Market mispricing of risk will continue

“Monetary policy normalisation” is a wonderfully reassuring phrase. It seems to hint that the mispricing of risk that has characterised markets since the financial crisis may soon be a thing of the past.

Maybe it even suggests that the curtain will come down on the misallocation of capital that has resulted from central banks’ ultra-low interest rates, a significant contributory factor in the developed world’s dismal productivity record since 2008. But think again. There are good grounds for thinking that mispricing of assets is not just down to freakish monetary policy.

For a start, the proportion of investors’ capital that is price-insensitive has never been higher. Exhibit A in support of this assertion is the UK inflation index-linked gilts market.

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

Bizarrely, there was no discernible decline in prices following the government’s announcement which can only stem from pension funds mechanistically pursuing investment strategies aimed at matching liabilities while hedging against interest rate and inflation risk.

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

Price insensitivity here means that capital inflows into passive funds reward yesterday’s winners and more especially the big index constituents. It is, in effect, a momentum or trend following strategy that helps ensure that prices are a poor reflection of fundamental value while reinforcing any tendency to market bubbles as fresh money pours in.

Equally important, in terms of distorting markets, is price over-sensitivity, which is another way of describing momentum investing. This is not supposed to exist in efficient markets where prices reflect fundamentals. Yet academics at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics have found evidence of systematic mispricing arising from this approach.

The eponymous Paul Woolley points out that mispricing is exacerbated where asset managers’ performance is benchmarked to an index. If they underperform the index they are obliged to buy assets which are rising strongly but under-represented in their portfolio while selling other assets. This amplifies price shocks in both directions, as with conventional momentum trading, but mainly upwards because of a natural market asymmetry: stock prices have a finite floor but no ceiling.

It also contributes to a short-termist capital market climate while sending bad price signals to managers of quoted companies when there is a need to reverse past under-investment in old economy sectors where scarcity has led to resurgent inflation.

Nor is this a healthy backdrop to encourage the huge overhaul of the global capital stock that is necessary to secure the transition to low carbon by 2050. Share price performance-related long-term incentive schemes where the long term is usually defined as a mere three years and share prices are volatile provide the wrong motivation. And a further market distortion arises from what academics Florian Berg, Julian Kölbel and Roberto Rigobon call “aggregate confusion” over environmental, social and governance reporting.

In a recent study they found significant divergence in ESG scores from six prominent scoring agencies. Consequences include distorted security prices because investors are confused and companies failing to improve ESG performance because their managers are confused.

International standard setters are now at work on sustainability, but the work will take time. So the scope for greenwashing by asset managers seeking to cash in on 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 lives of carbon-intensive assets for depreciation purposes in company accounts are few and far between. How many auditors, one wonders, could tell the difference between a stranded asset and a beached whale?

An underlying difficulty is that accountancy captures less and 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 a straightforward income to pay a pension or where investors routinely try to buy low and sell high. Meantime, the goal of market efficiency appears painfully elusive.

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