Rudi’s View: Five Key Risks To Consider

This story features WEB TRAVEL GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WEB

By Rudi Filapek-Vandyck, Editor

Can we trust our fellow-investors?

Many years ago, a local strategy update by UBS made that question the central premise of a share market assessment that, ultimately, resulted in the conclusion it was probably best to pull some profits to the sideline and prepare for more volatile times ahead.

With share markets near all-time record highs, and the forward-looking PE multiple for the ASX200 above 18x, a level seldom witnessed without a sell-off beckoning, while there are plenty of ‘risks’ lingering, it’s probably an apposite question to ask ourselves.

In last week’s edition, I explained how the resilience of markets and the steady rise in valuations this year can be explained by investors’ forward-looking focus. It may still be the case that, come 2025, this year’s confidence proves accurate and justified.

But markets are not 100% rational; they are made and moved by people.

The Nasdaq index year to date is up in excess of 22%, with the S&P500 not far behind and the Dow Jones (DJIA) up by 13.73%, ex dividends. In Australia, the local market including dividends has returned nearly 10% year-to-date. Many gains from individual equities have been multiple times larger.

Can we trust our fellow-investors to stay “confident” and “relaxed” when the proverbial hits the fan?

It used to be general market wisdom that ‘bad things tend to happen when markets trade on elevated valuations’, but it has been a while since I heard anyone referencing it.

Markets have been strong, for sure, and overall volatility has remained low. Outside of Australian banks, and the occasional hyped-up growth story, there hasn’t been too much around to genuinely worry markets.

For every profit warning that came out of nowhere, like Web Travel Group’s ((WEB)) on Monday, there are equally as many solid business stories around that offer lots of promise and upside. Appeased by central bank rate cuts, and the promise of a brave new world on the back of megatrends Gen.Ai, GLP-1s and others, markets have firmly kept their focus on the positives.

Let’s assume, for our own general risk-assessment, that bad news does tend to happen when markets only take into account the positives from the future on the assumption that no interruptions will occur, what risks are there we can identify?

Key Risk Number One

I suspect the immediate threat to current tranquility resides within the Israeli war with Iran and its neighbouring proxies.

Thus far, US president Biden has managed to prevent direct Israeli attacks on Iranian oil infrastructure, but general sentiment inside the US capital is that Biden’s influence seems to be waning.

A fresh update from analysts at RBC Capital concludes: “There is an expectation in Washington that Israel will indeed launch a major strike that will cause substantial damage”.

If correct, I  worry Iran will equally retaliate with force. Markets will have to price in the risk of broad escalation in the region.

RBC Capital: “While administration officials hope that Iran will opt for a more calibrated counteraction to enable an offramp, the Iranian leadership is not expected to sit on its hands and do nothing.

“We also continue to highlight that the US election calendar may also influence Netanyahu’s war calculations, with American support potentially at its peak before the polls close on November 5.

“We believe that there is a corner of the market that will hit the sell button on any sign that Israel is taking a pass on hitting Iranian oil facilities, and wind the clock back by several weeks.

“We would caution that we may be entering the most dangerous retaliatory spiral of this one-year war, and the risk of a full regional confrontation will remain appreciably high, even if Kharg Island is spared in the next Israeli strike.

“Moreover, based on our conversations here, Israel apparently has a serious contingency plan on the books to inflict a devastating blow on Iran’s oil industry.”

Key Risk Number Two

I am not a political expert, but could a spike in hostilities between Israel and Iran turn into the much talked about ‘October surprise’ that turns election momentum decisively in favour of a second Trump presidency?

In that case, markets’ focus will turn to the most obvious intentions that have been expressed; the slapping of import tariffs as high as 60% on Chinese products. Yes, there will likely be corporate tax cuts too, but those require procedure and time, while the promise is for tariffs to be applied from Day One of the new administration.

Right now, Wall Street has quietly accepted a win by Kamala Harris with a divided Congress remains the most likely outcome, and it is considered the least disruptive scenario too. But that’s assuming a non-favourable outcome won’t be challenged by Trump and his loyal base, which I think is but a plausible scenario.

Key Risk Number Three

The US economy might escape recession this year and in 2025, but global momentum is still on a downward-sloping trajectory, also emphasised by ongoing sluggish momentum for the economy in China. This has weighed down commodity prices and share prices for the likes of BHP Group ((BHP)) and Rio Tinto ((RIO)).

September witnessed a rapid turnaround when China indicated fresh stimulus measures will be announced to pull GDP growth up to the government-targeted 5%, but that early enthusiasm remains very much dependent on Chinese authorities’ ability to sustain investor confidence that all shall be rosy in the end.

That, by all means, remains far from guaranteed as the Chinese economy is now burdened by multiple structural headwinds and authorities are acutely aware they cannot simply throw more debt upon debt to remedy all internal problems, as it will create an even larger problem further out.

Not helping their cause is the fact export destinations in Europe and the US are no longer willing to accept cheap Chinese products that destroy their own manufacturing jobs. The challenge to keep the Chinese economy on song will only become more prominent if Trump’s 60% tariffs turn into reality.

The Chinese economy is now burdened by an over-supply in houses and infrastructure, while construction companies have taken on too much debt. The resultant decline in property prices is sending builders to the wall, and weighing on consumer confidence generally while local governments are facing less income from land sales.

It should also be noted the Chinese population is shrinking and public debt is now one of the highest in the world. Among the positives is the authorities’ resolve to continue supporting their domestic economy; one key difference with Japan after the bursting of its bubble in the early 1990s.

But also: total ‘leverage’ in China, combining public and private debt, as a percentage of GDP is now larger than for the US.

Chinese authorities know where the problems are. Their fix it initiatives aim to prop up the share market, at least stabilise property dynamics, support bank balance sheets and local government budgets, and restore consumer confidence. In the absence of a Big Bazooka stimulus program similar to what was applied during the GFC, it’s going to take a while before concrete results can be observed and measured.

Which is why the resource sector’s resurgence in September remains all about news flow, expectations, and general sentiment. At least for the short to medium term.

The one opposing thought that comes to mind is if the situation inside China would deteriorate decisively, be it because of a broader war or the Trump tariffs, the chances for another Big Bazooka stimulus program would plausibly increase.

Key Risk Number Four

Economic disappointment in the US and/or in China is by no means off the table, but a great deal of next year’s corporate profit forecasts relies on strong margins as much as it depends on robust economic momentum.

While high valuations in 2024 can be justified on those projections, needless to say they are still projections and any changes in underlying dynamics can have material consequences. One added positive (which hopefully remains just that) is next year’s margins should see the early impacts from businessess incorporating Gen.Ai.

Recent research by analysts at UBS has found virtually all of the corporate margin improvement in the US to date has come from interest rate cuts, lower taxes and technology companies. UBS struggles to find cyclicals “attractive” but also notes most of the time cyclicals and markets move in the same direction.

As far as economic indicators and signals are concerned, within the current context and markets set-up it’s probably fair to say both mildly negative and mildly positive signals are supportive of markets, but sentiment can turn in case of more decisive negative or positive signalling.

One stand-out negative development would occur if earnings momentum for US corporates deteriorates. UBS research states whenever this happens, markets tend to fall in 40% of occasions and in 47% of the time over the next year. Using a 13 weeks moving average, UBS believes US earnings momentum is starting to roll over.

The Q3 reporting season in the US has only just started. Its importance in the current context can hardly be over-stated.

Key Risk Number Five

Key risk number five is of a completely different nature; it’s the melt-up that occurs after central banks have been forced to inject even more liquidity in markets. A coordinated policy loosening by China and the US could well provide such a trigger, analysts at UBS have suggested.

On their assessment, share market ‘bubbes’ tend to happen when equities have sharply outperformed bonds over a prolonged period of time, with corporate profits coming under pressure, helped by a narrative of ‘this time is different’ and with the memory of a previous precedent at least 25 years old.

The key ingredient that is missing today, UBS argues, are benign monetary conditions. That would change if the Fed cuts its cash rate to below 3% and Beijing announces its next Bazooka stimulus, including the People’s Bank of China “printing” money. The broker adds there is US$6.3trn currently stationed in money market funds in the US.

Some experts are calling out ‘bad technicals’, but there’s certainly no agreement in that department, while the same observation can be made about investor positioning and/or ‘sentiment’.

Putting it all together, and without any need for panic or onerous, outsized adjustments, the FNArena/Vested Equities All-Weather Model Portfolio is lifting its allocation to cash on the sideline where it can wait for further developments and be re-allocated when opportunities start opening up.

In line with the philosophy behind this Portfolio, exposure includes multiple defensives including CSL ((CSL)), Woolworths ((WOW)) and Telstra ((TLS)), also with a skew towards larger-cap companies, as well as gold.

There’s never a watertight guarantee on how markets and each stock individually might perform, but at this stage we remain confidently relaxed, also realising the risks mentioned are just that, not inevitabilities.

Last week’s edition: 

Part One: https://fnarena.com/index.php/2024/10/09/rudis-view-market-reflects-risk-opportunities/

Part Two: https://fnarena.com/index.php/2024/10/10/rudis-view-china-scepsis-energy-preferences-the-us-election/

All-Weather Model Portfolio

The switch in market momentum in September has meant the All-Weather Model Portfolio could not keep up with the local index, but that’s not such a bad thing in light of the significant gap in performance over the year past.

Among the positive contributors for the Portfolio in September were WiseTech Global, Goodman Group, Aristocrat Leisure, Macquarie Group, TechOne and gold. All these positive contributions have accumulated over multiple years, which fits in well with the underlying philosophy as well as the core of my personal research.

FY24 review for the All-Weather Model Portfolio:
https://www.fnarena.com/index.php/download-article/?n=DE2A4552-E2C7-4DC7-0A896CE5CF68ACD8

Prior years:

FY23: https://www.fnarena.com/index.php/download-article/?n=DFC11150-CB36-C777-1AA3EDA640E2F5BF

FY22: https://www.fnarena.com/index.php/download-article/?n=DFE7241B-9CD8-61F1-1602C581A8E539C4

FY21: https://www.fnarena.com/index.php/download-article/?n=DFF82691-E53E-3CF5-17A2337D72CDB54F

Video: Why FNArena & All-Weather Stocks

I’ve used my participation to the InvestmentMarkets’ conference in July to explain how/why FNArena started & what investors get out of it, including research in All-Weathers and Gen.Ai

The video: https://bit.ly/3A1pLuz

Model Portfolios, Best Buys & Conviction Calls

This section appears from now on every Thursday morning in a separate update on the website. See Rudi’s Views for the archive going back to 2006 (not a typo).

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (21 since 2006); examples below.

(This story was written on Monday, 14th October, 2024. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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