Covid-19 fallout on the real economy and society is deep and pervasive: the overall debt level in the system is skyrocketing and some sectors are very unlikely to recover to pre-crisis levels. Rising social and inter-generation inequalities are the enemy to fight to avoid social upheaval.
Politics is the link between public narratives (reinforced in the media and on social media) and institutional narratives. The narratives that will emerge amid hot political events — the US presidential election and the debate around the allocation of resources from the EU Recovery Fund being the most relevant — will set the direction for financial markets.
Strong narratives can drive market consensus and lead to crowded trades around major themes. When narratives continue to build up, taking a contrarian view can be very dangerous and expensive for portfolio returns. This has been the case in the last few years prior to the rise of the Covid-19 pandemic, when markets were driven by the stimulus narrative (central banks first, Trump fiscal push after). This stimulus narrative continues, coupled with zero interest rates and inflation permanently forgotten in the Covid-19 era, but investors should be aware that narratives could change quickly.
Today, the mantra of financial markets is that core bond yields will remain low forever, but this assumption may prove more fragile than currently anticipated and have significant spillover regarding financial market performance.
Tackling post-Covid-19 challenges will require further expansion of debt to finance the investments needed to drive changes that could broadly benefit society. High debt levels will require higher inflation and real rates to remain low to favour the repayment of debt.
The assumption that interest rates will remain low forever has translated into an overly exposure to the ‘long duration call’ that is implicit in different trades in the market: long US Treasury (UST) trade, long investmentgrade credit, long Big Tech equities, long private equity or real estate. In the end, they are all trades playing the same long duration view.
The Fed unlimited QE has pushed UST yields to all-time lows. The Fed’s new framework of “average inflation target” means shortterm rates should stay near zero during the recovery phase, but this doesn’t imply that the long end of the curve cannot adjust to improving fundamentals. Some steepening has already started to materialise, but we could even reach a point when the steepness of this cycle could be greater, as the Fed and the ECB are not going to hike until inflation moves way above their target for a long period of time.
Any disappointment due to a stronger-thanexpected recovery or a technical reduction in the size of the quantitative easing (QE) programmes could trigger a sort of ‘taper tantrum’ and challenge the current assumption on core bond yields. Any increase in rates for whatever reason could make valuations in some segments of the equity market unsustainable, especially in the tech sector. Given the crowded trades in this space, any unwinding of positions could ignite market volatility. This is the key element to watch for today.
Currently, inflation is completely off the radar among market participants, but it should be monitored actively as an emerging theme in a world of rising de-globalisation forces and higher debt. Big data and artificial intelligence could become even more relevant in the investment world, as they allow for the tracking of these patterns and the use of them to better understand and forecast trends.
Investors should be prepared for a possible change in the narrative. These shifts are arguably the only sequence via which investors can systematically extract value. It will be critical that investors maintain a strong level of flexibility and liquidity to exploit those opportunities arising from inefficiencies and dislocations.
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1. In the words of Shiller, narrative economics is: “a theory of economic change that introduces an important new element to usual list of economic factors driving the economy: contagious popular stories that spread through word of mouth, the news media, and social media”.