Markets Keep Going Up. Where Are the Risks ?

Rule of thumb: the more expensive a financial asset is, the lower its prospective return. That’s simple. But sentiment and markets can become and stay irrational longer than investors can stay solvant, they say. So if you cannot predict when the markets will turn, it’s probably better to check where the risks are and monitor them the best you can. And invest with a margin of safety. Always…

UBS published a report from European equity strategy team that’s quite interesting in this regard.

First of, if you take the upside/downside profile of Stoxx Europe 600 index, here are your odds, per UBS report:

Source: UBS

So far you have 40 to 90 points upside and 50-60 points downside risk, which would make the asset class relatively attractive.

Nevertheless, investors should monitor a couple of market indicators:

  • US government yields and the yield curve (YC). Per UBS’s strategists and economists, « if bond yields were to rise rapidly that could be problematic for equities » and they point to 2013 taper tantrum when US 10Y rose 100 bp in a couple of months.

  • One related note is inflation. If inflation were to shoot up faster than currently expected by central banks, that could force some of them (Fed ?) to rise rates faster than currently priced by the market and provoke a market correction.

Of course there are structural problems in the world (demographics, lack of productivity, high global leverage) that raise the issue of deflation or low inflation, not inflation. But currently, rising commodities prices, low unemployment figures and better economic prospect can explain increasing inflation expectations via passthrough effects and potentially the impact of higher wage inflation.

  • Euro strength could be another problem. The European Union common currency is trading at a 3 year high. Per UBS’s calculation, each 10% in Euro appreciation (TWI) translates into 6% reduction in earnings.

European corporation have 44% of their sales exposed to Continental Europe, 7% to UK, 19% to North America and 30% to ROW.

Yet when Euro is backed by better macro, that also is a boost to European earnings, so all in all, stronger euro may not always be a negative. And so far, consensus hasn’t adjusted since EPS are expected to grow 12.5% in 2017 and 9.1% i 2018, relatively stable since last year.

  • US recession risk is not on the radar yet but many people talk about that. The risk might be even more remote since the current US recovery is one of the most muted in history (since WW2). Yet a flattening yield curve might be a reason to be careful there. Despite all the good news on the macro front, 10Y isn’t moving while 2Y has risen sharply. 2Y-10Y spread is 55 bp now vs 70 bp a couple of months ago.
Source: UBS
  • Volatility and market sentiment might be a last issue. UBS has a number of interesting charts on that point. Currently, more and more market participants are taking exposure to upside in equity markets through call options, and very few are protecting their portfolio via put options. The put/call ratio is now at lows last seen in 2000.
Source: UBS
Source: UBS

Euphoria may not be there, because there is no clear disconnect with fundamentals and we don’t see yet behavior that look clearly irrational (like selling CDO of CDOs or massive M&A transaction on multiples that are difficult to justify even in the most optimistic scenario).

Market correction is upon us. It’s not a matter of if but when.

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