As this bull market becomes extended it provides a great opportunity to evaluate where we are in the cycle and examine some of the risks that the market faces. Sanlam’s macro analyst, Matthew Brittain, wrote the piece below to remind us that higher prices bring along higher risks.
The surge in asset prices following the election of Donald Trump is one that makes us nervous. We see elevated valuations across asset classes. We see growing optimism as investors get comfortable forecasting growth further and further out. And most alarmingly, we see risk premiums steadily evaporate as investors are prepared to pay up for these optimistic forecasts. With investors being rewarded for waltzing further out the risk curve in the search for yield it becomes increasingly challenging to remain disciplined and focus on valuations.
If risky assets had a right to higher returns then they wouldn’t be risky
Below we have the standard, upward sloping, capital market line. On the left we start with a risk free investment, a short duration government issued note, and as you progress further out along the black line we track incrementally more risky investments which should, on average, produce an incrementally higher return. In the good times, such as now when risky assets are producing stellar returns, it is easy to get sucked into the belief that taking risk will lead to a higher return. In reality, riskier investments simply have a greater dispersion in expected outcome and it is up to investors to demand sufficient compensation for shouldering this uncertainty. When a margin of safety is not on offer history has shown consistently that it is better to watch from the side-lines than participate – often one does not need to be too patient.

Figure 1. Capital Market Line
Source. SPW UK
Extremely low short term interest rates have been a feature of this bull cycle, anchoring the short end of this capital market line near zero, or even below. This made other asset classes look relatively attractive by comparison, and indeed for most of the last few years there was a significant risk premium to provide some comfort. While we don’t think assets are in “Bubble Territory” (with the exception of some government bonds) their prices are definitely elevated relative to history and offer meagre incrementally higher returns than they did even a few months ago.
During 2015 and 2016 markets were fixated on when central bank policy would become hawkish and yet now this has become a far less influential factor as the attention has shifted to Trump – maybe the market’s next focus will be on something less bullish, pardon the pun. Remember the period when robust economic data was bad news for markets as it meant that rates were more likely to rise and when poor data would precipitate a surge in equities as the proverbial punch bowl of loose monetary policy was to stay around a little longer. It is fascinating to me that the market barely blinked at the recent guidance from the Fed that further rate hikes were imminent and even a shrinking of their balance sheet will start soon. Surely a year ago that would have precipitated a sharp sell off?
That is not to say there aren’t pockets of value, there are always opportunities. For example, we have benefitted from the high growth rates in Asia where expectations were quite reasonable. All we are saying is that it is up to investors to insist on proper compensation for taking on uncertainty and when this compensation is not on offer we must be careful not to fool ourselves into thinking that things are more certain than they really are.