Keeping risk at bay

Attitudes to risk, a concept long familiar to investors, gradually became a political fault line during the Sars-Cov-2 pandemic. Lockdowns were stoically accepted when admissions to intensive care units were sky-high, but the zeitgeist has shifted. Vaccines, natural immunity and milder variants have tipped the balance of public opinion towards libertarianism.

Thankfully, risk isn’t always about life or death, or about whether restrictions on basic freedoms are a trade-off worth making to save lives. Still, questions about acceptable loss, opportunity costs and compensation are part of any decision-making process. That’s especially true of investing; diversification may be the cornerstone idea of Modern Portfolio Theory (MPT), pioneered in the 1950s by Harry Markowitz, but seeking optimal risk-to-reward is a core tenet, too.  

Right now, the risks facing investors seem especially stark. True, bad headlines are always around because they sell newspapers and get people clicking on links. But there are fundamental shifts occurring in geopolitics, trade, inflation, monetary policy and the environment. Even if the worst of the pandemic has passed and Russian president Vladimir Putin doesn’t start a nuclear war, potential scenarios that aren’t apocalyptic in nature still warrant a strategic rethink of portfolios.

Investors shouldn’t shy away from these considerations. The trick is to understand what a portfolio is exposed to, and the likelihood the risks being taken will pay off. The answers can’t be known with certainty, so it is important, as a basic principle, that assets are diversified – if their value is less likely to be dragged down in unison on bad news, a portfolio won’t suffer such severe peak-to-trough drawdowns in rough periods for stock markets. For the purposes of this article, we will focus on the changes that may lie ahead for the global economy, and their implications for investors.

 

Risk, reward and the economy

At an individual stock level, the questions centre on whether a company is solvent (it can manage its long-term financial obligations), liquid (it can cover short-term liabilities as they fall due), and on the operational and market factors that determine how profitable and cash-generative a business is now and in the future. The sum of predicted cash flows from dividends and capital gains can be discounted back to the price paid to give an implied expected return. This can be thought of as the level of compensation investors think is fair given the downside risks for the company; for the firm, it is the cost of equity.

According to MPT, the idiosyncratic risks facing companies can be diversified away by holding a combination of shares. In a perfectly diversified equity portfolio the risk of owning shares equates to the rises and falls of the market. This is known as beta risk: if you own an exchange traded fund (ETF) that tracks a market index, your returns are simply market moves plus dividends, minus a small fee. 

Breaking those market returns down again, however, shows groups of companies with certain characteristics or ‘factors’ follow performance patterns at different times. This is particularly pertinent as we enter a new stage for the global economy. Thanks to the pandemic, and the west belatedly standing up to the threat posed by hostile regimes in Russia and China, energy security and supply chains are being re-thought. Structurally higher inflation (UK consumer price inflation stood at 6.2 per cent in February) may be a consequence that affects consumption, costs and output, as well as precipitating a change in monetary policy regime.

In March, The Bank of England raised interest rates for the second successive month, while the US Federal Reserve hiked for the first time since 2018. Significantly, the hawkish tone from Fed members, visualised by the so-called ‘dot plot’ of where they expect target rates to be at points in the future (see chart), suggests the Federal funds rate could reach 1.9 per cent by the end of 2022 – equivalent to six additional hikes.

Raising the cost of borrowing is designed to cool demand and prevent the effect of too much money chasing too few goods from bidding up prices to levels where the demand for higher wages spirals out of control. But dampening demand by making money scarcer and more expensive can cause a recession and increase unemployment. The trouble is the reward for accepting that pain could be lessened thanks to high energy prices caused by supply issues. The dreaded scenario is 1970s-style stagflation, where inflation remained high despite economies being in recession.

 

Share price drivers

What all this suggests for stock markets is that there will be much more dispersion in returns in future. That means understanding risk factors becomes all the more important. Work by Eugene Fama and Kenneth French in the late 1980s broke down the drivers of share prices into three factors. The first was simply beta, or the proportion of a stock’s returns that were related to its co-movement with the overall market. The second was the size of companies, with small-cap stocks having demonstrated a propensity to outperform. The third factor was value, via the observation that stocks rated on a cheaper price-to-book value periodically did better than peers.

When the initial three-factor model was first published, value had outperformed over the long run. In the past 20 years, that hasn’t been the case. One reason for this is that contemporary economic growth has been powered by businesses that mostly derive productivity gains from intangible assets such as research and development, technology patents and brands. Another is that historically low interest rates and other monetary policy measures to control the money supply, like quantitative easing (QE), have favoured investing in more expensive stocks that promise sustained earnings growth.

In 2015, Fama and French added two new factors to their model: the proportionate effect that companies’ profitability, as well as levels of investment, had on their stock returns. Profitability in particular can be equated with the popular ‘quality’ factor that index managers and ETF providers have successfully marketed to investors.

Before Fama and French updated their model, the work was built on by Mark Carhart. He added a different factor: momentum, the phenomenon of stocks continuing to do well after the market catches on to a theme or good news story. Momentum is something of an ephemeral factor and the portfolio turnover involved makes systems based on pure share price movements impractical and expensive, but it is a widely recognised force in markets.

To return to the simpler analysis of the original three-factor model, it is clear that easy money meant beta was the factor to back for larger companies. In other words, taking market risk paid off, and being a contrarian value stockpicker was poorly rewarded for all the time and effort involved.

Higher interest rates force a reset to valuation assumptions, however.

If shares trade at elevated levels, the implied forward rate of return is lower. In a low interest rate regime, this is more acceptable to investors for two reasons. First, low rates are supportive of economic growth, which is good for companies’ profits, making it more probable they will hit or beat earnings targets. Second, it makes shares more attractive relative to supposedly riskless assets. The difference between the yield on a 'safe' government bond and the implied cost of equity is known as the equity risk premium (ERP) – compensation for the risks of investing in shares. 

 

Making risk pay across a multi-asset portfolio

The changing monetary policy environment also has implications for overall portfolio construction. The idea of a risk-free rate of return was contributed to portfolio theory in the 1960s in what is now known as the capital asset pricing model (CAPM), which was developed and refined independently by several luminaries, including William F Sharpe, Jack Treynor, John Lintner and Jan Mossin. The premise of CAPM is that the availability of a guaranteed rate of return from an asset that won’t default enables portfolios to be built with an element of risk-free return. This can be combined with riskier assets to optimise risk/reward considerations, as opposed to simply relying on diversification between risk assets.

The risk-free rate is typically taken as the yield on a benchmark quality government bond. Note that government bonds aren’t without risk – the price of bonds fluctuates on the secondary market, so cash flows from the bond (the fixed coupon payments and, on maturity, payment of the sum lent to the issuer) offer the required yield. If held to maturity, however, the yield on a quality government bond like a US Treasury or a UK gilt is considered risk-free because those governments will not default on their debt.

The reason to hold such assets is insurance: unless they are sold early at a time when market yields rise (and prices therefore fall), all the cash flows are certain. Institutional investors such as pension funds are mandated to hold a proportion of risk-free assets because they must ensure cash flows as their liabilities fall due.

Textbooks tell retail investors to have a portion of their portfolios in high-quality government bond funds because they are a less risky holding than shares and may at least dilute the effect on the portfolio of a stock market sell-off. At the moment, given the expensiveness of bonds and the fact their prices are sensitive to rising interest rates, simply holding a cash buffer as portfolio insurance is a reasonable alternative.

At the end of 2020, CAPM innovator William Sharpe of Stanford University gave Investors’ Chronicle his thoughts on asset allocation:

“The key assumption of my work on adaptive asset allocation is that investors differ in their willingness to take risk to obtain expected return. This implies that a given investor's portfolio should have a relative relationship between its risk and that of the overall market. Considering the mix of major asset classes, the investor with an average risk tolerance should seek to maintain asset class positions in proportion to the market values of the underlying assets. An investor with greater risk tolerance should hold more in riskier asset classes and less in less risky classes, and so on. When asset class values change, my adaptive asset allocation approach can be used to adapt an investor's asset holdings to maintain a desired ratio of risk relative to that of the market as a whole.”

Whether positive or negative, the risk-free rate always matters. Premiums above it are the reward for taking greater risks. Practically, that means a rise or fall in the yield on safe government bonds demands a rethink in the pricing of all other assets, especially corporate bonds and equities.

With so many risks materialising in the world today, it is important to understand how well they are reflected in the prices of assets. If risks aren’t properly priced, that is potentially a signal to buy or sell securities.

 

What bond prices tell us

In the first instance, investors must appreciate why government bonds are priced as they are. Although these offer a risk-free rate, they are far from risk-free assets. For starters, there is a term premium, which is based on the premise that investors require higher coupons the longer their money is lent to the government.

Typically, therefore, the yield curve for government bonds (the yield to redemption plotted against time until maturity) is upward sloping. That is not always the case. Yield curves that begin to slope downward can suggest short-term pain, and have predicted most recent US and UK recessions. In this context, the recent convergence between the US 10- and two-year Treasury yields is ominous.

Linked to the term premium is the return investors expect to cover inflation. If prices in the economy are rising, nominal compensation must rise to limit the term premium being eroded. But the change isn’t always commensurate, and analysts make the distinction between real and nominal yields. If the latter rise by less than inflation, real yields can still fall.

The situation of investors accepting these lower real returns from safe assets and generally being more tolerant of inflation has been described by the BlackRock Investment Institute as the “new nominal”. This theory posits that the market equilibrium for real bond yields is lower than it once was.

Yet every monthly announcement of rising inflation puts the Fed under more pressure to act – even though the yield curve suggests the market is beginning to price in a serious policy mistake. Hiking interest rates causes bonds to sell off, raising yields to the level investors demand. Prices of bonds with maturities or lower coupons are more volatile and this sensitivity is calculated in a measure known as the bond’s duration. Interest rate or duration risk is a key consideration for bond investors. 

Primarily, the reason investors would prefer to own a longer-dated government bond is to lock in yield. If they are prepared to accept a yield that is less than that currently offered by short-dated bonds – as happens when the yield curve inverts – it is because they expect rates to fall in future. This is contrary to the strong indication given by the Fed that it will continue hiking and indicates the market thinks such actions are likely to cause a recession and be reversed rapidly.

 

Risk in flux

So far, the current monetary policy tightening cycle has been bad for the quality growth stocks that did so well in the past decade. But any backtracking by central banks will, as above, most likely be due to economies falling into recession. Bond markets apparently expect rates to go down again, but that doesn’t mean the shares of US tech companies will shoot straight back up.

Genuine economic pain will feed through to corporate profits, so the earnings ‘E’ part of price/earnings (PE) ratios could decline, lessening the justification for high share prices. Put another way, although risk-free rates will drop back again if central banks make a volte-face on tightening, so too will companies’ operating cash flows – and investors will be prepared to pay less for shares to maintain the equity risk premium.

Companies that rely more on debt funding face significantly greater risks. Raising interest rates increases the cost of borrowing. If this causes a recession, investors will be more nervous about extending credit, regardless of whether rates subsequently fall again. 

Investors in corporate credit demand a yield spread over the risk-free rate on government bonds to tie up their money with companies. A recession would see more companies fall from 'investment-grade' credit status, and those that retained it facing wider spreads. In this situation, central bank interest rates would fall but the market cost of corporate borrowing would remain elevated.

The yield curve on government bonds is beginning to suggest such a turn in events. Credit, which performed incredibly well as an asset class on the back of monetary stimulus in the pandemic, would sell-off in that scenario. But a reset of prices is arguably healthy. Shaking down weaker borrowers and offering investors a better spread on the stronger corporates would give the option of high-quality fixed-income assets to help balance portfolios away from being so heavily overweight equity risk.

Time spent on the investment-grade credit sidelines, until the asset class is more attractively priced, is an opportunity to consider the balance sheet strength and capital structure of companies. It’s an exercise from which equity investors would benefit, too.

Many companies had been taking advantage of low interest rates to take out cheap short-term loans without the covenants that bond investors typically ask for. These floating-rate loans can become more expensive to service as rates rise, but their low duration means the risks to investors are primarily default, rather than price sensitivities.

Of course, default is the most serious financial risk and the likelihood of it requires the greatest compensation, which is why the amount of short-term expensive debt issued by companies should be a liquidity red flag for investors considering buying corporate bonds or shares. It’s all part of investment due diligence; for any company with expensive short-term debt it is important to keep an eye on the cash ratio (cash and short-term marketable investments, divided by current liabilities).

 

Inflation, income and balance sheets

Quantitative analysis has continued to evolve since Fama and French produced their first three-factor model. In the current context, specific equity strategies are being developed for the challenges posed by the myriad step-changes in the macro environment. The cross-asset research team at Société Générale (SG) has employed an inflation-sensitive stock selection methodology since September 2020, with the aim of helping to manage the transition to an era of structurally higher inflation.

SG’s initial concentrated strategy, targeting stocks exposed to rising metal and food prices, was subsequently broadened into a systematic methodology that has tracked inflation expectations and outperformed the MSCI World index by approximately 8 per cent so far this year. Despite that, the strategy still trades on a forward PE of a little over 11 times – suggesting the system now represents a decently priced hedge against persistent inflation.

For the worse eventuality of stagflation, the SG quants advance the merits of a quality income system: concentrating on high-yielding companies less likely to be forced into cutting dividends in a period of recession or weak economic growth. Leading sectors for this SG strategy are utilities (although this weighting has dropped in the past year) and telecommunications; oil & gas fell away markedly as an income-paying sector in the pandemic but is making a comeback.  

Firms with quality balance sheets ought to be more resilient in monetary tightening cycles, although that’s notwithstanding the fact larger companies carry significant valuation risk. Further down the market capitalisation scale, SG’s third equity strategy focuses on quality small-caps. This system specifically focuses on Russell 2000 companies in the US market, but UK investors might apply some of the principles to Aim-traded shares.

In short, the idea is to select smaller-sized value stocks with the least likelihood of defaulting on debt and moderated price volatility. As well as a traditional value premium, the system relies on the mathematical model developed by Robert C Merton for calculating credit risk. The quality element is important, as tighter credit conditions will expose value traps in the market. The highly leveraged US small-cap market is a perfect hunting ground, but there are also some good companies with strong balance sheets on London’s junior market that could give careful stockpickers joy.

 

What price morality?

In light of current debates, we conclude with one particularly topical disconnect that may represent a premium to be exploited: the environmental, social and governance (ESG) risk factored into many companies’ securities. The war in Ukraine and global energy shortages have forced an appreciation of the nuance required in tackling sustainability issues. But the extent to which externalities caused by a business’s activities can be valued was already a source of contention.

In the view of Professor Aswath Damodaran, of New York University Stern Business School, one of the world’s foremost experts on risk premiums and valuation, stock prices to a large extent have always reflected all the factors they possibly can. Damodaran argues well-run, responsible companies existed before the ESG era: “I believe that firms should go about their businesses, subject to the constraint that they operate within societal norms, and that can sometimes lead to rejecting decisions that can increase value but at substantial cost to society. The notion that companies did not do that before the ESG movement came along is fiction.”

Emotive subjects like climate change will continue to stir fierce debate, but the onus of the argument may now shift from divestment to how best to own energy companies and engage effectively to influence the push to a lower carbon economy. That could change how this particular risk factor is perceived. And in the meantime, it is worth remembering that a company’s cost of capital is an investor’s implied future return.