Mr. Market is prone to mood swings. Right now, all is right with the world, he declares – a complete contrast to just a few months ago, when he was convinced a downturn was looming and it was time to run for the hills.
His abrupt shift to sunniness is on display in the monthly survey of fund managers conducted by Bank of America. Fears of an imminent U.S. recession are fading rapidly, according to the most recent polling results for December.
Even more striking, a net 29 per cent of these big investors expect global growth to improve over the next year – a 22-percentage-point increase from the October results. That is the biggest two-month shift ever recorded in the survey and a sign of the swelling optimism among the big-money crowd.
The big question for 2020 is how durable that optimism will prove to be. The past year has demonstrated, once again, that Mr. Market is not the most stable of observers. He can ricochet from despair to elation and back again, for reasons that appear rather flimsy in retrospect.
Just more than 12 months ago, for instance, share prices in Canada and the United States were plunging, in large part because the U.S. Federal Reserve seemed intent on raising interest rates. I wrote a story at that time noting that optimism had rarely seemed so radical. I listed some overlooked positive factors that I thought would support stock prices – notably the fact that the Fed was unlikely to deliberately drive the economy into a downturn.
I got things right – at least for a while. The Fed backed off on interest rates and markets recovered spectacularly in the early months of this year. But by midsummer, the mood was darkening once again. An inversion in the yield curve, a key measure of bond-market sentiment, convinced many investors a recession was inevitable. The U.S.-China trade battle looked as if it might be the trigger. By August, investors were scurrying for cover. They were buying up bonds, even at negative yields.
Now? All those fears are melting away. Most Bay Street and Wall Street analysts are expressing mild optimism, dialling down the odds of a recession in 2020, and forecasting stable interest rates and modest gains for stocks during the year ahead. In other words: smooth sailing.
Maybe. More realistically, the year ahead is likely to hold just as many surprises as the year just past. Investors should be aware of how delicately balanced the current market equilibrium is. Odds are that something will happen to upset that equilibrium, for good or for bad. Here are three major risks Mr. Market might want to consider.
Presidential pandemonium: Investors are usually wise to ignore politics, but this year may be the exception. In the U.S., Donald Trump has just been impeached. In Britain, Boris Johnson has just been handed a mandate for radical change. Meanwhile, demonstrators are challenging the established order with street protests in Hong Kong, France and a broad swath of Latin America. And, of course, there is the continuing tension of U.S.-China trade battles.
Plenty of potential outcomes could rattle markets. Consider, for instance, the U.S. presidential election, where victory in November by a reform-minded candidate such as Elizabeth Warren or Bernie Sanders would spook investors, especially in health-care, defence, pharma and bank stocks.
To be sure, those left-leaning candidates appear to be losing steam. On the other hand, Mr. Trump’s impeachment underlines the ugly choices ahead. Do investors really want to endure four more years of Mr. Trump’s self-pitying tweets, massive deficits and on-again, off-again trade battles? One way or the other, the presidential race will have a lot to say about the course of stocks over the next 12 months. And that is just one of several political risks that could destabilize markets.
No more central-bank sugar: The biggest factor behind the swing to optimism in recent months has been central banks’ willingness to rush to the rescue. The Bank of Canada has been a conspicuous exception to the trend, but the U.S. Federal Reserve, the European Central Bank (ECB) and a host of others from India to Brazil have all chopped their short-term policy rates in attempts to goose their economies and support asset prices.
They’re stoking the economic engine in other ways, as well. The ECB has started buying bonds again, in an attempt to keep a lid on longer-term interest rates. After a mid-September panic in the repo market for securitized overnight loans between large institutions, the Fed is also back at the table, buying up short-term government debt, while strenuously denying that this amounts to a renewed outburst of quantitative easing, its controversial crisis-era program.
Technicalities aside, all these programs amount to central banks telling markets, “We have your back.” That has worked out splendidly for now, but with policy rates already so low – and even negative in Europe and Japan – central banks don’t have a lot of room for further manoeuvre. Investors shouldn’t assume central banks will come to their aid in 2020 the way they have in the past.
A flicker of inflation: Only 11 per cent of U.S. money managers recently surveyed by RBC Capital Markets regarded stocks as cheap. So why do 51 per cent of these same managers describe themselves as bullish or very bullish?
It’s largely because today’s elevated valuations make sense if you assume the current equilibrium will continue. Most importantly, inflation must remain weak, while growth remains positive. Low inflation justifies low interest rates, and low interest rates make bonds less appealing. So long as the economy stays out of recession, stocks become the only game worth playing.
One factor that would upset this equilibrium is any sign that inflationary pressures are mounting. That would amount to a major shock. Over the past decade, inflation has been dormant. With unemployment near half-century lows in Canada and the U.S., however, wages may start to climb, leading to more general price gains and a case for raising interest rates. If so, Mr. Market’s complacency could vanish quickly.
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