Investor euphoria and corporate cautiousness. A conundrum ? No. A source of concern ? Yes*

Adjustment costs, commitment period and impatience with respect to the resolution of ambiguity explain why risk appetite is high for financial investments whereas cautiousness dominates in terms of real investments (capital expenditures). While this can be easily rationalized it is a source of concern.

Many years of exceptionally easy monetary policy on a global scale have forced investors in financial assets to take more risk. This attitude was understandable because asset owners wanted to maintain a sufficiently high expected return on their financial investments. It was also rational because the central bank liquidity injections caused an endogenous reduction of risk, so the expected return/expected risk ratio remained attractive despite a decline in expected returns on the back of higher asset valuations. Another reason why such an attitude made sense was that monetary policy was expected to kickstart the economy so logically financial investors anticipate the expected improvement in corporate cash-flows. In the real economy, capital expenditure (henceforth called real investments) have long been subdued. In Europe this is still very much the case: think of tight spreads on high yields bonds versus low levels of capital expenditures as a percentage of GDP. This is no longer the case in the US but even there, the pick-up in real investments has taken time. This is understandable: why should corporates invest when faced with excess capacity?

The interesting implication is a co-existence of financial exuberance and real economy cautiousness. This triggers the question where financial and real investors look at the same data? Why are the former confident and the latter not? One explanation is adjustment costs. Financial investments which do not meet expectations can be sold at minimal cost. With real investments this is either expensive, difficult or even impossible. When the conviction level about an investment is not very high, financial investors may give it a try, because of the low transaction costs. For real investments, people will hold off. Another reason is the commitment horizon. For financial investments this can be short if the asset owner wishes so, for real investments (adding capacity, building a new plant) it is long so one better makes sure that the underlying hypotheses are right. Closely related to this, but different, is the concept of the impatience with respect to the resolution of ambiguity[1]. Ambiguity refers to the observation that investment decisions, financial of real, are taken under uncertainty: there is an expectation of future cash-flows but these are uncertain, there is ambiguity with respect to the return on investment. Resolution of ambiguity means that investors are in a position to assess whether they have made the right (or wrong) decision. When it takes a lot of time for ambiguity to be resolved, impatient investors may feel reluctant to commit money, especially when adjustment costs are (prohibitively) high. This is typically the case when dealing with real investments where many things can go wrong or have to go right, for the investment to be profitable. Financial investments, while also displaying ambiguity in terms of pay-off will more rapidly reveal whether it was a good or bad idea to go there. For a given timeframe for the resolution of ambiguity, impatient investors will either invest with a short horizon (e g momentum investing in financial markets), or invest less (typically for real investments). Principal/agent relationships may also play a role: the CEO of a listed company with quarterly financial reporting may display more impatience than the CEO of a private held company. Moreover, professional investment managers may also suffer from impatience with respects to the real investment behavior of the companies they invest in.

Transaction costs, commitment horizon and impatience with respect to the resolution of uncertainty explain why for the same economic environment, risk taking can be high in financial investments and low for real investments. The Austrian School is concerned about real mal-investments with low interest rates and easy access to finance causing an excessive build-up of capacity and real investments which end up being unproductive. Perhaps we should be more concerned about financial investments which end up being mal-investments when monetary policy impulses are insufficiently submitted to the real economy. This makes it key that ECB QE turn out to be effective.

*a version of this text has been published in the French newspaper “Le Monde”

[1] The NBIM paper ? Time-varying expected returns and investor heterogeneity : foundations for rebalancing ? (NBIM, 2012) offers and excellent explanation of the importance of this concept of investment decision making.