As a young lad growing up in South Dublin, I received certain geography lessons on where I could, or could not, safely roam. In particular, I was warned not to stray north of O’Connell Street. I remember debating my mother on the issue, once when I wanted to go to a movie at a theatre near Parnell Square. I can’t remember exactly what I said, but I probably claimed that bad things didn’t happen on the North Side quite as frequently as South Side mothers thought they did. But my mother held her ground on this occasion…someone might or might not get beaten up in Parnell Square that afternoon. But if her son wasn’t there, it wouldn’t be him.
After almost every speech, someone asks me about risks – what keeps me up at night. And today, with a soft-landing economy and the stock market near record highs, it does seem like a good time to review risks. But it’s important to recognize the most obvious point about market risk. The risk to you, as an investor, isn’t simply the danger of some negative event – it is the product of the probability of that event and your exposure to it. How you are positioned says a great deal about how worried you should be about any risk.
Risks
One of the lessons of the 21st century, so far, is that the biggest risks to markets and the economy are events that we truly couldn’t predict, like 9/11, the pandemic and Lehman Brothers taking down the entire global financial system. However, surveying potential risks in 2024 suggests that they could be fall into one of five broad buckets: Economic trends, policy mistakes, geopolitical tensions, natural disasters and overvaluation.
On economic trends, our base case is that the soft landing continues, at least into 2025.
However, there is a risk that the expansion peters out before then. Consumer spending appears to be softening, with real non-durable goods spending lower in April than in December, sentiment still very low and credit-card and auto loan delinquency rates rising. Tuesday’s retail sales report will provide some fresh evidence on this issue. Business investment spending, outside of intellectual property, also seems relatively sluggish. It could also be that higher-for-longer interest rates will gradually lead to increased defaults in parts of commercial real estate and bankruptcies for some highly-levered companies in the private equity space.
It should be emphasized that there are also forces operating in the opposite direction. Year-over-year wage growth has outpaced inflation for over a year. The economy has produced more than 2.7 million new jobs over the past year and we estimate that household net worth has grown by $7 trillion so far this year, after advancing by $11 trillion, or 8%, last year. Still, weakening trends in consumer spending on the basics, combined with business cutbacks, could result in slower growth going forward, particularly if they were amplified by some further shock. Moreover, if the economy were to weaken enough for the Federal Reserve to cut interest rates aggressively, history suggests that their actions would do more to undermine confidence than promote borrowing and could thus actually trigger the recession they were trying to forestall.
A path to resurgent inflation is a little harder to see. However, it could happen if growth were to accelerate or some shock caused a spike in energy prices. Overall, while our base case is for continued expansion, there is some risk of a near-term recession and a smaller risk of rising inflation.
With divided government, it’s unlikely that we will see any major policy moves before the November elections. It is also unlikely that we will see any government shutdown and, regardless of who wins in November, the debt ceiling will, in all probability, be raised or suspended before the current suspension ends on January 1st of next year.
However, beyond this, there are risks of policy mistakes. Single-party government that resulted in big tax cuts or increases in spending could overheat the economy and worsen an already very troubling fiscal situation. A renewed tariff war would harm both the global economy and the U.S. economy. Moreover, while the current immigration situation is chaotic, to say the least, a sudden sharp reduction in both legal and illegal immigration could have serious consequences in a country that is seeing a steady decline in the native-born, working-age population.
Finally, there are serious though hard-to-quantify risks associated with the age and character of the two candidates running for president. Those wishing to assess these risks will have an opportunity to so in the presidential debate scheduled for Thursday of next week.
On geopolitical tensions, the on-going wars in Ukraine and Gaza are clearly destabilizing. In addition, there is an obvious risk to energy supplies, from tensions between the United States and Iran, and some threat to the supply of semiconductors, from tensions between China and Taiwan. Needless to say, the economic consequences of a serious escalation in either case would be overshadowed by even greater dangers. The same could be said of tensions between the U.S. and Russia and the U.S. and North Korea. Terrorism, whether associated with these tensions or not, also poses a risk.
However, in all cases, no matter how horrible the human toll, the impact on financial markets from geopolitical shocks depends on their impact on economic activity. If, in the aftermath of an event, the economy continued to function normally, while rebuilding or adjusting to a new reality, then financial market losses shouldn’t be permanent.
Natural disasters are, of course, the most difficult to predict. However, as shown by the impact of Hurricane Katrina on oil prices, the Tohoku earthquake and tsunami on global supply chains and, most notably, the shutdowns caused by Covid-19, natural disasters can have a significant impact on economic activity.
Looking forward, some of these risks seem low and stable – such as threats posed by earthquakes, volcanos and solar flares. In some cases the risks may be slowly rising….increased international travel raises the danger of pandemics while an acceleration in global warning may increase the risk of hurricanes. However, as with geopolitical events, the key question for investors is whether, in the aftermath of the event, economic activity is impaired or whether rebuilding activity actually provides a boost to economic activity.
Finally, there is the issue of valuations. On the fixed income side, valuations look reasonable. In the 50 years before the financial crisis, 10-year Treasury yields averaged 2.7% above core CPI inflation. Even if the core CPI inflation rate were to fall to 2% from its current 3.4%, (as we expect it to do over the next two years), the current 10-year Treasury yield of 4.22%, seems low, albeit to only to a moderate extent. Credit spreads are narrow – however, that may make sense in an extended soft-landing economy with low defaults.
U.S. equity valuations are high for mega-cap stocks, with the top 10 stocks sporting a forward P/E ratio of 30 times forward earnings – almost 50% above their average since 1996. However, the other stocks in the index are selling at an average forward P/E of just 17.5 times, only 12% higher than their average over the same period. A similar observation could be made within the style boxes overall, with large-cap looking expensive relative to small cap and growth looking expensive relative to value. Also, international equities continue to look very cheap relative to U.S. stocks, with the ACWI ex-U.S. selling at a forward P/E ratio of 13.5 times compared to 21.0 times for the S&P500.
Exposure
Since the start of 2023, the S&P500 has provided a cumulative total return of 44.9% while the Bloomberg Aggregate bond index has returned just 5.5%. Moreover, the stock market gains have been extraordinarily concentrated. Today, the top 10 stocks in the S&P500 account for an astonishing 37% of overall market cap while U.S. stocks account for an equally improbable 64% of global stock market capitalization.
There may not be that much risk to financial markets overall in any of this. A general rotation within the U.S. stock market or between U.S. stocks and international stocks or even from equities to fixed income would create winners as well as losers and should not necessarily impede the ability of business in general to finance its operations.
However, it does have implications for many individual investors. Those who passively invest in the S&P500 have the same heightened exposure to mega-cap tech as the index itself and more, if they have also explicitly bought growth stocks and shunned value stocks. Those who have more than 64% of their equity exposure allocated to U.S. equities (which is the vast majority of U.S. investors) are even more unbalanced in their exposure than global indices. And those who were aiming for a 60/40 allocation between U.S. equities and bonds, but who last rebalanced at the start of 2023, would now have a 67/33 allocation.
Moreover, all of this applies to investors who were at least attempting to achieve a balanced portfolio. Many investors on top of this have added positions in meme stocks or cryptocurrencies, assets that are only kept aloft by the hot air of hype and confusion.
Many investors, of course, appreciate that their portfolios are out of balance but are loath to write a check to Uncle Sam for realized capital gains. This does highlight the value of tax-smart investing.
However, others say today, as I remember many saying back in the late 1990s, that they will have plenty of time to reallocate if an overconcentrated market finally moves in the direction of balance. I am always nervous about such statements – there are far too many cases of people who knew that they should reallocate but never moved fast enough to actually achieve it.
It reminds me of one final argument I put to my mother many years ago. If there was any trouble, and, sure, I had a good pair of running shoes and I could get out of there quickly. She didn’t buy it – lots could go wrong with my escape plan and the truth is, sometimes there just isn’t a right time to be in the wrong place. The same is true for investors.