Amygdala or prefrontal cortex: which part of the brain tends to win out on markets?
As indices around the world have fallen into (and sometimes back out of) bear territory in recent days, you might have thought the big question for investors was what exactly the global economic outlook is, in light of the spread of the coronavirus, and the containment measures put in place by governments and companies. However, the reality is that, while there is already a significant economic and financial cost, it is impossible to forecast the virus’s spread and, therefore, its ultimate impact.
“Anything I say with respect to the coronavirus will be a guess, and that holds true for all non-scientists,” said Howard Marks of Oaktree Capital Management, co-manager of the St. James’s Place International Corporate Bond fund. “Overall, the news about the disease seems to get worse. The key questions are how the news will compare against the expectations factored into security prices, and whether and when we’ll get the virus under control. Since the market’s reaction will ultimately be a function of both economics and emotion, it’s impossible to quantify how far it will go.”
Given these levels of uncertainty, the next question is how investors will react – and, boy, were they reacting last week – first by mass selling and then, on Friday, by rapid buying, at least on Wall Street (although this morning’s European trading suggests selling is once again in favour). Will investors apply rational thinking (as controlled by their prefrontal cortex) to their buy-and-sell decisions, or will they allow animal instincts and emotions (controlled by their amygdala) to take over instead? To some fund managers, at least, rational thinking appears thin on the ground just now.
“Consider that, in the last week of February 2020, US markets suffered their biggest one-week drop since the 2008–09 global financial crisis and officially entered ‘correction’ territory,” said Wasatch Advisors, manager of the St. James’s Place Emerging Markets Equity fund. ” Similar irrational fluctuations have repeated through early March, creating a volatile environment that is difficult to predict.”
For some managers, however, the apparent overreaction of recent days may also reflect a longer-term phenomenon, in which central banks stoke investor confidence artificially.
“The continual intervention of central banks in financial markets for the last 20 years has encouraged risk-taking behaviour that created a financial system that was fragile and hence less
able to cope with the slightest stress,” said Ian Lance of RWC Partners. “This eventually materialised with the economic shock caused by the outbreak of the coronavirus.”
In fact, on Sunday evening, the Federal Reserve announced a shock cut that took the US base rate down to a range of 0–0.25%. Jerome Powell, the Fed chair, also said it would begin a new, $700 billion programme of quantitative easing, in which the central bank buys bonds to prop up markets – and the economy.
Yet if that’s what central banks are doing, the question remains: what should investors do now? Experience and prudence will, of course, remain key; but when markets are down this far, active managers should, at the least, be looking hard for companies that have been unfairly devalued in the mass sell-off.
“Many assets are still in the wrong hands and assets will also need to be forcibly sold in order to meet redemptions, which may occur,” said Mark Dowding of BlueBay Asset Management. “On top of this, we confront an unprecedented situation where banks and managers, BlueBay included, are enacting protocols with respect to splitting teams and working from remote locations. This will mean that liquidity will continue to be challenged and, in this environment, some sales will surely occur at distressed levels – and these are the moments when it is good to be in the position to buy rather than sell.”
The rising severity of the virus’s impact in both health and economic terms precipitated a wide range of policy responses last week from both governments and central banks.
In Italy, the government extended its lockdown policy, which had previously been limited to Lombardy, to the entire country. Then Rishi Sunak, in the current UK government’s inaugural Budget, announced a raft of measures to support growth in the months ahead (link to story here), not least a £30 billion boost in spending, or £175 billion over the next five years. But these decisions paled, in terms of market impact, next to the announcements made by Donald Trump and by major central banks.
The US president’s decision to announce, via live televised address, that he was imposing a 30-day travel ban on flights from most European countries (since expanded to include the UK and Ireland), caused equities to suffer their biggest one-day fall since 1987 on Thursday; although Friday’s rise for US equities significantly softened the week’s fall in aggregate.
The virus’s spread has, of course, become a European tale in recent weeks, placing central banks in the spotlight. The Bank of England cut rates by 0.5% shortly before the Budget (well-timed to avoid complaints of politicisation), meaning the UK economy will benefit from both fiscal and monetary boosts at a time of significant economic need. In its Economic and fiscal outlook, published last week, the Office for Budget Responsibility (OBR) said Brexit had already knocked two percentage points off the size of the UK economy. The OBR also said that the government’s fiscal boost would account for more than half of the expansion in output both this year and next.
The European Central Bank, on the other hand, disappointed investors last Thursday by choosing, contrary to expectations, to leave rates unchanged for the moment. That said, its rate currently stands at -0.5% – hardly expensive for borrowers.
All these developments rather overshadowed the other big story of the week, namely the continued comeback of Joe Biden in the Democratic primaries. Although markets generally prefer Biden to Sanders, they also give him a higher chance of beating Donald Trump in the autumn. As Biden’s star rose, however, US futures fell, indicating that they would prefer Trump to remain in place, tax cuts and all. One sector to rally strongly on equity markets following Biden’s success was healthcare, a sector Bernie Sanders is planning to target with new regulations.
BlueBay, Oaktree, RWC and Wasatch are fund managers for St. James’s Place.
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