It is this reflexivity that so troubled James Carville. Demands for higher returns by bond investors, typically in response to an economic, policy or political surprise, can provide a strong incentive for policymakers to change course regardless of their democratic mandate.
The challenge for investors is that such reflexive outcomes cannot be accurately predicted ahead of time as the necessary preconditions for a reflexive move in market prices is a surprise that, by its very nature, cannot be accurately predicted.
To reduce the risk of a reflexive response, central banks, company management teams and even governments try to avoid surprising the capital markets by forecasting outcomes and their decisions as far in advance as possible.
However, surprises are far more likely in unusual economic, financial, or political environments, such as those we currently face.
In order to protect portfolios against these reflective feedback loops while accessing the long-term returns available to investors, we must maintain a dual perspective when constructing portfolios.
In practice, this means considering a wide range of potential outcomes when building a portfolio rather than becoming too invested in a single narrative of what the future holds.
By investigating the likelihood and impact of a variety of economic and market events on a portfolio, the investor is likely to be less surprised by a particular event and therefore less prone to mistakes, leading to a better outcome for investors.
Long-term focus
Alongside this focus on the robustness of the portfolio to near-term events, an investor must also focus on accessing long-term returns.
As investor sentiment dominates returns over the short term and economic fundamentals dominate returns over the very long term, the valuation of an asset tends to dominate returns over a five to 10 year period.
This is because anomalous valuations that result from the reflexive loops described earlier are unwound over time and consequently asset prices move towards their fair value.
With this perspective, it is clear that the surprises that cause investors to make mistakes can also be a source of returns if investors are able use the subsequent price movements to access unusually high long-term returns.
To do this, it is essential that investors have a clear expectation of the fair value of each potential asset, as this provides an anchor against which current prices can be compared.
This fair value will, in part, depend on the stability and quality of the political and economic backdrop of the country in which the investments are being made.
So while James Carville was right to fear the response of the bond market and the influence it can have on policymakers, the interaction of politics and capital markets can create opportunities for investors who are able to take a long-term approach and avoid being spooked by the bully boys of the bond markets.
