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Over the past week, we witnessed a rise in cognitive dissonance. Cognitive dissonance appears when two or more discernible elements – this can be an opinion or piece of new information – conflict with each other. Inflation readings, inflation expectations versus terminal rate estimates or wage inflation versus unemployment are typical examples where dissonance might occur in the eyes of the beholder. We all want to reduce cognitive dissonance as we want to avoid the impact, and pain of a poor self-image. People tend to minimise or reject information that exposes their wrongly-held beliefs or investment stance. We have reached a point in the investment cycle where conflicting messages might start to outnumber consensus calls that support conservatism. Conservatism, defined as the phenomenon that investors only gradually adjust their views –be it asset allocation or portfolio construction – to new information, might or should be waning.
The release of the US CPI inflation numbers has been a case in point and requires some reflection. However, surprisingly, we will not discuss whether the latest batch of inflation numbers represents an inflection point. Whether, by November 2023, US inflation will settle at 2.9% priced through zero coupon 1-year inflation swap or at 2.48% priced through the 1-year inflation break-even rate or 5.1% as released through the University of Michigan 1-year inflation forecast, is open for debate. I want to address cognitive dissonance at the macro-level: I describe this as the choice between a rational investment stance versus outcomes that prospect theory might deliver or not.
Under a rational approach, an investor wants to maximise their expected utility by taking the weighted sum of possible outcomes, whereby each weight represents the probability that the corresponding outcome will be reached. What few realise is that such a rational investment approach is only interested in the utility of the final outcome or final state. One should not worry on how that final stage is reached. Applying such an investment stance has certain benefits at this juncture, after a 2022 valuation reset with a historically high amplitude. Indeed, across bond sectors, expected returns over respective investment horizons have settled between 3.25% (for EU government bonds) and 7.25% (for EUR HY including default probabilities). In between, one can find expected returns in USD Treasuries at around 4%, EUR IG credit at around 4.75%, USD IG credit at 6.5% or emerging market government bonds in local currency ranging between 7.5% and 8% depending on risk profile. The equity asset class rerated as a result of an aggressive spike in discount rates next to retracements in future earnings estimates. A rational investor weighs probabilities, for instance of the level and by when policy terminal rates will be reached, as priced by markets. In addition, probabilities of future inflation paths based on various market estimates & surveys (see above) provide a clear signal that points to a neutral stance across rates. Current default probabilities and forward earnings estimates point to relatively fair pricing across credit and equity. Naturally, we have to account for a different definition of neutral across investor types.
Whether the US FED terminal rate is reached at 4.75%, 5.00% or even 5.25% has somehow become less relevant as all such end-states have been priced already over the past 3 months. Inflation might be less clear, however current market and survey-based inflation estimates, base effects, tightening of financial conditions, declining capital investment growth and less labour tightness (with firing rounds increasing) all point to disinflationary conditions. Yet, adopting rationality by accepting that ‘all is in the price’ is difficult to adhere to when the number of uncertainty factors is as high as today. Moreover, investors’ risk attitude has been damaged, as recent performance history is weighing heavily against moving from underweight allocations towards neutral points. Potential ‘losses’ impact risk sentiment twice as hard as potential gains….and that brings us to the behavioural finance considerations.
Prospect theory is a behavioural model that shows how people decide between alternatives that involve risk and uncertainty (probability of gains or losses). It demonstrates that people think in terms of expected utility relative to a reference point rather than absolute outcomes. From an asset allocation perspective, investors decide in terms of losses or gains relative to a benchmark. During such an editing phase, investors apply rules of thumb or heuristics. Next, investors enter into an evaluation moment across various outcomes (loss and gain) and opt for an allocation with the apparent highest value. We find ourselves in a moment where beliefs (or the way in which we use information) are overly shaped by biases and heuristics rather than (historical) rational expectations.
Cognitive dissonance is all over the place: over 2022, the bond-equity correlation became positive, however new information on inflation will be neglected in order to stick to the current investment stance. Investors will start filtering information and most often align with the herd. Herding is greatly facilitating the reduction of cognitive dissonance.
Moreover, a single piece of new information will not lead to change. Conservatism is at play here. So one can expect that the drop in the inflation number last Thursday will not have delivered a turn for the better in bonds or a consolidation pattern in equity valuations. More proof is required. The rule of thumb is that it takes 3 to 5 surprise releases or observations for one’s opinion and investment stance to change. Conservatism delays asset allocation as well as portfolio construction changes.
Another way that prospect theory might delay rationality lies in the self-serving bias and biased self-attribution. The self-serving bias pushes us to interpret new information that is most favourable to us and minimise facts that would lead to other conclusions than the one we defend. Often, investors also tend to blame failures on others and attribute successes to their own ability known as biased self-attribution. On top, the availability heuristic makes us estimate the frequency or probability of an event. As the set of current conditions has led to performance hardship, we attach high subjective probabilities to a continuation of these going forward.
The above biases and heuristics feed moments of overreaction or underreaction depending on good versus bad market news. Market reactions between Thursday 10 over Friday 11 November fit the bill perfectly! It most often also leads to excessive trading. Investors will interpret signals differently and apply different probabilities to risk-free and risky asset return distributions. At the end, investors try to follow the optimal paths, but are confronted with conservatism and cognitive biases that make for a difficult journey.
Being aware of cognitive dissonance, at a macro and micro level, might enable investors to better prepare for episodes, relatively long or short, of panic or hype.
The panic episode started in January 2022. Frontloading tactics by central banks in raising policy rates point to a relative short pain episode. Next to the inflation signal last week, we have been receiving additional signals (tightened financial conditions, weak CEO confidence, anaemic capex growth…) that inform us that panic should make room for an episode where a rational investment stance might pay-off over the next three to five years. Focus on the end state, trying to walk the optimal path over the next quarters will not be easy.
Rational expectations theory points to a neutral asset allocation stance. Behaviour biases and heuristics might keep investors too long on the side-lines or in a defensive yet comfortable allocation framework.
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