Throughout 2017 domestic equity indices climbed steadily higher driven by strong global economic growth, while experiencing historically low volatility as most economic and geopolitical risks failed to materialize. To highlight the market’s 2017 performance, here are a few key statistics:
- The Dow made 71 new record highs and closed the year +25%
- The Nasdaq rose +28% led by Facebook, Amazon, Apple, Netflix and Google (the "FAANG stocks") which were up, on average, +48% for the year
- The S&P 500 climbed +19% and delivered positive performance every month of the year
- The VIX registered 9 of its 10 all-time lowest readings
Despite a positive start to 2018, there are many emerging risk trends which have the potential to sway global financial markets. Here are a few of the top risks most frequently cited by economists, including that of a changing tide in global central bank activity (i.e. the end of quantitative easing or "QE") and the risk of potential cryptocurrency volatility spilling into other asset classes as adoption increases.
What ultimately triggers a broader market selloff is often a confluence of factors including a volatility catalyst, such as a geopolitical event, coupled with forces that apply pressure on corporate profit margins and tightening corporate credit conditions. With that in mind, no list of risks can encompass all scenarios which can trigger losses; however these items deserve special attention due to their impact and probability.
Global Central Bank Leadership & Direction
QE comes to an end, interest rates/inflation ticks up
Across the globe, the US, Europe, Japan, Asia and emerging markets are all reporting economic and job growth combined with modest inflation. Central banks worldwide can take a bow for their effectiveness in managing a global economy through a financial crisis and a decade of low growth. But the next task for central banks is to embark on a policy of rate tightening and partial liquidation of their bond and asset portfolios built up since 2009.
Increasing yields, new Central Bank leadership, and the prospects of inflation are the new uncertainties for 2018 and will be the new challenges for a decade long equity rally. Previous regime and policy changes from central banks have come with market uncertainty, rotation in asset classes, and changes in market valuations and multiples.
Slowdown in China’s Credit Growth-fueled Economy
The China risk may be best summed up by this excerpt from a recent Wall Street Journal article by James Mackintosh:
“The last two falls of more than 10% in global equities were triggered by fears about China, in the summer of 2015 and the start of 2016. The risk has been discussed for years: China has too much debt and has used it to finance nonviable projects. To deal with this, China could weaken its currency (the cause of a 2015 global selloff), restructure bad debts or change the growth model to expand the economy faster than its debt. Xi Jinping’s economic plan is to focus on the quality of growth, not the headline number. It makes perfect sense: Slow sustainable growth is better than a debt-fueled boom followed by bust. But it is hard to switch the economy over without shutting down old industries, and that means dealing with their debts and finding new work for their workers. Worse, money-supply growth tends to have a lagged effect on the economy, so the impact of this year’s slower expansion may be felt in 2018.”
Cryptocurrency Contagion Effect
Evidence of Bitcoin’s qualifications as a bubble are abundant. From June 2016 to Dec 2017 Bitcoin returned 2,834% giving it a market cap of $305 billion. Overall there are now 1,400 cryptocurrencies in “circulation” and only a few of them are being used to purchase goods and services and in very limited quantity. Despite this, popular Bitcoin wallet Coinbase has become the most downloaded app, and the site now boasts 1.3. million accounts.
Currently, the cryptocurrency space has limited interconnectedness with broader financial markets, limiting the impact of its potential demise. As the space grows in 2018 it will begin to cast a long shadow over the financial system, and the increased use of leverage and the creation of new cryptocurrency-based financial instruments will only serve to increase the systemic risks it presents.
Higher Wage Growth or Commodity Prices compressing Corporate Profit Margins
Throughout 2017 market multiples trended ever higher on the rising tide of positive US earnings growth and historically low volatility. Entering 2018 valuations are stretched to the highest level since 2002, with the S&P 500 trading at about 18.5 times forward earnings, amid an expectation of further positive earnings growth along with an added jolt provided by lower corporate tax rates. This is the context for what might be the most probable risk-scenario of the year: an uptick in cyclical inflationary pressures in the form of wage growth or higher commodity prices, leading to an unforeseen compression of corporate profit margins and a sudden repricing of domestic equities.
Other Frequently-cited Risks among Economists
Some economists have highlighted other areas of potential risk, including:
- Market structure and liquidity issues
- A sudden unwinding of the crowded VIX trade
- Trade disruptions, such as politically motivated trade disruptions with China, or a potential renegotiation of NAFTA
- Escalation of tensions on Korean Peninsula
- Geopolitical tensions in the Middle East
- Cohesiveness of the European Union, such as Brexit negotiations, continued anti-EU sentiment and upcoming elections in Italy.
While none of the above risks is necessarily imminent, each represents a potential threat that could alter the current economic climate.
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