Three key risks to consider before a well-earned rest this silly season

Ally Selby

Livewire Markets

To say it’s been a tumultuous year is to put it mildly. It’s been a year of bushfires and floods, of crushing self-isolation and illuminating self-reflection, of a rapidly spreading virus and an equally rapid market crash and recovery.

Now, with a vaccine nearing on the not too distant horizon, investors have perked up; spurred by hopes of a quicker than anticipated return to economic normalcy and profit recovery.

Yet, MFS portfolio manager and global investment strategist Robert Almeida recommends investors remain wary.

“While investing has never been easy, today’s environment has raised the stakes,” he said.

“For myriad reasons, there are always flashy investment opportunities with attractive return prospects, ever more so given today’s near-zero interest rates on savings. But we have to ask ourselves, how many things have to bounce right for these ideas to live up to expectations?”

So, how could it go wrong?

Risk 1: Diminishing scope for further monetary policy

While central banks came to business’ rescue early on in the crisis, Almeida argues investors shouldn’t bet on further monetary stimulus.

“In circumstances such as these, central banks lend money, but it's governments that spend it, putting the onus for future economic growth prospects squarely on politicians’ shoulders,” he said.

Risk 2: Spreading COVID-19 cases

He also encourages investors to be wary of rising COVID-19 cases and hospitalisations across the Americas, Europe and parts of Asia, which may put the global economic recovery at risk.

“While hopes for a vaccine help investors envision a more normal future, they can’t solve the current, worsening situation,” Almeida said.

“We fear tightening stay-at-home and social distancing orders may lower mobility and put the thus-far-V-shaped recovery at risk while increasing the already immense need for fiscal support.

“Although investors have discounted that fiscal help is on the way, its timing and magnitude remain uncertain.”

Risk 3: Over-reliance on multiple expansion

Additionally, Almeida notes that during 2020, equity returns have relied entirely on multiple expansion, with the "pandemic-inspired collapse in earnings" to blame.

“While such a pattern isn’t atypical market behaviour before a recession’s end, its size leaves risk markets vulnerable to unforeseen negative economic surprises or an underwhelming fiscal policy response,” he said.

Overcoming the hurdles

When assessing these risks, Almeida encourages investors to focus on business risk profiles in relation to a range of possible future outcomes - such as a double-dip recession, another credit shock, reflation and stagnation.

It’s also important to question whether a business can endure the changing regulatory environment, he said, as well as whether its economic moat is deep enough to protect against competition in a fast-paced digital world. 

“Investing is thinking about what just happened and determining if events have altered the underlying strength or weakness of a business, then ascertaining what the cash flow profile may look like over the next several years and ultimately what that cash flow is worth,” Almeida said.

Opportunities for alpha in 2021

Almeida believes there to be significant opportunities for alpha and price differentiation as we head into the new year. However, he encourages investors to “allocate capital responsibly” amid the current highly uncertain environment.

“The best companies are the ones creating value for stakeholders, not extracting value from them,” he said.

“While those companies extracting value may have outsized financial performance, its duration is likely finite.”

Over the last decade, eroding revenue growth has resulted in a growing number of companies turning to suppliers, employees, bondholders and customers to extract growth, Almeida explained.

“However, the best companies — those with a partnership culture across all their stakeholders — tend to possess something scarce: superior financial results that endure and are reflected in their asset prices,” he said.

“That’s what we mean by allocating capital responsibly, which is our North Star in a highly uncertain world.” 

Never miss an update

Enjoy this wire? Hit the 'like' button to let us know. Stay up to date with my content by hitting the 'follow' button below and you'll be notified every time I post a wire. 

Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.

........
Livewire gives readers access to information and educational content provided by financial services professionals and companies (“Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

Ally Selby
Content Editor
Livewire Markets

Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.