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
  • Explain moral hazard
  • Identify post-financial crisis 'rules of thumb'
  • Describe the impact of Covid-19 on investor behaviour
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How to analyse investor behaviour in a post-Covid world
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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.

But what if the Fed pushes ahead, accelerating its timetable for interest rate hikes, more fearful of inflationary risks and moral hazard than asset prices?

Unlearning a behaviour can be quite painful, and removing a key belief from market participants can create a short-term void of buyers as investors struggle to reset their market narrative.

There is no alternative (to equities)

At the height of any crisis it is very difficult to take a step back and to strip out some of our natural investment biases. It is therefore key to follow an established, stress-tested process and try to gain perspective.

A key metric Brooks Macdonald focused on in March 2020 was the difference between the expected returns on cash, government bonds and equities.

This metric is arguably now the most discussed measure of the past 12 months and, while it does little to indicate when there may be a correction or rally in equities, it demonstrates how painful it can be to have an underweight exposure to equities on a structural basis  

It is painful from an inflation-adjusted standpoint and from a fear of missing out on relative equity returns.

Investors with cash, on the sidelines, fearful of inflation, have few asset classes to look to, and this lack of alternatives to equities has been a key support of the equity bull market of the past 18 months.

At times of market stress, equity prices fall, which all being equal increases the earnings yield, creating an even wider disparity between the yields available on equities compared with bonds.

So, what does this mean for investor behaviour? Following periods of market weakness, investors often re-enter equity markets in short order, reflecting not only a recognition of the ‘Tina’ environment, but also memories of missing out on the recent gains from equity markets. 

Are these learnt behaviours healthy? 

The current investor mindset has led equities to high absolute valuations compared with the past, and central bank support has kept government bond yields below expected inflation levels.

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