The correct price of risk and the improving returns picture

The article first appeared in the Financial Review on 10 April 2023

As an investor, my job isn’t to try to eliminate risk but rather to correctly price it. In fact, within the portfolio, I need to take on risk but at the right price.

I’ve been thinking quite a lot about this concept over the last 12 months as more and more risk has entered markets. Today, markets need to consider geopolitical risk, financial contagion risk, interest rate and inflation risk, risk from recession and regulatory risk as well as the risk from increased taxation.

Quite an eventful start to the year! Markets now reflect a risk-free rate of around 3 per cent to 4 per cent. We’ve seen significantly increased geopolitical risk. Additionally, inflation is troubling markets and higher interest rates have played a significant role in the collapse of Silicon Valley Bank and Signature Bank, not to mention dealing a severe blow to Credit Suisse.

With this as a backdrop, equity markets now present a much more interesting opportunity. History teaches us that when significant risks are priced into equity markets, they’re more likely to provide better longer-term investment returns.

There’s plenty to worry about but that also presents better opportunities for the future.

Let’s begin with interest rates and inflation. The Australian government bond yield curve indicates a risk-free rate in the 3 per cent to 4 per cent range, which is a much more sustainable rate and a better investment starting point than that of a couple of years ago.

This is down almost 0.5 per cent from only a month ago. Markets seem to be indicating we’re getting close to the peak for both interest rates and inflation.

In terms of interest rates, the Reserve Bank could continue to increase rates but there’s now a more balanced case to pause as we saw from the RBA’s April decision to keep rates at 3.6 per cent.

Time to pause

Volatility in markets, I always think, is the market struggling to value companies in a changing economic environment. If we move into a pause environment, markets are likely to become less volatile. Higher interest rates are also the key catalyst for concerns around a recession.

Our view is that global developed markets will likely head into recession this year. Australia, however, will likely avoid recession but grow at a slower rate. This view is consistent with bond yield curves around the world.

Australia’s links to better performing Asian countries, as well as higher population growth from immigration will likely put us in a much better position.

Higher interest rates also expose poor business practices, financial leverage and weak or challenged business models.

SVB and Signature Bank made poor management and business decisions and their business models effectively broke under the impact of higher interest rates. Credit Suisse was weakened after years of scandal and mismanagement and forced into a union with UBS.

After the initial run around to see who might have exposure to these and other weak financial institutions, the focus changed to other assets that could be impaired with higher interest rates.

While unlisted commercial real estate could be another flash point with much higher interest rates, the difference between US, European and Australian banks in terms of regulation, capital, fragmentation, and balance sheet strength highlighted that Australian banks were in a strong position to withstand ruction in financial markets.

Geopolitical risk is always difficult as it’s very binary. The important point, in this context anyway, is that it is getting priced into markets. Once again, this provides a much better starting point for investments. Assets are better priced due to higher geopolitical risk.

In my view you always want to invest in equities for at least a five to seven-year investment horizon, preferably 10! If you need the cash in 12 months or even three years, there’s too much volatility in equity markets for short-term investments.

But as we worry over the short term, I can’t help but get excited that I can now buy the market at a much better risk-adjusted price which will likely deliver much better longer-term returns.