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Market Comment  02/06/2017

Risk - it's a question of balance

Hector Kilpatrick, Chief Investment Officer at Cornelian Asset Managers explains why now is not the time to be fully risk on...

The US equity market is expensive and we are cautiously positioned

Equity market returns have been exceptionally strong over the short and medium term. Leading the charge has been the US stock market where, since the Trump Presidential election success, animal spirits have returned and optimism for the outlook of the US economy and, by extension, the global economy has increased markedly.

The US stockmarket has risen to levels approaching the upper end of their historic valuation ranges. This is not to say the market cannot push higher in the short term, but the air at these levels is rarefied.  It is, therefore, sensible to be somewhat cautious as market valuations always, in the end, mean revert.

Coinciding with the higher market levels are a variety of factors which should give pause for thought. Firstly, market volatility has been exceptionally low which is breeding complacency. Secondly, company operating margins are high relative to history and have always reverted to the mean in the past. Thirdly, company indebtedness has been rising steady such that current levels of leverage in the quoted sector are high relative to history and this reduces resilience.  

However, we are not yet ready to go fully risk off

But, for now, investors are ignoring these issues and are bidding stocks higher on the belief that the higher operating leverage will drive stronger earnings growth in a reflationary environment and, it must be said, we have sympathy with this view in the short term.

With increased confidence observed across a variety of sectors in the US, order books are likely to grow as end demand increases. In addition, it is likely that the American consumer will loosen their purse strings and retail spending will accelerate.

This all sounds very encouraging and from a real economy perspective should be welcomed. The problem is that stock market dynamics do not necessarily correlate with real economic activity as valuations are already discounting a lot of the good news and investors have yet to focus on what comes next. It may well be some time before the penny drops and for this reason, whilst we are cautiously positioned; we are not yet fully risk off.

What would make us reduce risk further?

We believe investors are materially underestimating the risk that US interest rates could rise much faster than is currently expected and, if this came about, believe it would knock confidence in company valuations regardless of the economic outlook.

Whilst the theme of accelerating US growth is our central scenario for the rest of the year, there is also a risk that Trump’s infrastructure spending and tax reform proposals are watered down significantly.  If this comes about, the equity market ‘Trump bounce’ that we’ve witnessed since last November could reverse.

Either way, the outlook for the US equity market looks challenged. The only question is timing. The US economic upswing and suspension of belief that interest rates will have to rise faster than expected could last a while yet and returns during this period could be strong, whilst the Trump bounce could unwind relatively quickly. So we have to get the balancing act right, whereby we ensure clients participate in the potential upside in equity prices whilst not taking undue levels of risk this late on in the investment cycle. For this reason, we have sought to broaden exposure to a variety of asset classes in order to diversify risk.

Hector Kilpatrick
Chief Investment Officer

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