This article first appeared in Investment Week.
2018 has begun where 2017 left off; with markets at record highs and a chorus of bullish optimism. This most unloved of bull markets looks set to continue for a while longer, if the consensus is anything to go by. But the longer the bull-run, the louder the bear case for a market correction becomes. Even the most optimistic concede a correction of some form is inevitable. For investors it’s fast becoming a game of chicken – how long are you prepared to stay on, knowing that at some stage you’re going to need to get off the ride and get off quickly?
For equities, current valuations can be justified at a stretch. There are some key supportive factors to be found in improving global growth; tax reform in the US; and supportive monetary and fiscal policy. Combined with positive market sentiment and you have the momentum to drive markets still higher. At that point you enter the realm of over-exuberance, where price movements disconnect from the fundamentals. This is bubble territory, the precursor for a correction, and is one of the key risks for 2018.
For now, equities look like the place to be, with Emerging Markets looking like a good play on global growth prospects and a region that still has some catching up to do relative to developed markets. The UK still looks the weaker prospect amongst those developed markets. Now is not the time to withdraw from equities but not to start loading up on risk either. Maintaining a watchful caution seems sensible.
As a risk diversifier bonds don’t look particularly attractive. With yields on sovereigns below inflation and spreads across the asset group as tight as they’ve ever been, bonds look vulnerable; especially given Central Banks’ desire to tighten. Only a full blown retreat from equities towards bonds could reverse the downward pressure on bond prices.
Investors need to look elsewhere to diversify their equity risk. Alternatives have got to be a key part of any defensive strategy now. Low beta exposures to both equities and bonds are the order of the day, in order to offer some portfolio insurance in the event of a market correction. Correlations between asset classes, groups and individual stocks are breaking down which creates a favourable environment for active managers and alternatives in particular.
- Improving global growth and supportive monetary and fiscal policy underpins current market levels
- Bullish optimism provides a strong tailwind for risk assets
- The longer the bull run in equities prevails the stronger the case for a market correction
- Over-exuberance will take equities into bubble territory increasing the probability of a more severe correction
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