At a time of growing optimism in markets, worrying about risk isn’t in vogue. But the current investment environment, and the ways it could develop, are complex, uncertain and risky.
An investor needs to be as aware of risk as they are about finding opportunities for returns. Their investment portfolio needs a robust, forward-looking investment process that identifies and actively manages both potential risks and return opportunities.
So what are the key risks for 2014 and what kind of investment process can best manage these and other risks?
On the surface, the outlook seems benign
2013 was a good year for investors: risk aversion eased and most developed share markets recorded strong gains. These returns, and current asset prices, imply a fairly benign outlook for 2014 and beyond. Interest rates are at historic lows, inflation seems under control, the economic outlook for the US, UK, Japan and Europe is improving and central banks are maintaining a bias towards monetary stimulus (although the US Federal Reserve intends to start “tapering”). What could go wrong?
Significant investment risks still threaten
Here are just some of the risks you should worry about in 2014.
1. Current market valuations: While markets’ addiction to quantitative easing has boosted returns, market valuations are becoming less and less attractive. The main driver of share market returns last year was not actual earnings growth, but investors’ expectations of future earnings growth. To justify current valuations, we need to see actual earnings that meet expectations.
Bonds also involve valuation risk for investors, particularly global government bonds, which are trading at or near historically low yields. This means bonds’ traditional role as a diversifier of share market risk is compromised, requiring portfolio constructors to find other sources of diversification and portfolio protection. Current share and bond valuations signal only modest return potential.
2. Inflation and potential policy errors: Current market pricing of shares and bonds suggests inflation isn’t a problem, and that the very loose monetary policies of central banks won’t lead to higher inflation. The complacency is disturbing, as the inflation risks from quantitative easing are greater than markets are assuming. Policy makers are actually walking a deflation-inflation tightrope and the risk of a policy mistake is high. They have used quantitative easing and very low interest rates to offset the deflationary impact of debt reduction. But the challenge for policy makers is when to withdraw the stimulus to avoid higher inflation without compromising the economic recovery. The risk is they leave their foot off the brake too long, leading to higher inflation.
3. China’s new growth model: China’s phenomenal recent growth required massive capital and infrastructure investment, creating huge demand for Australia’s resources. China’s new leadership intends to implement a new growth model which emphasises consumption over investment. This structural shift to achieve a more sustainable and stable, but slower, rate of growth has important and uncertain consequences for Australia’s economy, but certainly less demand for our commodities. It’s a potential risk investors shouldn’t ignore.
4. Ongoing adjustment in Europe: The eurozone is not yet on a stable adjustment path and remains a source of risk, despite signs of improving economic performance. Many of the public and private debt problems remain, measures to deal with vulnerable banks are only at an early stage, domestic demand remains subdued and unemployment is painfully high.
How investors can manage risk
The potential risks for investors this year are not limited to these. Because the market environment is constantly evolving, the future is inherently uncertain. So managing a portfolio based on a narrow set of risks makes the portfolio highly vulnerable to unforeseen developments.
To both manage risk and deliver long-term returns, the best investment approaches assume the world is always unpredictable. They explicitly seek to identify future risks and then take steps to manage them. Asking “what could go wrong?” is as important as identifying return potential.
Understanding where markets are at today and the wide range of scenarios that could unfold (good and bad) provides much-needed insight into different assets’ return potential and risks, and how they could change in each scenario. Only then can an asset allocation be determined that can both achieve a return objective and control risk.
In this environment, mainstream assets such as shares and bonds don’t offer the return potential or risk diversification they did in previous years. This means the portfolio will need to include a significant exposure to less traditional assets, and to strategies that invest across many asset classes and have more of an absolute return focus.
Finally, the portfolio’s asset allocation will need to be managed flexibly as market conditions evolve and potential risks and opportunities change. The ability to make significant portfolio adjustments means insights into dealing with future risks and capturing return opportunities can be implemented without constraints, better positioning the portfolio to meet its objectives.
