For much of the past decade, share markets have enjoyed a strong tailwind from low interest rates, government support and growing corporate profits. While markets have remained resilient and continued to reach new highs, there are several risks beneath the surface that investors should understand. Importantly, these risks do not mean a market crash is inevitable. However, they do suggest that we should be prepared for greater volatility and more modest returns than we've experienced in recent years.

Higher Interest Rates Are Changing the Investment Landscape

One of the biggest challenges facing share markets today is that interest rates remain much higher than they were during the period following the Global Financial Crisis and the COVID-19 pandemic. When interest rates rise, we see:

• Borrowing become more expensive for businesses and households.
• Consumers having less disposable income to spend.
• Companies facing higher financing costs, which reduce profits.
• Investors able to earn more from cash and fixed interest investments, making shares relatively less attractive.

Many share prices are based on expectations of future profits. Higher interest rates reduce the present value of those future earnings, particularly for growth companies whose profits are expected further down the track. This doesn't mean shares cannot perform well when interest rates are high, but it does mean companies need to deliver stronger earnings growth to justify higher valuations.

Markets Are Being Driven by a Small Number of Companies

One of the less obvious risks is the lack of "breadth" in many major share market indices. When we hear that a market index has reached a new all-time high, it can give the impression that most companies are performing strongly. In reality, a significant portion of recent gains has been driven by a relatively small group of very large companies. This concentration creates several concerns:

• The overall market can appear stronger than it really is.
• If a handful of highly valued companies stumble, the entire index can be affected.
• Investors may unknowingly become more concentrated in a small number of businesses.

A healthy market generally sees gains spread across many sectors and companies. When leadership becomes increasingly narrow, it can be a sign that investor optimism is focused on a limited group of stocks rather than the broader economy. Think of it like a sporting team. If only two or three players are scoring all the points, the team's success becomes heavily dependent on those individuals continuing to perform.

Government Spending and Rising Debt Levels

Governments around the world responded to recent crises by increasing spending and taking on significant amounts of debt. While this helped support economies during difficult periods, many countries now face debt levels that are substantially higher than historical norms. The challenge is that governments continue to run large budget deficits despite relatively strong economic conditions. This creates several long-term risks:

• Governments may need to spend more on interest repayments.
• Future tax increases may be required.
• Public spending may become harder to maintain.
• Financial markets may eventually demand higher returns to lend money to governments.

If government debt continues to grow faster than economic output, it can put pressure on economic growth and potentially crowd out private sector investment. At some point, governments will likely need to make difficult choices between higher taxes, lower spending, or accepting persistently high levels of debt.

Market Valuations Leave Less Room for Error

After several years of strong market performance, many shares are trading at relatively high valuations. When valuations are elevated, investors are effectively paying a premium for future growth. The risk is not necessarily that earnings will fall, but that they may not grow as quickly as investors expect. In these environments:

• Good news often becomes fully reflected in prices.
• Disappointments can lead to sharp share price falls.
• Markets become more sensitive to economic data and company results.

The higher the expectations, the less room there is for mistakes.

What Does This Mean for Us?

While these risks are real, they are not reasons to abandon investing. Successful long-term investors understand that uncertainty is a normal part of markets. Rather than trying to predict short-term movements, it is often better to focus on factors within your control:

• Maintaining a diversified portfolio.
• Holding an appropriate level of defensive assets such as cash and fixed interest.
• Investing across different sectors, countries and asset classes.
• Avoiding excessive concentration in popular themes or individual stocks.
• Staying focused on long-term objectives rather than short-term market headlines.
• Avoiding illiquid investments such as private credit, private equity, and unlisted property funds.

The Bottom Line

Today's share markets face a combination of challenges not seen for many years. Higher interest rates, narrow market leadership, elevated government debt and optimistic valuations all suggest that investors should approach markets with caution rather than complacency.

However, history shows that periods of uncertainty are a normal part of investing. Markets often experience setbacks, but quality businesses continue to adapt, innovate and grow over time. The key is not trying to predict every twist and turn in the market. Instead, it's about building and maintaining a well-diversified portfolio that can withstand different economic environments and remain aligned with your long-term financial goals.

Important information

This article contains general information only and does not take into account your objectives, financial situation or needs. Tax outcomes depend on individual circumstances and the legislation applying at the relevant time. Consider obtaining appropriate financial and tax advice before acting.