Maybe it’s time for investors to be careful.
The latest batch of annual outlook pieces from investment managers in the main stick to the tried and tested views of being cautiously optimistic, based on lower interest rates and still positive growth in economies. I agree we are likely to see somewhat lower interest rates and reasonable growth in some economies but that may not be enough for markets to power ahead.
Investors need to consider the level of risk in financial markets today.
I think there are a number of “red flags” out there which suggest some degree of caution.
Firstly we have come a long way and market moves have been greater that what the underlying trend in company profits has been. Almost half the advance we have seen in stock markets throughout 2024 has been driven by higher valuation not improved fundamentals. So today’s stock markets have a lot of expectations baked in.
And the moves in markets have been extreme. The advance in stock prices in the US in the past two years (at over 50%) is in the top 10% for equivalent periods in the past 100 years.
Such powerful moves and current high valuations suggest markets that may be “priced for perfection”.
Another Red Flag is the fact that the risk of a significant drawdown in equity markets has also increased. Goldman Sachs analysis shows that so far in 2025, the risk of a drawdown in share prices (which would be a decline of about 20% over a 12 month period) has increased to 30%. This is well above recent levels though significantly off previous peaks. Such risk is not reflected in stock-market volatility which remains reasonably low.
Investors also need to heed what bond markets are telling us. We may be in a regime of lower interest rates but financial conditions overall have tightened in the past month, driven mainly by bond yields. US 10 year bonds have seen yields go from 4.1% 6 weeks ago to 4.75% today. Bond investors in the US see less scope for falling interest rates than they had previously. German bonds also have moved from 2% to 2.6% in the same period. Equity investors ignore bond markets at their peril.
Another risk to be considered is the level of uncertainty about what global economic policy will look like over the next 12 months. Economic policy uncertainty (as measured by the EPU index; www.policyuncertainty.com) has soared in the past 2 months. This index is based on news coverage and it shows European policy uncertainty at an all-time high and US uncertainty driven up by lack of clarity on trade, tax and regulation. It’s hard to see a lot of this uncertainty being clarified in the near term. Added to what we know on Geo-political risk, this increases the potential for market set-backs that are hard to anticipate.
The investment landscape today is complicated. These various red flags or risks should at least be considered by investors as they look to build a resilient portfolio for the next 12 months and beyond.
Tradewinds 