Neither of the polar opposite views may contain the truth

Jun 16 2010 by Andrew Miller, The Journal

IN RECENT discussions with investors, we’ve felt we should almost be apologising for a lack of short-term conviction in commenting on current market volatility.

It would be presumptuous to align ourselves with the best, but Yeats’ lines – The best lack all conviction, while the worst Are full of passionate intensity – at least remind us that at times of stress, conviction is in short supply: more extreme but passionately held polar opposite views dominate the debate, whether those views are soundly based or not.

So, with memories of the financial anarchy loosed upon the world in late 2008 still fresh in the mind, it is, for example, difficult to refute convincingly the notion that Greece represents the beginnings of phase two of “Global Financial Collapse”; or that a renewed US recession and a wave of deflation is about to crush corporate profitability globally; or at the other extreme, that hyperinflation lurks around the corner as a result of central banks’ emergency liquidity injections in 2008-9.

We think none of these things are likely to happen, and in aggregate the data we’re looking at seems to support a “muddle through” view – but when we’ve just lived through such a graphic illustration of the potentially self-fulfilling nature of market nerves, to pretend to have conviction in the face of the market’s bipolar views would be almost irresponsible. The fact that pundits and some asset prices are arguing both for deflation and inflation at the same time further underlines the point: fear doesn’t have to be joined up.

Why have such views taken root now? There has certainly been no shortage of triggers and some credible commentators share some of the extreme views. But there has also been a steady stream of news pointing towards less extreme outcomes – and most recently, risk asset valuations have started to look compelling: for example, near double-digit yields again on some high-yield corporate credit indices.

One explanation for all this is anthropomorphic. Investors’ collective mood resembles that of someone who’s come very close to a nasty accident.

The immediate response is an adrenaline-fuelled surge in activity, and flight. Afterwards, in a position of relative safety, the adrenaline fades to be replaced by a sudden tiredness and emotional fragility. Financial markets arguably had their very own near-death experience in 2008-9: now, some distance (in our view at least) from the abyss, it’s as if the realisation of just how bad things almost were has suddenly hit investors.

We do continue to believe that on a six-month view, risk assets look oversold.

Despite last Friday’s disappointing retail sales data, the biggest macroeconomic fear that many investors had at the start of the year – that US consumers would stop spending altogether – has not materialised, even as credit has been shrinking. Even after May’s drop, nominal retail spending is still up 7% in year-on-year terms.

For investors who are able to take such a view, and willing to tolerate the volatility, this is likely to be a good entry point for stocks and high-yield credit. Always bear in mind though that investment values can fall as well as rise; investors may get back less than they invested.

Meanwhile, the tussle for relative outperformance within and between the developed and emerging world moves onto grass. May your team do well in South Africa. And for those of us whose team isn’t there, remember: absolute returns are important too.

:: Andrew Miller is head of the regional office of Barclays Wealth in Newcastle