Outside of the stock market being priced at one of its most expensive levels relative to underlying cash flows on record, there aren’t many things to be bearish about going into 2018. But the Wall Street Journal’s James Mackintosh has managed to come up with three risks that could derail the ongoing low volatility climb in the equity market. To wit:
Monetary tightening. The Federal Reserve raised rates three times this year, yet it became easier to borrow and over long periods actually got cheaper. Instead of rising, long-dated bond yields fell, and global monetary conditions were further eased by the weakness of the dollar. The Chicago Fed’s National Financial Conditions index is at the loosest since January 1994, the year that surprise Fed tightening crushed the bond markets….
China. 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 dangers are unchanged; yet, markets have stopped worrying.
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 pile. The first two are painful, and changes to the growth model typically led to recessions when tried by other fast-growing countries….
A correlation correction. One reason investors hold bonds is to cushion losses in an equity downturn. Since the late 1990s it has worked wonderfully, as bond prices tended to move in the opposite direction to shares over the short term, but the same direction in the long run.
This year has been yet another good year for this strategy, with bonds providing free insurance by rising in price even as shares did well. The danger is that the link between bonds and stocks goes back to how it was in the 1980s or early 1990s, with rising bond yields being bad for share prices. One plausible cause: Inflation returns, but growth stays weak. Another seems implausible, but shouldn’t be ruled out completely: Central bankers finally get fed up with investors relying on easy money, and decide they have to act to prevent asset prices from getting out of hand.
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