Narratives: Fear and Greed


14 Nov 2023

Andrew Holt explores the idea of narrative-driven markets and what they mean for investors.


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Andrew Holt explores the idea of narrative-driven markets and what they mean for investors.

Markets are not rational. If they were, no one would make any money. Strong fundamentals are sometimes not enough to stop the value of an asset falling. The economic and market narratives can be a bigger factor. And every investor wants to predict the future, to spot the influences that are shaping the investment universe. If you can unearth that, you are potentially on to a winner.

This year, that narrative has been a soft landing – one where central banks will succeed in bringing inflation under control. And it is a narrative that the pessimists appear to have got wrong. Although, some believe the jury is still out here.

So what is the latest economic narrative we are living under? What does it tell us about the markets? And more importantly, how should investors react?

One economist who has a formula to find out is Michael Metcalfe, head of macro strategy at State Street Global Markets. Every two weeks, he examines the intensity of media coverage around certain terms to see whether changes in that coverage show a correlation with market movements.

“If coverage and market impact [correlation] are above the historical average, we note this theme as showing important market hype and plot this on what we call a narrative map, which helps us identify which narratives are important for markets at any given time,” Metcalfe says.

So what narratives has he identified that are driving markets today? Metcalfe cites three: international conflict, investor sentiment and interest rates. “International conflict has sadly never been far from the headlines,” he says.

Read all about it

How these themes have played out from a narrative perspective is intriguing. “The media intensity and market impact of the narrative first spiked in mid-January 2022, as the press speculated about Russia’s coming invasion of Ukraine,” Metcalfe says. “It remained a market-driver for the next five months and its influence on markets has continued to ebb and flow.”

Then in early October, changes in the narrative were once again impacting markets, but the media coverage had become less intense. “Now with the tragic occurrences in the Middle East, the conflict narrative has risen to its highest level since the immediate aftermath of the outbreak of war in Ukraine. It remains unclear how long this conflict will last.”

Indeed, how the Israel-Hamas war plays out could create a whole new narrative trend. Wider geopolitical factors coming into play could create a new world of disorder, and with it, a whole new narrative potentially edging towards a bleak out- look. Paul Flood, head of mixed assets at Newton Investment Management, emphasises the global disparity. “East and West are at different points here,” he says. “It’s not great for bringing people together.”

Fiction is your enjoyment and your non-fiction is facts. You should invest on a non-fiction basis.

Paul Flood, Newton Investment Management

Investor sentiment

On a different level, how the conflict impacts oil prices and the commodity markets and with it inflation, is a considerable narrative. But it should be noted in the immediate aftermath of Hamas’ horrific attack on Israel, global markets were unmoved.

When it comes to interest rates and the investor sentiment narrative, Metcalfe finds, within his analysis, above average media coverage and impacting market returns. Both are “intuitive”, he says.

Expanding on this, Metcalfe adds: “Bond market volatility has been exceptionally high, so the market narrative on interest rates and what central banks are saying about them have been impactful for market returns.

“Then together with heightened geopolitical risk and interest rate volatility, news on investor sentiment and how they are reacting has also become more important. In particular, whether investors simply fall back to the benchmark are positioned to be significantly more defensive than they already.”

How investor sentiment reacts to this narrative and the reality of high rates for longer, as well as heightened political risk, will prove crucial for market outcomes in the final quarter of this year and beyond.

The reaction of investors is not the only central factor in the narrative outlook. “Arguably how central banks react to this combination of risks will be even more important,” Metcalfe says. “We note that coverage of central banks everywhere has become less hawkish.”

So with conflict, sentiment and rates being the dominant media narratives driving markets, investors have responded, Metcalfe says, by adopting a more defensive and less cyclical posture across their portfolios as well rebuilding overweight positions in safe havens such as the US dollar.

The Fed fails

Michael Field, senior equity strategist at Morningstar, says that one of the narratives that has been spun, admittedly successfully, since the financial crisis has been the idea that central bankers have such a hold on monetary policy that they can steer the economy clear of recessions through the tweaking of interest rates.

“It is this belief that is central to the idea of a soft-landing. But it is far too early to say the pessimists have gotten it wrong,” he says, turning the current accepted narrative on its head.

A key narrative is that European markets are fairly valued, according to Morningstar. “They are not cheap, but we cannot say they are expensive either,” Field says.

However, what they are not doing is pricing in a recession. “The market still very much has this belief, that we will be able to avoid a recession,” Field adds.

Central to this belief is the idea that interest rates have peaked, and that inflation will fall away from here, allowing central bankers to cut, and for the economy to continue to grow at a moderate pace.

This, Field observes, is the narrative that investors are still largely buying into. “But it contains one major flaw – the assumption that inflation will continue to fall rapidly from here,” he says. “While, inflation has basically halved from the double-digit highs witnessed late last year, explained largely by falling food and energy prices, this is only the first part of the fall and was the easy part.”

A sticky problem

This does, therefore, have an important inflation narrative – but not in the way we currently understand it. As what this means is we are now left with goods and services inflation, which is much stickier, and could take years, not months, to fall to anywhere near central banks’ 2% target.

This new narrative around the problem of sticky inflation could be with us for some time, presenting obvious challenges to investors.

“So, the assumption that central banks, like the conductor of a symphony orchestra, can perfectly harmonise rates to fall just enough to avoid recession, while still being high enough to quell inflation, is somewhat fanciful,” Field says.

For him, the more likely scenario now, and something central bankers are intimating, is that we may have to live with higher rates for longer. What, therefore, does this mean for growth-focused equities?

“It means their valuations will likely have to correct again,” Field says, “while corporates with high levels of debt, and hence high interest payments, may see the value of their bonds adjust to the higher level of risk attached to operating in a higher interest-rate environment.”

Blowing bubbles

Looking at things differently, David Jane, a fund manager in Premier Miton’s macro thematic multi-asset team, offers something of a contrarian analysis on the narrative-driven markets idea. “In my view, the effect is actually reversed. Narrative follows price.

“The broad majority of investors leap onto a narrative to explain price movements,” he adds. “Human nature needs stories to explain things, not data.”

A good example he cites is the apocryphal story of the fund manager asking his broker why a stock has risen strongly. In the absence of a good answer the broker says: ‘more buyers than sellers’. “A classic case of narrative following price,” he says.

Expanding on his thinking, Jane says that once a narrative becomes established a so-called ‘reflexivity effect’ takes hold. “Price movements reinforce the narrative, proving the narrative true and so on,” he adds. “This is especially true where liquidity is abundant. This process can ultimately lead to bubbles forming,” he adds.

Adding to his interpretation, Jane expands further. “Narratives are basically shorthand for explaining what are highly complex systems,” he says. “This leads to obvious inconsistencies of rising bond yields, on the higher for longer argument, but growth stocks, such as the magnificent seven, performing strongly on, supposedly, the artificial intelligence (AI) story. It is difficult to put a consistent story across both.”

In Jane’s view, the overriding, long-term narrative, will likely remain ‘higher for longer’, the end, ultimately of the disinflation narrative. “This will set the overall market regime for the coming years, but will no doubt be interspersed with other stories, such as reshoring, AI, energy and resource scarcity in the interim.”

Under the hood

But Anthony Arefian, director of global markets research at Los Angeles Capital Management, offers a similar sceptical view when it comes to the narrative-driven markets idea. “We absolutely appreciate that narratives can and do drive sentiment and price action, but it’s usually initial price action that creates the narrative to begin with,” he says.

“As everyone knows, the market is forward-looking,” Arefian adds. “It can take months if not quarters before the justification for price action today becomes clear to investors. For example, global equities bottomed in Q4 2022, and continued to behave strongly into 2023 while investors still feared a ‘hard landing’.”

It does appear that the risk of a hard landing has declined materially, hence the strong year-to-date performance in equities. But Arefian offers a caveat here. “While a hard landing might be o the table, investors aren’t completely convinced that we are beginning a new economic boom or anything resembling one.”

This becomes obvious when you go ‘under the hood’ in equities, Arefian says. “For example, small cap and micro-cap stocks have lagged their large cap counterparts quite badly.”

He also shares Jane’s analysis in bigging up particular blue- chip stocks. “The performance of the magnificent seven imply that investors are hiding behind the highest quality, monopoly- like businesses, as we navigate this uncertain economic environment,” Arefian says.

The broad majority of investors leap onto a narrative to explain price movements.

Paul Flood, Newton Investment Management

The magnificent seven

Inevitably, inflation keeps rearing its head in the narrative driven markets outlook. Arefian sees investor concerns shifting from worries about inflation to preferences for structural growth as we potentially enter the late stages of the economic cycle. “2022 was all about inflation, which benefits companies with high operating leverage,” he says. “We noted that use of the term inflation by management teams during earnings calls skyrocketed in 2022, peaking in Q3 2022. It has since fallen off sharply.”

In 2023, he believes investors have been looking for quality, reasonably priced growth and stable cashflows. “While a recession hasn’t materialised yet, we believe that investors are nevertheless seeking large companies with quality assets and management teams, and those with the ability to grow cashflows regardless of where we are in the economic cycle,” he says. “This is not indicative of behaviour during a renewed economic boom.”

However, Arefian says this does not mean a preference for defensives today, as interest-rate sensitive utilities, staples and real estate investment trusts (REITs) have underperformed as rates have risen higher.

“Economically sensitive small caps have also underperformed – again, not indicative of economic strength looking ahead, and broad indices have been carried by the ‘magnificent seven’ – Apple, Amazon, Alphabet, Meta, Nvidia, Tesla and Microsoft – which accounted for 60% of the ACWI’s 10.5% year-to-date gain through September.”

This puts a strong case for investors to look at a large caps narrative. “Many of the largest companies in the US have large positive net cash positions and, in this respect, can benefit from rising rates,” Arefian says.

Developing world

Some of the drivers of narratives are the on-going changes in the way the world is developing. Paul Flood says technology is at the heart of the narrative-driven markets idea. “Narrative-driven markets are part of our digital driven world,” he says. “We used to have a lot more time before information was fed through to people. Now it is on X [formerly Twitter], and other social media, and people become more aware of it. People then get excited or panic. This then acts as a big narrative driver.”

Then stocks themselves get in on the narrative-driving act with their own narrative to promote themselves to investors. “Within the growth part of the market you get all the main stocks doing this,” he says. “CEOs have become more aware of the brand value that they have with their products which leads on to their own stock presenting narratives.”

This presents an important question: are the narratives in markets today primarily technology driven? “It is both the speed and the velocity of information,” Flood says. “You are constantly moving from one thing to the next. That changes the way investors think, and then react.”

But not all investors play by those rules. Flood says he tries to ignore the noisier narratives. “We have generally a low portfolio turnover,” he says. But there is a big proviso here, where the narrative noise can be unsettling. “There is a behavioural side to the job as well, and if you are constantly being fed negative news stories there is a point where you begin to question your investment philosophy and process,” Flood says.

No value

Looking at the big narrative influences in recent years, Flood says: “Over the last decade, it has been all about growth. Value hasn’t worked. Or if you weren’t in the technology stocks and mega caps, then it was painful.

“That changed the positions many investors had in their portfolios. Long duration worked, then in 2022 it didn’t. It was very painful that year.”

Flood advises pension funds caught up in a narrative, to stick with a long-term view. “To an extent, pension funds can avoid the noise,” he says, before adding: “But if you underperform for too long, eventually someone gets sacked and then someone else is brought in who has done well. So even in the pensions industry investments can come under pressure from narratives.”

Flood offers investors advice in dealing with the narrative challenges. “Being diversified helps you to deal with the bumps in the road.”

He also says investors can exploit the accepted narrative by stepping into it and taking a different, contrarian, sometimes opposite approach. For example, when things are negative in the market, look at where the investment opportunities are, irrespective of what the narrative is saying. This could be seen as something of a counter narrative approach. “It is about getting to the facts,” Flood says.

“The narrative is a story, but we want to deal in facts. As it is the facts that will determine the long-term returns. Whereas the narrative is usually about the short-term trends in the market,” he adds.

Central control

Returning to an important narrative, Flood questions if central banks can maintain control over inflation. “Our view is that over the last two decades, central banks have not had control over inflation. It has been down to China and deglobalisation that led to a deflationary force and kept inflation in developed markets down,” he adds. “We are going to a slightly higher level of inflation going forward.”

Here Flood highlights the shifting ebb and flow of recent narratives. “We went from hard to soft landing to no landing. And what I would say, is all narratives do is justify a particular position in the market.

“And an important question is: does the narrative get placed on after the events have evolved? It has to start somewhere. But, of course, there is always some truth in a narrative, because that is why it resonates with lots of people and becomes a narrative in the first place,” he adds.

Flood offers another interpretation to the narrative-driven markets idea. “It is a bit like fiction versus non-fiction,” he says. “Fiction is your enjoyment and your non-fiction is facts. You should invest on a non-fiction basis.”

But interestingly, some investments are driven solely by narratives. Jose Pellicer, global head of investment strategy at M&G real estate, says: “Commercial real estate is entirely narrative driven. And has always been narrative driven. It is how real estate operates.

“The key reason for this is the different dynamics affecting the market. It is not about the short term, everything is long term,” he adds. “And driving that long-term outlook is a narrative about real estate and what is does [for investors].” This offers a completely different take on narrative-driven markets, one where the narrative creates a long-term investment rather than a short-term trend, as is usually the case with narratives in the market.

Your truth

But narratives inevitably can also be problematic for investors. “Narratives create bubbles,” Flood says. “They are always there in the market: it is greed and fear. What you need to make sure is you are not exposed to either. Too much greed or fear is something to avoid.”

Flood concludes by offering a philosophical approach to the whole narratives idea. “The point is, the narrative isn’t the truth,” Flood says.

“The narrative is something to raise attention to something in the market,” he adds. “And the narrative can be overplayed or underplayed. To avoid being caught up in that, you have to have a process and a philosophy. This doesn’t work all the time. As investors you have to take an approach that best meets the circumstances.”

Narratives are therefore shaping investment decisions whether covertly or overtly, and will no doubt continue to do so for many years to come.


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