Last week we took an optimistic view of the upside story for investors this year. But the upside in investing is never the full story. Understanding and quantifying risk is critical for investment success. A healthy dose of optimism helps in investing, but we must never be overly optimistic. As such we lay out below the risks investors should be considering this year, their likelihood of occurring, and how investors can protect themselves.
In our view, the three major risks facing investors in 2022 are:
- Inflation: Markets are currently pricing in peak inflation sometime in the first half of 2022. If inflation continues to rise and surprises markets with its persistence, asset markets would have to price in higher discount rates. In practice, this could mean more market volatility and declines in asset prices.
- Central banks get it wrong: In the face of rising inflation and a hot economy, central banks could raise interest rates too quickly, thus slowing the economy too much and triggering a recession. Overreaction by central banks has been a trigger for the end of the business cycle many times in the past (2008 and 2001 are recent examples).
- Bubbles burst: Some assets are exhibiting the characteristics of a price bubble. Crypto currencies, for example, have sucked in hundreds of billions of dollars despite very high volatility. If one or more of these bubbles were to collapse, the fear could spread to other markets and have a negative wealth effect on the economy.
Inflation clearly is already a risk which has materialised. The most recent CPI reading in the US was 7%, the highest in more than thirty years. But the rate of monthly increases in inflation has slowed down and there’s growing evidence that the supply chain crisis will ease, acting as a break on inflation later in 2022. For now, we agree with market consensus that inflationary pressure should ease. A great way of protecting a portfolio from inflation risks is to invest in businesses with pricing power (i.e., they can pass on cost inflation without suffering from lower demand or margins). Commodities, real estate, and businesses offering automation solutions also offer havens from inflation risk.
Central banks certainly could get their policy wrong this year. But for now, they are raising rates for the right reasons. The economy is performing well, the labour market is strong, and so it makes sense to raise interest rates.
While crypto and ‘hype’ stocks are certainly in bubble territory, many areas of the stock market are certainly not and still offer attractive valuations. Bubbles coming back down to earth could create short-term volatility, but we think that would be a good thing in the medium term. Bubbles bursting have in the past typically preceded long periods of outperformance by stocks trading on more attractive valuations. This risk crystalising could be a blessing for actively managed investment strategies, but very bad for investors in passive funds or with any exposure to bubble assets.
To end on a note of optimism, this is the first time in two years we’re confident enough to not list ‘pandemic’ as the number one risk facing markets. That alone is something to be celebrated.
Disclaimer: The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Capital Strategies Limited or its related companies. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.
