Six potential risks that could affect markets

Chief investment officer casts his eye over possible headwinds as investors navigate uncertain future

Six potential risks that could affect markets

As more people get vaccinated and the economic recovery moves into its next stage, investors could be lulled into a sense of security. Remember, however, the markets are forward looking and constantly weighing the future.

Rob Edel, chief investment officer at Nicola Wealth, identified six risks now facing markets and analysed their potential impact.

1, Excessive stock valuations

As equity markets continue to set records, regardless of the metric used, only during the dotcom fuelled rally of the late 1990s have stocks been priced so dearly. There are clear examples of “froth”, from the performance of stocks in companies losing money to the mania around cryptocurrencies.

However, what’s driving the broader markets, according to Edel, is corporate earnings. He said: “More concerning is that despite continuing to surprise to the upside, stronger earnings are getting a less favourable market reaction. Is this because the earnings recovery is already fully discounted, or because traders are concluding the recovery is played out and this is as good as it gets?”

2, Peak economic recovery?

Strategas recently pointed out that very hot PMI data has historically coincided with a stalled market rally, and on cue, Bloomberg reported in early May a small drop-off in an ISM manufacturing survey. Is this the first sign the economy might be cooling, and what the bond market and decline in yields in April was reacting to?

Edel said it would be premature to hit the panic button. While Goldman Sachs believes growth should peak in Q2, this should be expected given the V-shaped nature of the post-pandemic recovery, and it “doesn’t mean growth is now set to contract”.

“The complexities of restarting the economy mean the recovery won’t be perfectly linear,” Edel said. “Case in point, the U.S. only created 266,000 jobs in April, well short of the estimated 1 million expected. Despite this, many businesses are finding it hard to find workers and needing to resort to offering sign-on bonuses. Generous unemployment benefits, lingering Covid concerns, and school closure have created some bottlenecks in getting Americans backs to work.”

He added: “While this is an inconvenience, we don’t see this as fatal to the recovery, or the bull market.”

3, Bond market taper tantrum

Edel argued that the best evidence it wasn’t slower economic growth causing lower bond yields can be found in the bond market itself. While a decline in Treasury yields could be associated with the threat of slower growth, if this was true he would also expect credit spreads to widen, which they did not.

Edel said: “In trying to explain the apparent contradictory move, some analysts have questioned whether bonds just got over-sold and consolidation in sentiment and flows was needed in the market. Also plausible is foreign demand, with U.S. yields hedged backed into Japanese Yen at five-year highs. If this is the case, foreign demand could help slow or even cap yields from going higher.”

4, Higher taxes

Another tail risk identified by investors is a fiscal or monetary policy mistake or blunder. Is there anxiety over President Biden’s plans to increase spending and higher taxes? According to RBC’s institutional Equity clients in March, most believe Biden’s policies will be negative for stocks over the next four years, a deterioration over their more bullish view at the end of last year.

As for a policy error by the Fed in starting to tighten monetary policy prematurely, Powell has shown no such inclination and appears at the service of the current bull market, Edel added.

5, Inflation

Inflation is key to investor success this year, and probably next. Higher inflation is almost a given based on an easy comparison from last year, supply disruptions, pent-up demand, soaring input prices, and record money supply growth.

There are offsets, however, and the Fed is firm is its belief its transitory. Productivity has come back to life during the pandemic, with companies forced to embrace digital solutions for an economy forced to social distance.

Aggregate economic numbers tell the story. While economic output is nearing pre-pandemic levels, we are still short by some 8 million jobs.

Edel said: “The end product of this is falling unit labour costs and productivity growth. Of course, like inflation, it could also be transitory, but companies may find the new practices they were forced to employ work just fine going forward.

“As for money supply, while it is true a 25% increase has the potential to create massive inflationary pressures, this is only the case if companies and consumers spend it. Currently, lower money velocity is offsetting much of the increase in money supply, as evidenced by increasing bank deposit rates and stagnant loan growth.”

6, COVID-19 variants

According to Bloomberg, the unfolding events in hot spots like India could result in Covid claiming more lives this year than in 2020. More relevant to markets is the declining daily vaccination rate in the US. Unlike Canada, the decline is not due to supply, the US has access to ample product. The U.S. is running out of people willing to get the vaccine.

Edel said: “Regionally, the situation is even worse, with certain States on a trajectory that could see them fall short of herd immunity required to prevent the virus from spreading in the future. Without herd immunity, fully re-opening the economy becomes more questionable.”