The shift to greater government intervention in financial markets and a heavy focus on a handful of strong-performing companies means investors should look for short-duration shares, companies with strong balance sheets and investment in real assets, according to Talaria Capital.
Hugh Selby-Smith, co-chief investment officer with the Australian investment firm, said a key theme for financial markets was the transition in monetary regimes as the global economy moved from globalisation into a new period of higher debt and government intervention.
“Governments are playing a more interventionist role in managing their economies, often pursuing political objectives at the expense of long-term economic discipline,” Selby-Smith said.
He pointed out deficit spending and debt accumulation played a key role in growing corporate profits, but even the United States government had struggled to deal with debt.
Interest payments on public debt were close to US$1 trillion, while corporate tax receipts were US$452 billion, and with mandatory programs consuming most of the budget, cost cutting was still heavily constrained, he noted.
“The gap between the ambitions of the now defunct Department of Government Efficiency and its limited achievements highlights how difficult it is for governments to meaningfully reduce spending,” he said.
“Earnings growth in large-cap US equities has driven optimism, but that optimism is increasingly disconnected from the realities sustaining those profits,” he added, noting much of that growth was also driven by debt.
Over the past decade, the US corporate profit pool expanded by about US$1.7 trillion and almost 90 per cent of that increase was due to growth in the deficit, he noted.
As such, he regarded US equity valuations as being at the extreme end of their historical range, leading some investors to reconsider their portfolio allocations.
“Valuation is one of the few indicators with demonstrable explanatory power for long-run returns. From a shorter-term perspective, headline valuations for the S&P 500 are stretched,” he said.
“Current conditions represent a classic peak-on-peak set-up, with elevated earnings multiples resting on unusually high profit margins.
“At a minimum, elevated valuations and high concentration should prompt investors to ask where diversification is possible.
“There is value beyond expensive headline indices and mega-cap stocks. Even before drilling down into individual securities, the opportunity set outside US large caps offers a materially better trade-off between risk and expected real return than headline US indices today.”