JUNO INVESTING ©

Sleepless Nights: Five Big Risks for the Markets

JUNO INVESTING ©
Sleepless Nights: Five Big Risks for the Markets

 

The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.

AUTUMN 2017

By Andrew Kenningham

Last year, perhaps surprisingly, the world’s financial markets took several big geopolitical shocks in their stride. The UK’s vote to leave the European Union (EU) led to only a short-term fall in equity prices, though the sterling’s fall has proved to be longer-lasting. 

The slump in US markets after Donald Trump’s victory in the US presidential election lasted only a few hours. And markets shrugged off the defeat of Italy’s Prime Minister, Matteo Renzi, in a constitutional referendum held in December. 

This year may prove to be more volatile. Plenty of risks still linger or have recently emerged, and five in particular stand out. 

1.  Good Trump, bad Trump

In recent years, threats to the US economy have mostly come from external sources, such as the eurozone debt crisis, China or Brexit. But this year, the biggest risk may come from within the White House itself. 

For now, investors have focused on the possible positives from a Trump administration, notably the prospect of a large fiscal stimulus, which could lift growth and boost market confidence. They’ve assumed that Trump’s actions will not live up to his protectionist talk. 

These assumptions may prove naïve. Trump has appointed some well-known trade ‘hawks’ to his administration. And the constitution gives the US president considerable powers over trade policy, including the scope to withdraw from trade agreements without the approval of Congress. 

What’s more, Trump may well adopt a far more aggressive stance towards China over foreign policy issues. Or he could embark on a conflict in the Middle East or a controversial détente with Russia. The sheer uncertainty may eventually spook US financial markets. 

2.  China crisis brewing?

Investors will also be keeping a wary eye on China. At the beginning of last year, many commentators warned that China was on the cusp of an economic crisis, which would send shockwaves around the world. In the event, China’s growth rate appears to have actually sped up last year. 

Growth in China is likely to slow slightly in the coming months, as the authorities focus on reducing risks, rather than boosting growth. Despite this, the country’s economic problems are mounting. 

For a start, the People’s Bank of China is gradually running down its reserves. Admittedly, it still had US$3 trillion at the end of 2016, which should be enough to keep the currency stable for the time being. But investors may get jittery if reserves continue to fall. 

What’s more, corporate debts in China are continuing to climb. For now, China should have enough ammunition to avoid a crisis. But the markets may not view things that way! 

3.  From Brexit to Frexit

The other big geopolitical threat is from Europe. Investors have so far taken a fairly benign view of the UK vote to leave the EU, perhaps because the UK economy has been performing fairly well since the referendum. 

But the eurozone debt crisis could flare up again on the basis of speculation that other countries will also break away from the EU. Anti-EU politicians are poised to make gains in France, the Netherlands, and even Germany this year. 

Although opinion polls and betting markets suggest that Marine Le Pen will not win the French presidential election in May, such predictions consistently proved wrong in 2016! And investors may not be as relaxed about a Le Pen victory in France as they were about the Brexit vote. Le Pen’s far-right National Front party wants France to leave the eurozone. Such a move would pose a threat to the entire European Union project, given the historical importance of France and Germany in keeping Europe united. 

4.  A bond market bloodbath

The prospect of a large fiscal stimulus and higher inflation in the US has already caused bond yields to rise sharply since the presidential elections. This is because investors expect the US Federal Reserve (the Fed) to raise interest rates decisively over the coming years. 

Ten-year US Treasury bond yields rose from 1.9 per cent on 8 November to 2.4 per cent at the end of 2016. Yields of bonds of other governments have also increased. 

The sell-off in bond markets could get out of hand if inflation takes off in the US, or if ‘bond vigilantes’ begin to worry about the size of the federal government debt. This in turn could have a knock-on effect on equity markets and on investor confidence. 

After all, previous bouts of monetary policy tightening in the US have been followed by economic downturns. For example, high US interest rates led to a recession in the US in the early 1980s, and the Fed’s rate hikes in 1994 led to the Mexican peso crisis. 

5.  A stronger dollar

The final risk is from the currency markets. Expectations for stronger growth and higher interest rates in the US have caused the US dollar to rise since the presidential elections.  

For now, any increase in the value of the US dollar looks likely to be much smaller than the
20 per cent rise that we saw in 2015. But if it climbs much further, some emerging economies, such as South Africa and Turkey, which have a lot of dollar debt, could experience difficulties. A strong US dollar could also reignite fears about the stability of the Chinese currency. 

Today’s rising dollar has parallels with the 1980s. During Ronald Reagan’s administration, a combination of looser fiscal policy (mostly due to tax cuts and increased defence spending) and tighter monetary policy caused the dollar to soar. Worries about surging imports from Japan prompted Reagan to adopt more protectionist policies – although in the end things turned out reasonably well. 

In summary, then, the most likely outcome is a modest rise in equity markets and bond yields this year. But investors may not be sleeping easy, with plenty of things to keep them awake at night.

DEFINITIONS

BOND VIGILANTE: A phrase coined in the 1980s to describe an investor in the bond markets who sells their bond holdings in the face of perceived fiscal risks. This drives bond prices down, and increases yields, making borrowing costs for governments more expensive.  

DÉTENTE: An improvement in previously strained relations. 

FISCAL POLICY: The way a government manages its spending and sets tax rates.

HAWK: A hawk is someone with political or economic views at one extreme end of the spectrum. A trade hawk advocates strong protectionist measures.

MONETARY POLICY: The way a country’s central bank manages interest rates and the money supply.

PROTECTIONIST: A policy that shields domestic producers from foreign competition. Ways in which this is implemented include changing tariffs, quotas, or import quantities.