US interest rate hikes, geopolitical tensions and China's growing debt burden are among the risk factors CIO is keeping an eye on. But while short-term market corrections can't be ruled out, CIO thinks the bear is still asleep for now.
By and large, global markets have carried their strong performance of late 2017 into the start of 2018. Risky assets have continued to rally, with emerging market equities (up 8 percent year-to-date) a standout performer. "The S&P 500 has extended its longest period without a 10 percent correction over a rolling six-month window since 1929, and had its strongest start to a year for 20 years," writes CIO strategist Dirk Effenberger in the new Global Risk Radar. The bull market, it seems, is grinding on.
Where this year differs from last is in the behavior of interest rates. Ten-year US Treasury yields are already up 30 basis points in 2018, having risen only slightly over the whole of 2017. "While we only expect bond yields to move up gradually from here, their recent rise echoes one of the key risks for markets in 2018 - an accelerated rate hiking cycle by the US Federal Reserve (Fed)," Effenberger explains. "In fact, Fed tightening could cause the next bear market in equities further down the line, if higher bond yields start to raise concerns about real economic activity and private sector debt refinancing." However, CIO assigns only a very low probability to this risk for now - though it believes it's worth monitoring closely.
Meanwhile, rising global equity valuations have caused some investors to grow jittery. CIO acknowledges that valuations (based on trailing P/E) are rich in a historical context - but it doesn't believe any individual market has yet reached worrying territory. Synchronized global economic growth offers a supportive earnings backdrop, and central bank policy is still accommodative.
"Rising stock market valuations are by no means a risk in their own right, but they do increase the chances that some other risk trigger impairs the current positive market sentiment and turns one of the longest equity bull markets in history into a bear market," Effenberger says. But while short-term, technical market corrections can't be ruled out, CIO doesn't expect a larger drawdown in the near term. "In other words, the bear is likely to stay asleep over the next six months," the strategist says. CIO remains overweight global equities in its tactical asset allocation.
Other risk factors on CIO's radar include geopolitical hotspots, China's credit buildup, and US protectionism (here, CIO expects the Trump administration to impose some one-off tariffs but stop short of causing a full-blown international trade conflict). From North Korean military provocations to political instability in the Middle East, geopolitical hotspots can flare up at any time, but CIO notes that recent periods of escalation have only had a limited, short-lived effect on markets. "In our view, none of the risks we monitor seem imminent enough to cause a bear market in risky assets over the next six to 12 months," Effenberger concludes.
For further information, please see the latest Global Risk Radar.