Financial markets are awash with risk right now, said Rick Bookstaber, founder of Fabric RQ, but one risk category that investors likely won’t have to worry about long-term is geopolitical.
Even though Russia has invaded Ukraine and there are concerns that its belligerence could spill over into other parts of the world, geopolitical risk’s impact on financial markets tends to be relatively shallow and short-lived, said Bookstaber on the Standard Deviations podcast from Orion Advisor Solutions, hosted by Dr. Daniel Crosby.
“Part of it is that it is in the self interest of any country and anybody who is attacking another country to maintain that country’s structure, economy and production,” said Bookstaber. “So if we take the case where one country invades another, typically, they don’t lay waste to that whole country. Production still occurs, and of course, there’s still the substitute ability.”
The world is interconnected, which can create vulnerability if one key resource producer is taken out by conflict or natural disaster, but it also creates resilience in that other countries can step up if one commodity exporter is crippled. While energy markets may be out of balance for some time, Bookstaber mentioned that such substitute producers will likely pick up the slack in food production.
As far as markets are concerned, wars are “hiccups,” said Booksktaber, but the dramatic images associated with war often have an outsized impact on investor behaviors.
So what does threaten today’s market?
Nowhere To Hide
“The two biggest risks for the market are the heavy concentration and perceived overvaluation in tech stocks, and inflation,” said Crosby. “In some ways these things seem like they sit at odds with each other, because if I look at the reality of 7.5% inflation and its wealth destroying effects, I go ‘Whoa! It’s time to get long some equities, I need to be taking some risk!”
But with stretched valuations, excessive risk taking in equities could also potentially be bad, said Crosby, especially if there’s some sort of re-rating or re-pricing.
Investors need to be careful about labeling equities as a good hedge against inflation, said Bookstaber, as some equities are better hedges than others.
“If you’re a price-taker, that’s not so good, if you can dictate prices you’re fine: I’d rather be Wal-Mart than the people producing the shovels that Wal-Mart sells,” he said. “If you make your money through intellectual property, you’re in better shape than if you’re a pure brick-and-mortar and you have to rely on the prices of commodities and labor.”
Bonds, along with many equities, are a major casualty of inflation, said Bookstaber.
Investors may have trouble making decisions in an inflationary context because there hasn’t been very much inflation in the recent past.
“The period from 1968 to 1982 was a period of nothing much happening in the equities markets—it went down, it came back up, it went down again and it came back up again,” said Bookstaber. “If you’re in 1982 and you’re looking at your portfolio, it was likely near the same place it was at in 1968, so clearly, equities didn’t do a lot for you during that period. The period from 1974 on to 1982 or 1983 was one of high inflation, and through some of that we had stagflation. A lot of the inflation was clearly directed at a critical commodity at the time, oil. So based on that experience, you might say that equities will not be as great a driver of returns or hedge against inflation.”
There’s another problem with equities right now—they are (still) overvalued, historically speaking. In February, valuations across most equity categories were at or above all-time highs.
Inflation’s deleterious impacts can be amplified by outsized valuations, said Bookstaber, as inflation leads analysts to discount more highly the earnings they anticipate from certain companies in the future.
“You couldn’t justify the same price-to-equity ratio when earnings are discounted at a higher rate,” said Bookstaber. “Given the high p/e ratio, a rise in inflation, which gives a rise to nominal rates is going to be really adverse to the equity market and may be the trigger that starts the readjustment in valuations.”
Risks and Triggers
“If you’re in risk management as opposed to portfolio management, there are two things going on, two components of risk that have to kind of combine to create the combustible mixture that leads to a market drop,” said Bookstaber. “One is vulnerability in the market, the other is a trigger, an event that makes that vulnerability matter. The vulnerability is kind of like how thick the ice is on the lake, and the event is like the boulder that falls down into the lake.”
From a risk standpoint, Bookstaber believes that the market is in a high-risk state: high leverage and margin, investors over-allocated to equities, and concentration in mega-cap technology stocks.
But high risk doesn’t mean that a bubble is in the process of bursting—an event is needed to pop the bubble like a pin-prick, said Bookstaber. For reasons already stated, the invasion of Ukraine probably wasn’t the event. Markets can sustain growth for “years and years” while remaining in a high-risk state.
“This is the nature of risk management, if you’re a portfolio manager and you’re wrong 55% of the time you’re not going to survive, but if you’re a risk manager you’re going to be wrong 90% of the time because a risk is something that occurs 5% of the time or less,” said Bookstaber.
Don’t Count on the Fed
Some investors believe that we’re in an era of extraordinary policy intervention where central banks and lawmakers won’t allow a full-scale market collapse. This view was born from some of the “aggressive and courageous” moves by the Federal Reserve in response to March 2020’s Covid-19-caused market collapse.
In its response the Fed acted quickly to support a flagging Treasury market, eventually expanding their asset purchases to corporate bonds and ETFs.
“So okay, that was March 2020,” said Bookstaber. “I just don’t see that happening again. I don’t see the Fed doing the same thing when it’s a normal bursting of the bubble. It’s not their job to deal with the ups and downs of the market. Even if you think they maybe would do it, maybe isn’t a good basis for changing your decisions in terms of risk.”