February’s surge in volatility, the recent dip in the eurozone’s growth momentum, the prospects of a series of US key rate hikes and of the ECB’s change of tone as it prepares to halt quantitative easing (QE) are all factors that risk intensifying arguments in favour of high conviction approaches to asset management in the months ahead: unconstrained investing makes a comeback.

Could this signal the end of benchmarks? If so, it would mark the umpteenth swing of the pendulum: after the great bond massacre of 1994, many investors began to doubt the utility of using benchmarks for bond fund management. Less than ten years later, after the bursting of the dot.com bubble, high conviction management strategies became popular again. And again, after 2008, they swung back into vogue. From an economic perspective, these observations raise two important questions: what explains this swinging pendulum? And what is the economic impact of the transition towards high conviction management strategies?

The swinging pendulum can be attributed to the monetary cycle. A very accommodating monetary policy favours more risky asset categories. This is one of the central banks’ objectives: they are considered to be an essential part of the transmission channel, via the wealth effect, and above all via their impact on the cost of corporate financing. When monetary policy is eased, risk premiums become more attractive – the economic and financial risk is still high, but is bound to decline under the central bank’s actions – creating an incentive to increase exposure to directional market movements to the detriment of individual stocks. When the tide is rising, it doesn’t matter which boat you choose to board, as long as you are not left sitting on the dock. This is especially true when monetary policy is under no constraint –in this cycle, central banks even managed circumventing the zero lower bound. Investors have just one question to answer: what is the cumulative amount of monetary easing that can be expected?

Once monetary policy enters the normalisation process (winding down of QE, start-up of a new cycle of key rate increases), the central bank comes under two constraints. First, it must communicate its intentions through forward guidance without triggering financial market turmoil. In valuing assets, this constraint is reflected in the required risk premium. Ambiguous guidance about the central bank’s intentions to tighten monetary policy would strain the prices of risky assets. The second constraint is even more fundamental. The central bank must keep pace with inflation as it converges on its target, but it must not surpass this target (in the ECB’s case), or at least by not too much, or for too long (in the Fed’s case). This constraint influences both asset values, via cash flow forecasts (downside risk), and the risk-free rate (upside risk).

This is where the pendulum comes into play. In the midst of a monetary tightening cycle, there are two big questions: 1) how resilient is earnings growth to the prospects of an economic slowdown, and 2) do highly indebted companies have the capacity to pay their interest charges? During periods of slow economic growth, the relative performance of companies tends to diverge. Recent research shows that in this environment, stock prices react more strongly to new information and move in a more differentiated manner than when economic growth is strong. This argues for an active approach to stock selection. This reasoning can also be extended to bond investments: companies with the lowest debt burden are going to be much more resilient than other companies to the deterioration in both growth and interest rates. This divergence in performance reflects differences in their cyclical sensitivity, and is a stylized fact of the economic and financial cycle. When taken into account or anticipated by investors, this factor has a pro-cyclical impact: higher financing costs for the most heavily indebted companies when they must refinance their debt and a decline in the price/earnings ratio. This can trigger a feedback loop with the deterioration in the financial prospects of the companies in question. In the financial markets, correlations will increase, and we will see a contagion effect: while some investors’ individual stock selections will increasingly diverge from their benchmarks, other investors, more wary of the negative impact of this movement on the economy as a whole, will be inclined to reduce the risk exposure of their portfolios through tactical allocations that clearly favour what are seen as the most stable assets. In other words, the more constraints the central banks face, the more investors will need high convictions and drop their own constraints.