Beware the return of risk

Last week’s volatility on Wall Street including Friday’s large selloff should serve as a reminder that although all the forecasts for 2018 are bullish, there can be many pitfalls ahead, primarily from the US where risk has not featured for many years but could be making a return now.

However, before discussing where problems could come from though, there are a few points that are worth noting.

First, the S&P 500 gained 5.6 per cent in January, its best return since 1997. According to some market pundits, if the index is positive in January, there is an 82 per cent chance that it will be positive for the whole year. The Dow Jones Industrial Average in the meantime, rose 5.8 per cent and the Nasdaq 7.4 per cent. Of course, past performance is no guide to the future and there is no logical or fundamental reason why the mantra “as goes January, so goes the rest of the year’’ should apply in 2018.

Second, the Straits Times Index’s January rise was 3.85 per cent. Daily volume has not been particularly good, hovering just above the broking industry’s unofficial breakeven level of S$1b per day, though it spiked up to S$1.93b on Wed, the last day of the month. In the three days leading up to Wed, volume averaged S$1.4b.

This jump in volume – and sometimes prices – typically occurs at month-end for various reasons, though no one knows for sure. One possibility is portfolio rebalancing by institutions; another is month-end “window-dressing’’. Whatever the case, investors should bear in mind that volume and prices often rise sharply at the end of each month and each quarter.

The near-unanimous bullish picture that analysts painted at the start of the year is based on there being a synchronized global economic recovery amidst subdued inflation, the latter suggesting that interest rates will not be raised too rapidly. Over in the US, the recent passage of a new tax bill that incorporates a cut in corporate tax has led to the belief that earnings will be further elevated, thus adding to the stock market optimism.

As a result, Wall Street has consistently risen to all-time highs over the past 15 months, taking with it global markets including Singapore. Meanwhile almost all brokerages and banks are bullish on equities and the VIX Index, which measures the US options market’s best assessment of future volatility and is often dubbed the “fear’’ index, has for most of the past 5-6 years traded at record lows, suggesting that market risk has not been a big consideration.

Contrarians however, often interpret a low VIX reading as suggesting a high degree of complacency and therefore a signal of rising danger. Prudent investors should also bear in mind that the US market has risen in a virtual straight line for about eight years now and recognize that this cannot continue forever. As noted earlier, last week’s plunges are perhaps the first sign of this recognition.

As we enter the ninth year of Wall St’s bull market, it therefore makes sense to prepare oneself for possible trouble ahead by asking what could slam the brakes on Wall St’s record rally and if so, send local stocks down?

First, note that the main reason for the large rally in global stocks since the US sub-prime crisis of 2008 is the massive amounts of liquidity that was unleashed by first the US Federal Reserve and then by many other developed countries’ central banks, including the European Central Bank, Bank of England and Bank of Japan.

The Fed for example, slashed interest rates to almost zero whilst expanding its balance sheet to about US$4 trillion, with most of this money finding its way into risky assets like stocks. Today, the consequent liquidity support from these measures is being slowly withdrawn – interest rates are being raised and the US has ceased buying bonds and will let those it currently owns expire. In fact, Friday’s selloff was reportedly because of sudden worry that interest rates will be raised faster than previously thought.

Second, will economic growth continue without Fed support? If not, then even if there is a sudden downturn, slashing rates and pumping money into the system as has been the case over the past decade may not work. Although experts think the answer is “yes’’, there are already indications of sub-par growth going forward – US output growth and labor productivity for example, are extremely low and investors will appreciate that if both remain anemic, growth could quickly lose momentum.

To see this, consider that the US’s Bureau of Labor Statistics (BLS) in its January 2017 “Beyond the Numbers’’ report said the shock to output growth from the sub-prime crisis has not been resolved.

“A key aspect of the recovery thus far is that, not only has output growth been well below historical trends, but it is even further behind the growth rates necessary to overcome the effect of the massive decline in output during the Great Recession. To counteract such a large decline and lift the current cycle’s growth rate back up to historical averages, output would have had to grow much faster than average during the recovery. But output has done the opposite thus far, growing more slowly than average during the recovery’’ reported the BLS.

As for the impact on labor productivity, the BLS found that since 2010, it has stagnated and by the third quarter of 2016 is growing at only 1.1 per cent, well below the long-term average of 2.3 per cent.

Third, by all measures of value, US stocks are very expensive – historical price-earnings (PE), cyclically-adjusted PE, price/book and forward PE. This might be justified if earnings really expand as is hoped, but this not a given, especially with trade wars looming and volatility in the US dollar.

Fourth, just because geopolitical risk did not figure much in 2017 does not mean the same will apply in 2018. Schroders in its Talking Point for January titled “Themes for 2018: The Return of Political Risk’’ warned that politics could play a big role this year, especially in the US where mid-term elections are scheduled and in Europe, where a general election in Italy will be held in March.

All told, with valuations as stretched as they are and with the prospect of the Fed raising rates faster than expected, investors here should be wary of growing turbulence on Wall Street where risk appears to have returned to the table.