CPD  

How to analyse investor behaviour in a post-Covid world

  • Explain moral hazard
  • Identify post-financial crisis 'rules of thumb'
  • Describe the impact of Covid-19 on investor behaviour
CPD
Approx.30min

Economists argue over the exact catalyst that started the rebound in risk appetite that drove equities from their lows, but it was most likely to be investors concluding that the sheer weight of stimulus was more than sufficient to cover even the most bearish of Covid-19 outcomes.

Investors were convinced that, should it be needed, governments and central banks would continue to provide more and more stimulus. 

‘Moral hazard’ refers to a situation where a party to an agreement does not suffer the economic loss of a risk and therefore may take the risk without consequences.

This view became prevalent among market participants who adopted the opinion that falling assets would ultimately be propped up, or even bought by central banks, should the situation continue to worsen.

Arguably, this has reinforced investor behaviour rather than created an entirely new mindset.

Since the financial crisis, bad economic news has often been associated with a good stock-market outcome as investors price in additional stimulus or more accommodation for a longer period of time.

During times of concern over the past 18 months, investors have priced in additional accommodation within the bond market rather than reflecting poorer news in lower equity prices.

The view that central banks and governments are in some way underwriting risk within asset markets could be quite dangerous.

It comes at a time when authorities are attempting to transition to a more normal world, at least partially weaned off the ultra-cheap money required to stimulate demand last year.

Looking ahead to 2022, a central bank ‘policy error’ is one of the greatest risks to financial markets. At the heart of this is the conundrum faced by central bankers: do they react to the risk of inflation proving 'stickier' or do they want to look beyond what may well prove transitory.

At the same time, central bankers clearly want to take steps to remove some of the pandemic support that propped up markets last year, given the economic progress made within many developed market countries, as well as globally.

The debate within central banks mirrors that within governments who look at falling unemployment levels and higher levels of economic activity, and question whether it is prudent to continue providing fiscal support with debt-to-GDP at extended levels.

A withdrawal of monetary-policy support can take several forms. Least impactful arguably is the taper, ie reducing the scale of asset buying, followed by quantitative tightening, ie reducing the amount of assets on the central bank’s balance sheet, or raising interest rates.

Currently, investors have been conditioned to believe that central banks will stop short of action that will destabilise markets, as the Federal Reserve did in December 2018, and which has happened many times in recent memory.