“Doubt is not a pleasant condition, but certainty is absurd.” Voltaire
Financial markets are built on perennial doubts. Doubts that trends may or may not continue, doubts over policies, doubts over investors’ nerves.
As Voltaire stated, doubt is not a pleasant condition, but in financial markets is a necessity as certainty of future outcomes would clearly end the system as we know it. Doubts in markets are a source of risk but naturally also a source of opportunity. The key to long term success is to skew the odds in favor of a forecasted outcome while hedging against terminal risk. That is why the process of research is a continuous ritual that accompanies every investor. Admittedly, this juncture seems more “doubtful” than ever as we witness lofty valuations in most assets, contrasting inflation indicators, a new mercurial administration, geopolitical fractures and a potentially revolutionary, and yet controversial, technology such as artificial
intelligence.
As highlighted in previous missives, the greater risk currently comes from positioning and valuations. Too many investors are similarly positioned in assets carrying excessive valuations relative to historical norms. While this element is not necessarily a guarantee of imminent doom and gloom, it has reliably forecasted lower than average returns. A counterargument to this historical recurrence is the belief that we are in the midst of a major redesigning of our economy. This economic transformation will require massive amounts of capital, from governments but increasingly so from private investors. The built-out of AI will need large investments in data centers and massive spending in meeting new energy demands in a context of climate change. If this paradigm is indeed the new norm, valuations will matter a lot less, inflation will remain higher than expected and private markets will play an increasingly important role in financing the economy. Another interesting element that is becoming evident is that, while diversification remains a core component of an informed investment strategy, how investors diversify is just as important. Stocks and bonds have recently produced an erratic correlation which has weakened some of the historical asset allocations. For large investors alternative solutions such as Hedge Funds and Private Equity can be the right answer. For investors with higher liquidity and size constrictions, modern diversification may need to come from other areas such as infrastructures niches, liquid alternative strategies, and gold. We are not great believers in digital assets, especially as exotic diversifiers, given their short history but it is undeniable that such assets are slowing gaining traction at the institutional level and they may ultimately prove useful.
From a diversification perspective, we are also not too thrilled by Emerging Markets. While the valuations discount to US assets puts them on the map, the current framework of the Chinese economy stuck in a deflationary limbo and global headwinds for trade, make Emerging Markets a risky bet. Among traditional assets, not everything is actually expensive. Energy is trading at low multiples reflecting an expected imbalance between supply and demand for oil in 2025. And yet, given the above-mentioned AI trend, we can imagine that ultimately energy providers will carry the day.
Pharmaceuticals and biotech are also trading at major discounts to the average stock. A combination of political headwinds and high interest rates has kept investors weary of the sector. On the plus side, R&D is cranking positive outcomes and if interest rates come down just a little that could spark the much-awaited wave of mergers and acquisitions. And then there are bonds. In our blog after the election results, we indicated a slight change of opinion. The new administration seems inclined to implement a set of policies that carry a high inflationary profile. This framework will probably push the yield curve to a steeper shape making short to intermediate maturities more favorable than long duration bonds. Higher rates for longer may diminish the diversifying quality of bonds and may not help total return with increases in principal values but they are certainly welcome by income investors who can collect decent coupons without having to go out on the credit risk curve. In the fixed income universe, agency mortgage-backed securities seem to be attractive providing a fair return consistent with good liquidity despite occasional bursts of short-term volatility. Real Estate remains a story of niches. Overall, the new expectations of higher for longer rates is a clear negative. However, there are a few pockets that will continue to benefit from long term favorable trends such as digital centers and health care. One thing is for sure, as John Pierpont Morgan once said when asked his opinion about the future direction of the stock market: “Young man, I believe the market is going to fluctuate.”
As always, we would like to thank you for the renewed confidence in our work,
Youri Bujko
Davide Accomazzo