Overblown or under-appreciated? 6 risks the market may have wrong

Newspapers sell fear, while equity markets sell optimism. Basing an investment strategy on the latest financial headlines is a great way to destroy capital. But while the news cycle often likes to focus on the ‘big issue’ of the day, whether it be tariffs, growth in China, or European banks, they often overlook the real risks in the economy. One famous example was Jim Cramer on CNBC, claiming that "Bear Stearns is fine" just days before its collapse.

In an effort to tune out the noise and focus on the real issues, we reached out to three experts to get their take on which risks the market was overblowing, and which remained under-appreciated.

Responses come from Scott Haslem, Chief Investment Officer at Crestone Wealth Management; Andrew McAuley, Chief Investment Officer of Credit Suisse Private Bank Australia; and Tracey McNaughton, Head of Asset Allocation at Wilsons Advisory.

Is inflation really dead?

Scott Haslem, Chief Investment Officer, Crestone Wealth Management

An underappreciated risk

This is somewhat subject to the time horizon. Over the coming months, equity markets are potentially underplaying the risk that the cacophony of geo-political noise could sufficiently crush global business confidence and capex plans, so as to undermine the otherwise strong jobs and consumer sectors that are currently supporting growth and company earnings globally. 

These geopolitical hotspots include not only the US-China trade dispute, but the Hong Kong democracy demonstrations, the unstable Italian government as well as the UK where the risk of a hard Brexit has risen.

Looking further ahead, over the next couple of years, the risk that inflation is not as ‘dead’ as those clamouring for negative bond yields are expecting, is a risk that has the potential to markedly impact on asset returns and style factors within portfolios. 

Long duration and sovereign bonds are without doubt the most crowded trade in the market at present. Inflation protection is currently very cheap and well worth considering as part of a defensive allocation.

And one that's overblown

In the other direction, we believe there is very little risk the RBA will be drawn into a negative interest rate (or even unconventional policy) environment, despite the attention this has been getting in the media. 

Clearly, the RBA needs to show appropriate risk management by revealing it's deeply considered the options. It will also weigh up the pros and cons of potentially underperforming its inflation target against the operational and macro problems associated with taking the cash rate to zero or lower. 

Given the recent (and likely additional 50bp) of RBA rate cuts, APRA lending changes, personal income tax cuts and stabilisation in the housing sector (as far as prices and sentiment is concerned), Australia appears arguably better placed than a couple of years ago to deal with any material weakening in the global economy (particularly if China is intensifying its domestic stimulus to sustain its own growth rate).

The 'recession' in Aussie housing has also come and gone, and the unemployment rate is still near 5%.

Stop focusing on the risks

Andrew McAuley, Chief Investment Officer, Credit Suisse Private Bank Australia

An underappreciated risk

The biggest underestimated risk is the focus on risks. There seems to be a negative feedback loop permeating markets and the people who commentate on them. The reality is we have share markets near all-time highs and have experienced record returns in bonds. No major economy is in recession. Admittedly, global GDP growth is pedestrian, we predict 2.8% YoY growth into 2020. But inflation is low, and the major central banks have been vocal and active in their desire to ease monetary conditions to prevent further slowdown much less a recession.

The consensus is we are near the end of the cycle. However, normally at the end of a cycle inflation is rising and so are central bank cash rates. There is no sign of that now. Rather than enjoying the rise of markets, investors seem focused on gloomy “what ifs”.

And one that's overblown

The tariff war is a negative, but overblown. In May the IMF suggested that 25% tariffs on all trade between the US and China would subtract 0.3% from global GDP. Not a particularly material number. That said, the tariffs are impacting sentiment, and sentiment can negatively influence corporate spending. We think there are three ways to take advantage of tariffs:

Firstly, favour service companies, it is hard to apply a tariff to a service. A good example is the US software sector.

Secondly, companies that compete against US companies in China are positioned to win market share. For example, Adidas and L’Oreal could win market share off Nike and Estee Lauder.

Thirdly, winners are those countries with lowest exposure to manufacturing, lowest exposure to the US and whose exports to China compete with the US.

In this case, the Australian economy is set to benefit. The US runs a trade surplus with Australia. The Trump administration is incentivised to ensure we aren’t inadvertently affected by tariffs. But our exports to China, that compete with the US, will be the real winners. Sectors such as LNG, cotton, beef, coal and any other commodity we produce, where the US has been importing or would like to import to China, now have an advantage. For example, in the case of LNG, a 25% tariff applies to US LNG but not to Australian LNG.

We think the big miners are well positioned as the Chinese look to stimulate their economy, and the negativity permeating markets pushes the Aussie Dollar down.

The biggest casualty of very low rates

Tracey McNaughton, Head of Asset Allocation, Wilsons Advisory

An underappreciated risk

In our opinion, the most under-appreciated and least well understood risk in the market today is liquidity risk. As official interest rates move lower, expected returns from investing decreases. This is the direct outcome of a shift down in the capital markets line (the plot of risk and return across different asset classes).

A decline in expected return can be digested if it is only for a relatively short period of time. If, however, the low interest rate environment lasts for a long period of time as increasingly seems the case, expectations of future returns begin to come down. 

When expectations change, behaviour changes. Investors begin to “chase yield” and move out of their “preferred habitat” and into riskier investments in an attempt to maintain returns.

This creates a gravitational pull lower in yields as the weight of money compresses risk premiums. The capital markets line begins to flatten meaning each extra unit of risk an investor takes, is rewarded with less return. The lower returns this generates feeds further yield chasing behaviour and so it goes. The biggest casualty in this process is liquidity.

And one that's overblown

Conversely, the biggest risk that we think is being overplayed within the equity market right now is the risk that a trade deal will emerge between the US and China. Dangerously, equity markets are responding more to hope and rhetoric than anything factual. In our opinion, the differences between the two countries are too great and the stakes (that extend beyond just trade) are too high. We believe a deal will ultimately emerge, but it will take longer than current market pricing suggests.

Many of the issues around which negotiations currently revolve, such as theft-by-hacking of intellectual property, are issues where China denies being at fault. On other issues, such as forced technology transfer, intellectual property protection, and non-tariff barriers, would force President Xi to scale down his ambitions for Chinese economic development.

So even if a deal is made, it is likely to be a partial deal at best.

Conclusion

At all stages of the investment journey you will be presented with a list of ‘risks’ that can make you feel uneasy. Looking through the list of risks there are only a handful that you as an investor has any control over. Geopolitical tensions and the next moves by central banks are notoriously difficult to predict. It is clearly prudent to be aware of the risks but allocating a greater portion of your energy to the things you can control is almost guaranteed to be a better use of your time.

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