Investors, however, do not pay equal attention to all risks, especially if they are difficult to evaluate and easy to overlook near term. Often ignored risks include large trade imbalances; large government budget deficits and accumulated government debts; the growth in and magnitude of consumer debt relative to personal income; housing price bubbles; and the chance that China and Japan will grow reluctant to continue financing the US deficit.
Furthermore, it is possible that new accounting “shenanigans” may come to light, as well as the true cost of stock options, the true value of pension assets and liabilities, the long-term impact that healthcare costs will have on corporate profitability, and the mere fact that PE multiples looked at from many perspectives remain on the high side.
Risks that investors are paying attention to today include: the preference for businesses to hold cash rather invest; the risk that oil remains at $50-plus (e40) a barrel; the risk that commodity prices in general may continue to rise; and the risk that China’s efforts to cool their own economy leads to a drop in China’s appetite for importing foreign goods.
On the positive side, earnings have continued growing, albeit more slowly. In addition, the fact that firms are holding a lot of cash suggests that growth prospects may improve when such firms begin investing again. Another positive sign is that consumer spending has remained robust.
US equities look overpriced relative to equities elsewhere in the developed world (particularly relative to Asia). Further, measures as to how much risk has been priced into the US equity market suggest that investors are, relatively speaking, complacent about the balance of these risks. Investors have, for example, seen deficits last for years without clearly observable impact, and they hear no time bomb ticking.
US equities are likely to underperform other developed equity markets at the margin near-term until a material catalyst appears on the scene. More often than not, a rise in interest rates acts as just such a catalyst, so we are carefully watching the interest rate environment for the possible hints.
Max Darnell, chief investment officer and director of research, First Quadrant
