In the days leading up to Super Bowl 51, as odds-makers endeavored to create profitably matched books, a wholly logical pregame prediction scenario unfolded. Just prior to kick off, the juggernaut New England Patriots were three-point favorites, with about 2:3 odds of an outright win. If you had bet on a Patriots win prior to the game, and had then not tuned in to watch, you would have been modestly profitable and happy. That is, aside from the fact that you had just missed what was arguably the greatest football game ever played. However, if instead you watched the game and reacted to the “news flow” your actual profit/loss would probably look very different.
The story of a miraculous comeback
Indeed, this is because midway through the third quarter of the game, when the Patriots were trailing 28-3, the pregame bets in favor of the Patriots looked doomed. The real-time odds of the Patriots mounting a comeback had fallen to 11:1 against. One might have been very tempted to take the easy money that the Atlanta Falcons were about to win their first Super Bowl. Or, by contrast, you might have realized that writing 11:1 odds against Patriot’s quarterback Tom Brady’s ability to come back and win was perhaps crazy, and one might have gone the other way and made a killing. That’s because late in the game, the story (the lopsided score) was what was driving the odds, but by the end of the day the opposite case became reality. Precisely because the Patriots beat the incredibly long odds, the legacy of Super Bowl 51 will forever be the story of a miraculous comeback. We find this game to be a very useful analogy as we consider the investment landscape today.
It’s vital to filter out the noise
We have long argued that it is vital for investors to filter out the noise that creates short-term flash points and instead stay focused on the secular themes that are driving valuations over the longer run (such as demographic trends and technological innovation). Today, it is price action that is driving these investable themes, rather than news flow, and the amplitude of the real economic cycle has flattened alongside a breakdown in sector correlations (due to technological disruption). The noise in markets today (to be given little weight) is the “news” of the latest Tweet, or how close an employment report came to consensus estimates, etc. Meanwhile, real economy prices are leading the way to appropriate allocations across asset classes, driven by these secular influences. Indeed, the prices of money (Fed funds), savings (inflation term premium), capital (credit spreads), labor (wages), trade (USD), and insurance (volatility) are all historically low, which is resulting in exceptionally easy financial conditions.
In the past, a huge driver of economic activity was simply the global aggregate demand curve shifting to the right. Further, throughout modern history global nominal gross domestic product (GDP) growth (in USD) had never turned negative as the aggregate demand curve continuously shifted up and to the right along the supply curve. That drove both quantities and prices higher year after year. Yet over recent quarters, a dramatic paradigm shift has occurred, so that now the secular trend is a shifting of the aggregate supply curve. To wit, as the supply curve moves down and to the right along the demand curve, the overall global economy enjoys rising quantities married to falling prices. That virtuous outcome has the ironic effect of dampening traditional economic indicators, like nominal GDP. However, we believe that the obvious global economic momentum today is in fact the result of this very phenomenon. This can be observed through the display of real economic optimism (Purchasing Managers Indexes) and consumption volumes.
Companies are heavily reliant on growing revenue
This revolutionary supply curve paradigm is putting relentless downward pressure on prices everywhere and leading to incredible performance dispersion across asset classes and sectors. Indeed, downward pressure on profit margins is intense, so companies are heavily reliant on growing revenue. We see only four ways to accomplish that: 1) grow revenues alongside slow systemic economic growth, 2) mergers and acquisitions (buying growth), 3) create a new market/technology, or 4) take market share (disrupt the industry). Entire industries increasingly face difficulties as a result of supply-enhancing technological disruption, a trend that is accelerating. Indeed, just this year, media, retail, automotive, and food sectors are joining energy and telecommunications in facing brand new challenges that are putting pressure on sales, margins, and bottom lines. As a result, we have seen valuations across company/industry capital stacks suffer demonstrable underperformance.
So what do all these dynamics imply for investment? It used to seem as if the latest data releases moved markets, whose direction was determined solely by incremental news. But today, it’s prices that matter and prices are being determined by the secular influences of demographics, technology, and concomitant economic disruption. In Super Bowl 51, the price of betting on the Patriots to come back from a huge third-quarter deficit got too cheap. If you took advantage of that mispricing and positioned accordingly it would have resulted in a handsome cash payout. We suggest investors learn this lesson of the gridiron, by closely following information that can be derived by prices, rather than “news,” as it is the former that’s leading us to the places where cash is flowing.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog. Russell Brownback, Managing Director, is a member of the Corporate Credit Group within BlackRock Fundamental Fixed Income and co-authored this post.
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