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