Equity markets continued their upward march in the second quarter, seemingly impervious to the divisive political environment and lack of progress on reflationary policies. The combination of strong corporate earnings growth and low inflation provides a positive market backdrop, offsetting investor disappointment about policy gridlock.
Although the economic environment remains encouraging, there are mounting concerns that investors are too complacent about the risks of a market correction. It’s commonly said that bull markets don’t die of old age, and consensus expectations are for the bull market to continue into 2018. However, bull markets may end abruptly with painful market corrections. Investors should identify potential catalysts for a market correction, and monitor for indications that the catalyst is becoming a higher-likelihood event. Federal Reserve policy tops the list of the five potential catalysts that investors should monitor.
The Fed takes away the punch bowl. Quantitative easing has had an extraordinary influence on financial markets since the global financial crisis, and the Fed plans to normalize monetary policy by increasing interest rates and reducing the size of the Fed’s balance sheet. The Fed’s dot plot of estimates signals that the fed funds rate will break 2 percent by the end of 2018, which contrasts with market estimates for rates to rise much less aggressively next year. The stock market may decline if the Fed hikes rates in accordance with 2018 dot-plot estimates rather than the slower pace anticipated by investors today.
High growth technology-centered firms, including the FANG stocks — Facebook (ticker: FB), Amazon.com ( AMZN), Netflix ( NFLX) and Google ( GOOG, GOOGL) — may lose momentum if faced with a meaningfully higher discount rate for future earnings, while high dividend-paying stocks such as real estate investment trusts and utilities would also suffer in a higher interest rate environment.
[See: 7 ETFs for a Solid Portfolio Defense.]
The composition of the Fed is another potential concern. With Janet Yellen’s term as Fed chair expiring early next year, President Donald Trump will have the opportunity to appoint a new chair while filling other vacancies on the Fed Board of Governors. Early speculation about potential appointees centers on candidates who favor a rules-based approach to monetary policy. A rules-based approach could lead to a more dramatic move upward in rates, increasing the likelihood of a market correction.
Another delicate policy consideration is the Fed’s plan to begin to shrink its balance sheet of more than $4 trillion of Treasury and mortgage-backed securities. Given the massive amount of the Fed’s holdings, any policy missteps could create major ripple effects in stock and bond markets.
China catches a cold, the rest of the world catches the flu. China is responsible for more than 40 percent of global GDP growth, and is the world’s dominant buyer of many commodities. Chinese economic growth remained robust in the first half of the year.
However, China is struggling with serious economic imbalances, including high debt among state-owned enterprises and a troubling rise in speculative shadow-banking activities. China is instituting policy measures designed to deleverage the financial sector and slow real estate speculation, trying to gradually address imbalances that present significant long-term risks.
Most economists expect a modest slowdown in Chinese second half growth, but any signs of a “hard” economic landing in China would likely be a catalyst for a market correction in much of the world.
Oil collapses, or oil soars. The sharp decline in oil prices in 2015 led to an earnings recession, an increase in high yield spreads, and economic stress in many commodity-producing emerging markets.
Growth in shale production or breakdown in OPEC agreements to limit production could drive prices down, creating instability in high-yield markets or among less stable oil-producing countries. Although some of the weakest energy companies have already defaulted on debt, an extended period of weak oil prices could create stress for companies just starting to recover, and instability for countries ill-equipped to endure another bout with economic and social stress.
[See: 10 Tips for Keeping a Cool Head in a Market Meltdown.]
Rising oil prices creates a different set of risks, as consumers who have grown accustomed to low prices may have to tighten their belts if prices rise. Some economists project that oil prices will go up in the second half of the year, given the lagged effect of OPEC production cuts and increased demand.
Interestingly, a rapid rise or fall in oil prices could be a catalyst for a market correction.
Geopolitical conflict creates a spillover into the economy. Geopolitical risks are abundant, and some of the most worrisome risks have serious economic implications.
Missile launches by North Korea are a continuing concern, and there appear to be limited potential solutions. Disappointment in the lack of progress on North Korea has seemingly motivated the Trump Administration to turn the heat up on China. In recent weeks, the U.S. State Department has criticized China for human trafficking, the Treasury Department has sanctioned Bank of Dandong for its dealings with North Korea, and the Trump Administration decided to go ahead with a $1.4 billion arms sale to Taiwan. Rising tensions between the U.S. and China could spill into the markets.
Although near-term European political risks have eased, Italy remains a concern given high debt, low competitiveness and the uncertainty about the upcoming Italian general election.
The Brexit situation remains unresolved, with uncertainty about whether Prime Minister Theresa May will retain power long enough to lead the UK through Brexit talks.
Geopolitical challenges could interrupt the equity rally and renew the appeal of bonds as a safe haven in an uncertain world.
Trump’s tweets about trade become policy. Trade was a prominent issue during the presidential campaign and remains one the most common topics discussed by President Trump on his Twitter feed. Trump’s rhetoric on trade, however, have been more strident than his actual policies moves to date. If Trump moves more aggressively on trade than currently expected, an equity market correction could follow.
The continuation of a Goldilocks economy — not too hot, not too cold — provides a foundation for the bull market to continue. Growth could potentially accelerate if reflationary policies such as tax reform provide a positive surprise later in the year.
However, given the long bull market and elevated valuations in the U.S., the risk of a market correction is a possibility that shouldn’t be ignored. The bull market won’t die of old age, but investors should remain vigilant about potential catalysts for an untimely demise.
[See: The Best ETFs Retirees Can Buy.]
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