“What worries you the most?” “What keeps you up at night?” I get these questions a lot from investors looking for insight into what might cause the next market correction. These questions are even more in focus now, given the drop in global markets that we witnessed on Thursday.
As I write in my latest Investment Directions monthly market outlook, the global equity market faces a number of risks. However, the risks I worry about most are those that aren’t completely reflected in relevant asset prices. In other words, if these scenarios occur, investors aren’t being compensated for any resulting violent market reaction. Here’s a look at four such risks.
The risk of a US slowdown – Not discounted in US valuations. While US valuations currently look reasonable, they’re predicated on a US economy growing at around 2% to 2.5%. The risk of slower growth is not priced into the market. If US economic data continues to disappoint, and we get a growth hiccup in the second or third quarter, then we’re likely to see some US market weakness.
The risk of a crisis in the Middle East – Not fully discounted in oil prices. Oil is currently trading a little higher than I would expect given the current supply situation and inventory levels. This suggests that a bit of risk premium is built into oil prices. However, prices aren’t high enough to discount potential large events related to a Middle East crisis. As a result, in a scenario such as an Iranian production shutdown, oil prices would likely spike.
The risk of a eurozone crisis flare-up – Not fully discounted in eurozone valuations. Many people are worried about a European banking crisis or the euro dissolving, so eurozone stock prices already reflect a fair amount of risk. But prices in the region still could be cheaper.