The first two months of 2023 have been a rollercoaster for investors. Equity markets soared in January then gave back half of their gains in February as the New Year rally ran out of steam. But the really spectacular round trip has been taken by bond investors. An index measuring the combined performance of government and corporate bonds rose 4pc in the first month of the year – which is a lot in the normally staid world of fixed income investments – but, after a U-turn in February, bond prices are now back where they started, with yields on two-year Treasuries approaching 5pc.
What has happened is simple enough to explain. In a continuation of the pendulum swings of 2022, investors started the year thinking that the end was in sight for the US Federal Reserve’s (Fed) rate-hiking cycle only for a string of stronger than expected economic data releases to disabuse them of their over-optimism. First, red hot labour market figures showed that America is still creating jobs at a ferocious pace; then, one after the other, inflation measures such as consumer and factory gate prices and the Fed’s favoured measure of personal consumption expenditures blew away expectations. In January, the consensus said inflation was close to being tamed; in February, it hit back with a vengeance.
What’s striking about this dramatic reversal in investor sentiment is that no-one should really have been surprised. All they had to do was listen to the man with his finger on the inflationary pulse, the chairman of the Fed, Jay Powell. He has been trying to persuade the markets all year that the battle against inflation is far from over and that this will mean higher for longer interest rates than investors have priced. No-one can claim they weren’t told; we just chose not to listen.
So, at the start of the year, the Fed predicted interest rates would peak at something over 5pc and stay there until it was clear that inflation was falling sustainably. The market decided it knew better and priced in a sub-5pc peak in the early summer and then a rapid retreat to a new normal level of around 3pc by next spring as the Fed turned its attention from overcoming inflation to fighting an economic slowdown. Two months on and the market is now pencilling in a 5.4pc peak and there’s talk of rates going as far as 6pc. Even the Fed is now starting to look a bit behind the curve.
They say investors should not try to fight the Fed. We should also avoid the temptation to think we can outsmart it. But then overconfidence goes with the territory in investment. It is the most prevalent of the many reasons that we investors shoot ourselves in the foot when it comes to managing our money.
It’s not just investors who think they know more than they do. Most experts suffer from overconfidence, and some groups are more prone to it than others. A study of different professionals, conducted in the 1990s, showed that doctors have a particular tendency to overrate their ability. After being given a set of case notes, and self-marking themselves as 90pc confident about their diagnosis, they were shown to be correct just 15pc of the time. Interestingly, meteorologists did much better, with their predicted accuracy coming very close to their actual success in making forecasts on the basis of recent weather patterns.
I think there is a good, and relevant, reason for this. Weather forecasters operate in a complex environment that is changing all the time and where there is immediate and obvious feedback on whether they got it right. You just have to look out of the window. As a result, they are more inclined to work on the basis of a range of probabilities and to avoid spurious precision. The similarities with investing should be clear.
In practice, investors tend to behave more like medics. Expertise is put on a pedestal in our industry and we undervalue the power of the unpredictable. The twin illusions of control and knowledge lead to overconfidence. Perhaps it’s unsurprising that in a separate survey of professional investors, 75pc claimed to be better than average at their job. Similar, I think, to the proportion of us that thinks we are above-average drivers!
Once events have proved us wrong, we investors are also highly skilled at retrospectively explaining our errors. Two of the common defences that are relevant to this year’s bond market round trip might be termed ‘ceteris paribus’ and ‘it just hasn’t happened yet’. With the first an investor can argue that their optimism at the start of this year was reasonable if it hadn’t been blown off course by ‘events’ – this year’s being an unexpectedly warm winter in the Northern hemisphere (reducing the cost of gas) and the abrupt ending of China’s Zero-Covid Policy.
The second excuse says that the predicted outcome – falling inflation, lower interest rates and so a positive backdrop for bonds – has not yet occurred but it will in due course. Both provide a get-out that avoids having to admit you simply got it wrong.
But for everyone else, including those with real money at stake, excuses aren’t worth a great deal. For those of us trying to navigate the ups and downs of the market, the optimism and dashed hopes of the first two months of this year are real and have to be managed.
Doing so through this fog of uncertainty requires us: to invest like a weatherman, weighing probabilities and accepting a wide range of possible outcomes; to avoid the belief that we are the smartest person in the room; to diversify away the risk that we are simply wrong; to stop trying to time the market; and, most importantly, to listen to people with whom we disagree. We may not have wished to believe Mr Powell in January, but February suggests he may have been right all along.
