Like millions of others, I’ve been watching Broadchurch, anxiously waiting to see if Mark Lattimer has finally jumped off those iconic cliffs. Unlike millions of others, looking at that sheer drop in Dorset has begun to remind me of asset markets.
Falling from the ‘cliff of panic’
10 April 2017
David Coombs, Head of multi asset investments
Bond yields have fallen rapidly again while equity markets shrug this off and approach new record highs, leaving many investors feeling confused and disorientated by the macroeconomic events swirling around them right now.
Often when equity markets continue to rise despite bad news investors are said to be “climbing the wall of worry”. So, having climbed it, are we about to topple off the “cliff of panic”?
A nagging worry I have right now is the sheer volume of cash flows into passive investments, driven by a single-minded need to drive costs down. Now I believe passive investments can be a very useful short- to medium-term tool that can be used to get quick and cheap exposure to asset classes – this can be particularly helpful as a hedge. But do we really believe allocating capital indiscriminately over the long term is a sustainable way to invest? Is it appropriate to allocate capital to the worst chief executive in the FTSE 100 or the company with the lowest return on equity based solely on its market cap?
What happens if sentiment turns negative and these passive funds see equally large outflows? That means indiscriminate selling, tossing the good out with the bad. I picture lemmings wavering on the cliff edge before jumping off en masse with dopey smiles on their faces.
I believe the current drive to low-cost investing is distracting investors away from other equally important factors, such as ensuring capital is utilised as efficiently as possible by those we trust with its safekeeping. If you believe that markets are ultimately efficient, then stock rotation – and therefore volatility – is going to rise over the next five years as money flows from those that use it poorly to those that maximise returns.
Equity indices could be pretty pedestrian in the short to medium term, given the amount of money that has flowed in to them in recent years, so companies that can demonstrate superior returns on capital employed will, I suspect, outperform. Capturing this outperformance will be critical if positive returns are to be achieved.
If passive investing continues to dominate, then I worry equity indices could progress to extreme valuations irrespective of quality, leading us to the edge of a significant correction. And Mark might just jump!