Are investors pricing in risks accurately?

Fri, 4 Apr Pre-Open

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The global stock markets are on a roll, continuing to hit record highs. Developed world stock markets led by the US have recovered strongly from the depths of the financial crisis, driven by the Federal Reserve's extraordinarily accommodative policy. The broad US market has now risen 180% since it bottom, five years ago. Back home in India, the key benchmark indices BSE Sensex and NSE-Nifty are also at record highs. So are risks to the world economy over?

The answer is no. Major changes are afoot across the global economy. The US is transitioning from quantitative easing (QE) to tapering to gradual normalization of monetary policy, as evidenced by the Federal Reserve's recent statement. This year, tapering is priced in, but uncertainty about the timing and speed of the Fed's efforts to normalize policy interest rates is creating volatility. Some investors and governments now worry that the Fed may raise rates too soon and too fast, causing economic and financial shockwaves.

In Europe, challenges include the implementation of the banking union within the Euro zone, unusually high unemployment (particularly for young population) and navigating disinflation in order to stave off the threat of deflation. However, those challenges are quite well known and, barring unforeseen developments, should be for the most part discounted by the markets. The newest challenge for Europe is a serious risk that the current conflict in Ukraine will lead to Cold War II and possibly even a hot war if Russia invades the east of the country. The economic consequences of such an outcome would be immense.

In Japan, the triple stimulus launched by Prime Minister Shinzo Abe 18 months ago, consisting of a more flexible fiscal policy, more aggressive monetary easing and structural reforms, has brought Japan to a new era. But still the inflation target set by the government may not be achieved.

China is also going through an important transition - shifting from an investment-driven growth model to a consumption-driven growth model. But the sheer size of the economy and the pace of the population shift make implementing the right policies and sustaining political stability a challenge. As such, there is a fear of hard landing in China.

While stress points around geopolitics (Russia, elections in Emerging Markets, maturing of the Chinese financial system) will create uncertainty, they can provide fertile hunting ground for investors. From a markets standpoint, valuations are not cheap, but they are not expensive versus historical standards. The key would be to find the right stocks at right valuations to insulate from these risks.