Diminishing rewards for taking risk

29th April, 2021

In a recent blog post, Thomas Becket, chief investment officer at Psigma, spoke of the “growing problem of reduced reward for future investment risk”. He believes that today’s asset prices have borrowed growth from the future and that is likely to make life harder for investors over the next few years.

Certainly, asset prices appear to be tipping above their long-run averages, particularly in the US. It is a crude tool, but cyclically adjusted PE ratios over 30x have historically been associated with weaker performance over the subsequent decade. The US is already there and other developed markets are nudging closer.

Equally, there are fewer obvious spots of value in the market. After a strong run, valuations for economically-sensitive areas such as banks and natural resources have started to move closer to growth areas since the start of the year. Also, the obvious places to position in a recovery, such as smaller companies, have moved a long way very quickly.

This is starting to look a little precarious, particularly given that the pandemic is by no means over. Variants from Brazil and India could outrun the vaccine programmes, forcing further lockdowns and economic disruption. The recovery is dependent on outrunning a virus that has proved extremely versatile.

That said, it is difficult to argue with the numbers. Economic recovery continues at pace, particularly in the US. The US consumer has emerged from lockdown with plenty of enthusiasm to spend, spend, spend and the most recent retail sales statistics showed growth of almost 10% year on year. Industrial production is up, employment is up and the IMF recently suggested that developed markets may emerge from the pandemic relatively unscathed.

The biggest risk, says Becket, is that “a cessation of the never-ending support of financial markets by the central banks”. He adds: “If we see a return of high economic growth and inflation, will this mean that the implicit and explicit stimulus of central bankers might have to end?… There are also signs that bubbles are building in parts of financial markets, a situation created by rampant money creation by central banks and inefficient stimuli served up by governments. If any of these bubbles burst, the collateral damage across expensive and complacent asset markets could be painful.”

Market expansion often goes on longer than might be expected. Stock market valuations often reach a point of irrationality before they start to fall. However, investors need to be aware that risks are mounting and be ready to act decisively if circumstances dictate.

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This article was sourced from Adviser-Hub.co.uk.

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