Current valuations across most assets tell us that future returns will be low and the risk of a significant correction is high. None of this means markets will collapse tomorrow, but it does mean that there is limited cushioning to absorb a shock.
Putting aside the risks to individual asset classes, the bigger risk to investors is “shortfall risk”. In other words, stretched valuations and subsequent low prospective returns means that the typical “diversified” or balanced portfolio that relies largely on a relatively large and static allocation to equities will likely deliver returns to investors that are well short of their target.
A second, and potentially bigger risk is that low prospective returns encourage investors to do things to try and lift returns that ultimately back-fire. This is not unusual late in the cycle. It happened prior to the GFC, it happened prior to the tech bubble and it’s happening now. But, trying to boost returns through the injudicious use of leverage,, or moving into illiquid assets, could prove costly. There is after-all no free lunch.
Investors are kidding themselves if they think there are strategies that allow you to stay invested in “stretched” assets and avoid the carnage that follows. Sure, there’s things you can do at the margin (like options and volatility based derivative strategies) but they are expensive and ineffective – particularly in size.
The only sure fire way to avoid loss is to not own the assets that are the most at risk – particularly those that will do the most damage to a portfolio if the valuation risks are realised.
The top strategy on our risk mitigation checklist is “avoid”. This means don’t be afraid to go to cash if you’re likely to lose money on other assets. Yields may be low, but they are certain (at least in the short run), liquid and they are an effective call on option on future opportunity. When valuations improve is when you want to be able to take risk.
It’s difficult and dangerous in the current environment to single out individual assets that will shine, because if the risks implied by valuations are realised, correlations will rise and everything will suffer.
Against this, there are 2 things we think will be important. The first is don’t be afraid to step out of the way – avoidance is an effective strategy. Cash is attractive in reward / risk space and will be particularly attractive if risk assets start to re-price. The second is to look below the surface. The desynchronisation of economies, and potentially monetary policy, means there will be opportunities as currencies, interest rates and sector themes (i.e. growth v value) realign.
For example, from a valuation standpoint, we like Sterling (GBP), which still cheap post Brexit. On the other hand, the AUD is still overvalued, and given its correlation to the global growth cycle, it will fall if risk assets re-price.