The market’s mispricing of risk will continue

“Normalization of monetary policy” is a wonderfully reassuring phrase. This seems to indicate that the mispricing of risk that has characterized markets since the financial crisis may soon be a thing of the past.

It may even suggest that the curtain will fall on the misallocation of capital resulting from ultra-low central bank interest rates, a significant factor that has contributed to the developed world’s dismal productivity record since 2008. But think again. There are good reasons to think that the mispricing of assets is not only due to a capricious monetary policy.

For starters, the proportion of investors’ capital that is price insensitive has never been higher. Exhibit A in support of this claim is the UK inflation-linked gilt market.

The government has pronounced that in 2030 the retail price index will be abandoned in favor of a link with the consumer price index including housing costs. As the CPIH gives a lower rate than the RPI, this will conveniently reduce the government’s borrowing costs. Consultants Con Keating and Jon Spain estimate that over the remaining life of the existing stock of pegged gilts, the saving could be between £90 billion and £120 billion at current market prices. This will come at the expense mainly of defined benefit pension plans.

Bizarrely, there was no discernible drop in prices after the government announcement, which can only come from pension funds mechanically pursuing investment strategies aimed at matching liabilities while hedging against interest rate and inflation risks.

Then, of course, there is the phenomenon of passive investing. According to the Investment Company Institute, a trade organization, passively managed index funds have just overtaken the ownership of actively managed funds in the US stock market.

Price insensitivity here means that capital inflows into passive funds reward yesterday’s winners and especially large index constituents. It’s basically a momentum or trend-following strategy that helps ensure that prices misrepresent fundamental value while reinforcing any tendency for market bubbles as new money rolls in.

Equally important, in terms of market distortion, is price oversensitivity, which is another way to describe momentum investing. This is not supposed to exist in efficient markets where prices reflect fundamentals. Yet scholars from the Paul Woolley Center for the Study of Capital Market Dysfunctionality at the London School of Economics have found evidence of systematic mispricing resulting from this approach.

The eponymous Paul Woolley points out that mispricing is exacerbated when the performance of asset managers is compared to an index. If they underperform the index, they are forced to buy sharply rising but underrepresented assets in their portfolio while selling other assets. This amplifies price shocks in both directions, as with classic momentum trading, but mostly on the upside due to a natural market asymmetry: stock prices have a finite floor but no ceiling.

It also contributes to a short-term climate in capital markets while sending the wrong price signals to managers of listed companies when it is necessary to reverse past underinvestment in old economy sectors where shortage has led to an upsurge in inflation.

Nor is it a healthy context to encourage the vast overhaul of the global capital stock that is needed to transition to a low-carbon economy by 2050. Long-term incentive schemes linked to stock price performance, where the long term is generally defined as three years and stock prices are volatile provides the wrong incentive. And another market distortion stems from what scholars Florian Berg, Julian Kölbel and Roberto Rigobon call the “global confusion” over environmental, social and governance reporting.

In a recent study they found a significant discrepancy in the ESG scores of six leading rating agencies. Consequences include distorted stock prices because investors are confused and companies fail to improve ESG performance because their managers are confused.

International standard setters are currently working on sustainability, but the work will take time. Thus, the scope of greenwashing by asset managers seeking to profit from what Franklin Templeton’s Ben Meng calls the ESG gold rush remains. And there are questions about the competence of auditors here. Revisions to the lifespan of carbon-intensive assets for depreciation purposes in company accounts are few and far between. How many listeners, one wonders, could tell the difference between a beached asset and a beached whale?

An underlying difficulty is that accounting increasingly captures less of what matters in the modern economy, such as human capital and the value of data. And we are a long way from a world in which stock prices reflect fundamentals, where people invest to generate direct income to pay a pension, or where investors routinely try to buy low and sell high. In the meantime, the goal of market efficiency seems painfully elusive.

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