INSIGHTS

On July 15, 2022

The Ostrich Effect and the “Precession”

In behavioral finance, the ostrich effect is defined as news that is contrary to one’s investment portfolio. This effect speaks to the general rule that the negative returns in nearly every asset and debt measurement is akin to an ostrich pulling its head out of the sand to realize the environment that was once assumed has shifted significantly. The reality is that the market is pricing in not only limited growth possibilities, but a phantom that has not been dealt with in three decades, the “Precession.”

Inflation is a specter that influences every aspect of investors’ lives. Once it gains traction, a feedback loop occurs wherein the supply and demand of goods and services become caught in the churn. A new economic framework was needed last year regarding inflation when its effects became less than transitory. As a result, investment portfolios matching the once forgotten paradigm needed to be altered. The positive about high inflation numbers affecting consumers and corporate earnings is that it is typically muted. The unwelcomed news, however, is that for this to happen there must be destruction in demand due to balance sheets and income being strained by higher prices and ultimately the Federal Reserve needing to raise rates rapidly to the point of recession.

Recessions under the framework we have been referencing follow the period of 1960-1991. Most investors view the economic and market cycles of 1991-2020 as the natural order of portfolios. In the period we believe we are in, recession occurred every 4.5 years versus the recent periods of 8.6 years. The difference, though, is inflation and how it circumvents expansions and becomes a more traditional cycle. The recessions themselves lasted similar lengths. In a study done on secular inflation cycles by Citigroup, the average upswing and downswing in inflation to get back to original levels has lasted roughly a decade. 

However, time and seasonality are not great measurements for when these occur. It is more about the fundamentals, environment and how consumers, corporations and the government are leveraged or not leveraged. The 2020 recession was not a traditional demand- or leverage-driven recession, but rather one synthetically induced by the pandemic. While still a recession, the mere fact that it was the shortest recession on record going back to 1854 glaringly shows that the last natural recession began over 14 years ago.

With this framework in place, the new portfolio regime has many variations. We are long commodities and base materials, and see merit in energy, basic materials, consumer staples and select financial institutions. We also see a need for diversification into international companies during this long cycle and are keen on emerging markets, particularly as European markets become more attractive with the recent pullback. These are longer term prospects and look to ride out the cycles within the secular move of the inflation framework. Fixed income investments need to be tactical and vigilant to manage credit and duration during these cycles, with the focus on the conflict between the economy’s destination and fixed income’s exacerbated pricing. In short, look for anomalies in the credit markets.

CRN: 2022-0712-10167 R