In their classic song, “Lola”, The Kinks’ Ray Davies wrote the above line regarding the changing gender scene in London in the 1960s. The same line could easily be written about investment markets today. Anyone who is trying to use their textbooks from the economics course at school will struggle to make sense of the current markets or predict their reaction to a particular piece of news.
On Friday, the US released their monthly employment reports, which showed stronger activity than had been expected with good jobs growth and a healthy US economy. This should have seen equity markets move higher, as a strong economy is generally good for equities, but on Friday, equities were immediately sold off, as the markets interpreted that the unemployment data made it less likely that the Federal Reserve would cut interest rates, which had been one of the driving forces of the current market strength. This is not necessarily healthy. For choice, we would all like stock market strength to be based on a healthy growing economy rather than the stimulus of lower interest rates, but since the Global Financial Crisis in 2008, interest rates have played an increasingly important role in the direction of asset prices.
The economic textbook would be even less helpful when analysing the fixed income markets. According to economic theory, sharply declining long-term interest rates are a harbinger of recession and an inverted yield curve, where long-dated bonds’ yields are below those at the short end of the maturity curve, is further confirmation of that scenario. It would not be unreasonable to expect that equity markets would come under extreme pressure in such a scenario. In the last month, however, we have seen long-term rates decline sharply and we have seen the US yield curve flick in and out of inversion several times over the last year, yet, apart from the fourth quarter sell off, equity markets have been robust and, despite investor optimism being close to the Global Financial Crisis lows, they continue to climb the wall of worry.
So if we can’t rely on our textbooks to guide us on how to invest, how do we navigate such difficult markets? The main lesson to learn is diversification. In a world where uncertainty reigns, it is a brave investor who puts all of their eggs in a single basket as we must now accept that, whatever their ultimate direction, one of the few certainties is that volatility will increase as the market reacts to news shocks. Given the current incumbent in the White House and his penchant for diplomacy through Twitter, there will be no shortage of that news flow. Never have those words written by The Kinks over 50 years ago seemed so appropriate.
State Street Investor Confidence Index
Source: Bloomberg
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