Why the biggest threat to the stock market rally is the one that no one is talking about

Lacklustre global growth, continued US-China sparring and geopolitical risks over Iran are all potential triggers for a major sell-off, but none appear likely to materialise
Instead, the danger may come from vulnerabilities yet to be identified. History shows a ‘black swan’ event is not so unthinkable

Nicholas Spiro

Published: 10:00pm, 23 Jan, 2020

Why you can trust SCMP

Call it the Teflon market. The list of potential triggers for a major sell-off continues to grow, yet none of the most frequently cited ones appear menacing enough to cause investor sentiment to deteriorate sharply.

Last year, global equity and bond markets enjoyed their strongest and broadest gains since 2010, according to data from JPMorgan. The benchmark S&P 500 index surged nearly 30 per cent, the yield on 10-year US Treasury bonds plunged 80 basis points, while spreads on US corporate bonds narrowed sharply.

In the first three weeks of 2020, the rally has gained further momentum despite an escalation in geopolitical tensions following the US assassination of Iran’s top military commander. The S&P 500 has risen a further 2.8 per cent, putting the gauge within striking distance of its longest and largest bull run in history.

Indeed, as JPMorgan noted in a research report published last Friday, global markets are now “generating early signs of excess as measured by cross-asset price momentum, positioning and valuations”.

However, these frothy conditions, while increasing the scope for a disorderly sell-off, only pose a serious threat if there is a high degree of conviction among investors and financial commentators about the catalyst for a sharp fall in asset prices.

Right now, the most likely “spoilers” are not disruptive enough to put markets under severe strain.

While global growth remains lacklustre – the world’s manufacturing sector barely expanded last month, and was still contracting in a number of countries, including Germany, Japan and Britain, survey data from IHS Markit shows – markets were too pessimistic last year, and are now taking comfort in signs that the slowdown has bottomed out, even though growth is still weak. Excessive gloom has been supplanted by optimism that is somewhat premature.

Another potential trigger for renewed turmoil is a re-escalation in trade tensions. While the phase one deal signed by Beijing and Washington last week helped turbocharge the rally in stock markets in the final quarter of last year, it leaves the most contentious issues plaguing US-China relations unresolved, fuelling scepticism over the scope and timing of the second phase of the deal. Still, the mere easing of tensions has been enough to buoy sentiment, at least for the time being.

The third most likely catalyst for a sell-off – the surge in geopolitical risk – is, in many ways, the most worrisome in view of the mounting threat of a direct confrontation between Tehran and Washington, amplified by the unpredictability of US President Donald Trump.

Yet, investors are notoriously bad at assessing, let alone pricing, geopolitical risk, and tend to play down, or simply ignore, such threats.

However, markets are much more sensitive to a sudden and sharp rise in bond yields – the main cause of the first of two dramatic sell-offs in 2018. German and Japanese yields have already risen significantly over the past several months. If the green shoots of recovery become more visible this year, bond markets could come under significant pressure.

The stakes are high for stock markets. According to data from Bloomberg, low bond yields and the prospect of a “lower for longer” interest rate regime accounted for 90 per cent of the S&P 500’s return last year. Any major tremor in fixed income would send equity markets tumbling.

Far from shrugging off Iran crisis, markets are rooted to the spot

Yet, given the high bar the Federal Reserve has set itself to resume monetary tightening, a sharp and sustained rise in bond yields seems unlikely.

This begs the question: if none of the most obvious triggers for a major sell-off are unsettling markets, what should investors be worried about?

To paraphrase former US defence secretary Donald Rumsfeld, there is a fair chance that the catalyst for the next bout of turmoil will be one of the “known unknowns” as opposed to the “known knowns”, and could even be among the “unknown unknowns”.

Financial crises, and even periods of intense yet transient selling pressure, are often precipitated by vulnerabilities that are difficult to identify. The most recent example was the so-called “Volmageddon” episode in February 2018 when the sudden collapse of several obscure funds that were betting on continued calm in markets caused a brutal sell-off.

While the Fed was in tightening mode back then, exacerbating the turmoil, equity valuations were not as stretched as they are today.

Market bulls who claim ‘this time is different’ may be in for rude awakening

The scope for a much more disorderly decline in asset prices in response to a “black swan” event – an extremely rare development that wreaks havoc on markets and economies – is significant. The spread of the new coronavirus is unlikely to be the catalyst, yet it serves as a reminder to investors of the dangers of complacency.

Triggers for market shocks are devilishly hard to anticipate. Yet, just because the most talked about ones are having little impact on sentiment does not mean that today’s Teflon market will stay resilient. Eventually, something is bound to stick.

Nicholas Spiro is a partner at Lauressa Advisory

This article appeared in the South China Morning Post print edition as: Investors shouldn’t be lulled into complacency in a Teflon market

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