Us Investment Risk: Mispricing Or Strategic Move?

Is US investment risk mispriced? This is a question that has been asked by many, and for good reason. There is a long history of financial markets mispricing major macroeconomic risks, and this mispricing can have detrimental effects on markets and investors. While the shifts in asset prices can lead to arbitrage opportunities, they also help economists understand what causes the mispricing of assets. This mispricing can be caused by a variety of factors, including the specific characteristics of individual assets, macroeconomic issues, and the behaviour of institutional investors. With so many factors at play, it is no wonder that the topic of US investment risk mispricing is a complex and ongoing discussion.

US inflation odds and disinflation

The US experienced high inflation rates after the COVID-19 pandemic, with the consumer price index (CPI) inflation peaking at nearly 9% in June 2022. However, as of February 2025, the economy is expected to experience another disinflationary wave, with core PCE annualizing at or below 2% in the first half of 2025. This prediction is supported by leading indicators of shelter inflation, which represents 30%+ of the core US inflation baskets, as well as weakness in the housing market indicated by shrinking job openings in the construction sector.

Disinflation can be caused by a recession or when a central bank tightens its monetary policy. While disinflation can be painful as it is usually accompanied by a recession, the outcome is generally positive for the economy. High inflation can disproportionately affect low- and fixed-income households, so disinflation can reduce those effects.

Passive investing and risk-insensitive investors

Passive investing is a strategy that aims to maximise returns by minimising the costs of buying and selling securities. Passive investors typically invest in mutual funds or exchange-traded funds (ETFs) that mimic the holdings of a representative benchmark, such as the S&P 500 index. This strategy is called passive investing because fund managers do not need to actively hunt for investments; they simply buy and sell the investments that their target benchmark trades. Passive investing is less expensive and complex than active management and often produces superior after-tax results over medium to long time horizons.

Passive investing methods seek to reduce the costs of selecting investments by simplifying the portfolio construction process and reducing fees triggered by frequent trading. Passive investing often, but not always, adopts a long-term, buy-and-hold approach, holding securities for relatively long periods to gradually build wealth. Passive managers generally believe it is difficult to out-think the market over short periods, so they try to match market or sector performance.

The popularity of passive investing has grown due to the premise that active managers rarely outperform indices, and investing in mutual funds is more expensive than it is worth. However, passive investing has become a crowded trade, and some argue that passive investors will see lower returns than fundamentally rigorous active investors over the next few years. Passive investing may also suffer from a lack of flexibility, as fund managers are usually prohibited from using defensive measures such as reducing a position in shares of particular securities, even if they think those share prices will decline.

Passive investing is subject to total market risk, including stock market risk, longevity risk, purpose risk, inflation, interest rate hikes, and taxation. One of the biggest risks of passive investing is mistaking active investments for passive ones. For example, active ETFs operate like mutual funds, but they have a portfolio manager who can adjust the underlying assets rather than following a benchmark or index. These funds have decreased transparency and increased costs.

Another risk of passive investing is equating low cost with low risk. The idea that passive investing automatically means low risk may create a false sense of security, and investors may be more exposed to increases in market volatility than they realise. Passive investing may also result in smaller potential returns, as passive funds rarely beat their benchmark index and usually return slightly less due to operating costs.

Macroeconomic shocks and oil price shocks

The interaction between oil prices and macroeconomic performance has been an area of interest since the 1970s, when large oil price spikes were observed. Oil supply shocks are frequently considered to be the source of worldwide macroeconomic volatility and stagflation during that period.

The effects of oil price shocks differ depending on the source of the oil price shift and the type of economy in question. Oil-importing economies, for instance, experience a temporary increase in real GDP following an oil price increase driven by global economic activity, while a decline in real GDP is observed when the oil demand shock is specific to oil.

The effects of oil price shocks on oil-exporting economies are less clear. Rising oil prices can lead to higher oil export revenues in an inelastic market, benefiting these economies. However, oil-importing countries that produce and export other forms of energy may also benefit from soaring oil prices through increased demand for their oil substitutes.

In the case of oil supply shocks, oil- and energy-importing economies face a permanent fall in economic activity, while the impact on net energy-exporting economies is insignificant or even positive. Inflationary effects are also generally smaller for net energy exporters due to an appreciation of their exchange rates.

The dynamic effects of oil demand shocks, on the other hand, tend to be similar across countries. A temporary increase in real GDP is observed for all countries following a global activity shock, whereas output temporarily declines following an oil-specific demand shock.

The transmission mechanism of oil shocks is also important to consider. Direct effects on the general price level through rising energy prices are expected in the short term, while additional inflationary effects may arise as higher energy input costs or wage demands feed into consumer prices. These indirect effects are more delayed and can be influenced by monetary policy reactions.

Over time, the dynamic effects of oil shocks have changed. The oil market has undergone structural changes, including increased oil price volatility since the mid-1980s, which have affected the relationship between oil prices and economic activity. The steepening of the oil demand curve has also distorted empirical comparisons of macroeconomic effects over time.

In summary, the economic effects of oil price changes depend on the underlying source of the change and the type of economy in question. Monetary policy implications differ accordingly, and the role of oil and other forms of energy in the economy also play a significant part in shaping the dynamic effects of oil shocks.

Systematic risk and market efficiency

The relationship between systematic risk and market efficiency is complex. In an efficient market, systematic risk should be accurately priced into the value of securities. However, market inefficiencies can lead to situations where systematic risk is mispriced, creating opportunities for arbitrage. For instance, during financial crises or significant market events, systematic risk may be underestimated or overlooked, resulting in asset prices that deviate from their intrinsic value. This mispricing can persist for extended periods, particularly in the presence of market distortions or investor behaviour that amplifies these deviations.

The mispricing of systematic risk can have significant implications for investors and the broader market. On the one hand, it can create opportunities for investors to profit by identifying and capitalising on these discrepancies. Active investors and value-sensitive investors, for example, may benefit from market inefficiencies by taking contrarian positions or adopting strategies that exploit the mispricing. On the other hand, the mispricing of systematic risk can also lead to a higher level of overall risk in the financial markets. This is because mispricing can be a reflection of broader macro issues or constraints faced by institutions that own or trade the assets. For instance, constraints on intermediary funding or capital-raising capabilities can impact asset prices and contribute to systematic risk.

Furthermore, the presence of passive investors and algorithmic traders, who are largely insensitive to value and risk, can exacerbate the issue of systematic risk mispricing. Passive investors tend to hold stocks regardless of valuations or market risks, contributing to a general insensitivity to value and risk in the market. Similarly, algorithmic traders rely on momentum and technical indicators, often disregarding fundamental risks and contributing to market distortions. These factors can lead to a short-termist capital market climate and send inaccurate price signals to managers of quoted companies.

In conclusion, systematic risk and market efficiency are interconnected concepts that play a crucial role in understanding investment risk mispricing. While efficient markets should, in theory, incorporate systematic risk into asset pricing, market inefficiencies and behavioural factors often lead to mispricing. This mispricing can create opportunities for certain investors while also increasing the overall risk in the financial markets. Therefore, investors need to carefully assess the current macroeconomic risks and adjust their investment strategies accordingly to navigate the complexities of systematic risk and market efficiency.

Financial crises and capital constraints

The 2008 financial crisis provides a unique perspective on the impact of financial crises on corporate behaviour. A survey of 1,050 Chief Financial Officers (CFOs) from 39 countries revealed that firms experienced credit constraints and made significant cuts to their spending plans as a result.

The survey, conducted in December 2008, found that constrained firms planned to reduce employment, technology spending, capital investment, marketing expenditures, and dividend payments by significant margins in 2009. They also drew more heavily on lines of credit, fearing that banks would restrict access in the future. This was particularly notable in the US, where 13% of constrained firms tapped credit lines to meet expected cash needs, and 17% did so out of concern that their banks would shut off their credit.

The inability to borrow externally caused many firms to bypass attractive investment opportunities. 86% of constrained US CFOs reported that their investment in attractive projects was restricted during the credit crisis, and more than half of all respondents said they would cancel or postpone planned investments. This trend was also observed in Europe and Asia, with similar or even stronger results.

The impact of the financial crisis on corporate investment decisions was significant, with many firms opting to cancel or postpone investments, burn through cash reserves, or sell assets to fund operations. These findings highlight how financial constraints can hamper investment in valuable projects and reduce the strength of future economic recovery.

The survey also revealed differences between small and large firms in terms of their vulnerability to credit constraints. Among US respondents, 75% were classified as small firms, and while 41% reported being "not affected" by credit constraints in Q4 2008, 22% were "very affected." In contrast, among large firms, 49% reported being "not affected," and only 16% were "very affected."

These results provide valuable insights into how financial constraints during a crisis can impact corporate spending, investment decisions, and the overall economic recovery.

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