As observed by Dan Geller, the founder of the behavioral finance-focused research and investment firm Analyticom LLC, it has been quite a week for the U.S. and global financial markets.
On Monday September 20, the Dow Jones Industrial Average (DJIA) dropped to 33,970, a decline of nearly 1,000 points from the September 10 level. By Thursday, the DJIA had returned nearly back to where it was before the dip.
Geller suggests there was no fundamental change during this time that can be directly and convincingly linked to the rapid swings in equity prices—up or down. On the one hand, the U.S. Federal Reserve announced exactly what it was expected to announce at a key policy meeting. As had been predicted by market observers, the Fed held its benchmark interest rates near zero while indicating that rate hikes could be coming sooner than expected, and it significantly cut its economic outlook for this year. On the other, the Chinese real-estate situation related to the health of the nation’s vast property market—as encapsulated by the ongoing debt crisis of the major company Evergrande—was still the same on Thursday as it was on Monday.
Taking all this together, Geller says the past week yet again demonstrates just how much of an effect investor sentiment, optimism and fear can have on short-term market conditions.
“The only change was the financial response mode of investors during this time period,” Geller suggests. “Decision science, which is the study of financial decisions, features two modes of financial response. These are the instinctive response and the analytical response. Scientific research shows that money anxiety is the alternator between the instinctive and analytical decision modes.”
Stated more simply, when the level of money anxiety increases, investors tend to make instinctive investment decisions that are likely to be flawed and result in a loss. Geller says this dynamic clearly played out in earnest during the week, and many investors appear to have panicked and sold their equity positions at the mid-week dip.
Geller says investors should interpret the week’s market whipsaw as an incentive to “neutralize instinctive decisions by promoting the science of financial decisions,” suggesting that investors commit to follow the scientific projection rather than their instinctive response to sell when panicking. Such an approach brings peace of mind during a volatile period in the market, such as the one experienced in the last two weeks, he argues.
‘Remain Calm and Carry On’
Some similar comments were shared by Brad McMillan, chief investment officer for Commonwealth Financial Network. His main message is “remain calm and carry on,” though there are some very real causes of concern to pay attention to. Indeed, among the potentially market-moving issues McMillan is focused on is the debt ceiling—more specifically the fact that, to pay for the spending Congress has authorized, the U.S. Treasury needs to borrow more money.
“But it can’t borrow more money because Congress has said there is a ceiling to how much it can borrow, and the Treasury has hit that ceiling,” McMillan observes. “We have seen this movie several times before. The Treasury hit the debt ceiling several months ago and since then has been using ‘the usual emergency measures’ to pay the bills. Those emergency measures will run out sometime next month, however.”
While the debt ceiling issue is in many respects a political matter, in McMillan’s view, it nevertheless has real economic implications. Stated simply, this is because U.S. Treasury debt is universally considered a risk-free asset. If the government doesn’t pay its obligations to Treasury debt investors—if it defaults—then that risk-free status comes into question.
“As the foundation of the global financial system, any default could shake that whole structure, rattling markets,” McMillan warns. “On a more extended time frame, as the U.S. credit score goes down, the interest rates we pay could go up. So, this is a bad thing. While this is definitely a manufactured crisis, it is also potentially a real one.”
McMillan says investors should take some comfort from the fact that this particular debt ceiling crisis is not, at its core, an economic crisis. That is, the U.S. can borrow enough money to pay its bills, and that has never been in question.
“From a political standpoint, this is and remains a big deal,” he suggests. “The overwhelming likelihood is that we will get a deal before the Treasury runs out of money, but that outcome is not certain. So, for political drama, watch this space. We could see another governmental shutdown to conserve money, and we could see dramatic headlines about which bills get paid and which don’t. Even if we don’t get a deal and do get those headlines, though, from an economic and market standpoint, the impact would likely be limited.”
As McMillan points out, there are tools and workarounds to minimize the damage until the politicians reach an agreement.
“Yes, there would be a pause in payments, but government bills will be paid, eventually, just as they have been in past debt ceiling confrontations,” he suggests. “Since the bills will be paid, the only real economic impact will be in the delay, and that will be small. We have seen this already, as the direct effect of past confrontations and even shutdowns has been negligible over time. From a market perspective, we might see more impact, especially in the short term. Volatility is likely. But as with the economy, once a deal is finally reached, that damage will pass fairly quickly.”
The Inflation Outlook
Alberto Matellán, chief economist at MAPRE Asset Management, also shared market commentary this week, bringing in the topic of higher inflation and contemplating its various causes and effects.
As Matellán observes, consumer price index (CPI) Inflation is clearly high, but it is not clear whether this is temporary or not.
“In any case, we have been used to very low inflation in the past 15 to 20 years,” he says. “Actually, most financial markets professionals nowadays have never experienced high inflation, let alone invested in such an environment.”
Naturally, for inflation not to be temporary, there must be some mechanism that keeps CPIs rising. In most cases, that is salaries or potentially regulations, Matellán says.
“That is why central banks, and the Fed in particular, look to labor developments so closely,” he suggests. “Of the many different shortages we are facing, the most important ones are in labor, energy and electronic components. … Not all inflation we can see now is because of these shortages, but at least a great share of it is. In addition, these shortages are not self-fulfilling, so inflation might be temporary in this sense, but may last a very long time. Therefore, the concept ‘temporary’ is not clear in this context.”
In Matellán’s view, such inflation cannot be fought effectively through monetary measures driven by central banks, unless such measures provoke a huge slowdown in growth, “which is not the point.”
“So, what might central banks do?” he asks. “Let it run, which is exactly what they are doing. … It is dangerous because citizens’ rage is much more pronounced with inflation than with low growth. Throughout history, several political regimes have collapsed because of high prices, but none, to my knowledge, because of low growth. … Obviously, uncontrolled inflation makes it much more difficult for households to make ends meet, and this process can easily get quickly out of control.”
Despite the sober warning, Matellán concludes that it is likelier that the current spike in inflation will be temporary, but it will be a very important issue for investors to watch, because in the current environment, central banks may not be able to control inflation as much as they—and investors—think they can, whether up or down.