If you read the headlines of the leading financial publications on a regular basis, you will know that most investors seem to be afraid of the current market environment. Headlines such as Forget the stock rally, investors are holding cash, Credit Suisse: Clients Say They Are “Lost”, Sentiment At Record Low and Investors Continue To Sell Stocks Missing Massive S&P 500 Rally are commonplace. Sentiment seems to suggest that most retail and institutional investors are afraid that a sudden market downturn could be just around the corner.
Only time will tell what catalyst will spark the next major market decline, although analysts at Natixis believe they have narrowed it down to three key risks that could be the undoing of this bull market — the second longest ever.
What shocks could have a major impact on financial markets?
Natixis is looking for the shocks that have a non-null probability of occurring. In other words, these are shocks that are not currently expected by financial markets if they materialise they are likely to spark a strong reaction by traders and investors.
A transformation of the current economic slowdown in the US into a real recession is one such event. For the optimists, it’s unlikely this slowdown will occur in the near-term. After a lacklustre second quarter GDP reading of 1.2% vs. the 2.6% expected, the US economy is on track to grow at a 3.6% annualised rate in the third quarter according to the Atlanta Federal Reserve’s GDP Now forecast model. On the other hand, there are those that say the second quarter GDP reading of 1.2% indicates that the US economy is ending the late cycle stage growth will only slow from here on out. The third quarter GDP reading is key to settling this argument.
Another event that could unsettle markets is a far steeper-than-expected rise in the oil price. Indeed, if the price of oil were to increase rapidly from its current level of around $50 a barrel to a level of $70 or $80 a barrel, it would effectively slam the brakes on growth in emerging market countries. Countries which are significant energy importers would suffer the most namely China, India, Turkey, South Africa, the Eurozone and Japan. Higher oil prices would also lead to a sharp rise in inflation, making it difficult to maintain the very expansionary monetary policies Japan, the UK and the Eurozone are currently undertaking. Rising inflation would push up long-term interest rates again, and it is impossible to quantify what effect this would have on long-term economic growth, especially when growth is weak in so many regions already.
The last mini-black swan event Natixis is on the lookout for is a significant change in US economic policy after the presidential election. Unfortunately, both candidates are hinting at major economic policy changes if they are elected into office. Donald Trump is calling for protectionism and steep tax cuts, which are likely to lead to a sharp increase in fiscal deficits. Meanwhile, Hillary Clinton promises a significant rise in the minimum wage and an extension of the social welfare system. More spending would either be funded by higher taxes or a sharp increase in fiscal deficits. In both cases, Natixis is predicting higher inflation in the US, (due to protectionism or higher wages) worsening public finances and a deterioration in US foreign trade (either due to tax cuts or hikes in low wages).
So, those are the three catalysts which could be responsible for the unwinding of the current bull market. Now all we have to do is wait for one of these scenarios to play out.