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Roubini: 8 Risks That Could Trigger the Next Correction

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Nouriel Roubini Nouriel Roubini. (Photo: Dania Maxwell/Bloomberg)

Markets have rallied since January — so much so that some now foresee a market “melt-up” — with equities continuing to rise sharply above their current elevated levels.

One could argue that this latest risk-on cycle will continue for the rest of the year. But Nouriel Roubini, professor of economics at New York University’s Stern School of Business, argues that there are a wide array of financial and political risks clearly in view, and one should not assume that the current enthusiasm will last the year.

“[W]hile investors’ latest love affair with equity markets may continue this year, it will remain a fickle and volatile relationship,” according to Roubini. “Any number of disappointments could trigger another risk-off and, possibly, a sharp market correction. The question is not whether it will happen, but when.”

In a commentary piece for Project Syndicate, Roubini outlined eight factors that could trigger another market risk-off or correction.

1. High Price-to-Earnings Ratio

The price-to-earnings ratio is high in many markets, particularly for U.S. equities. According to Roubini, this means that even a modest negative shock could trigger a correction.

“U.S. corporate profit margins are so high that there could be an ‘earnings recession’ this year if growth remains around 2%, while production costs may increase with a tight labor market,” Roubini wrote.

2. Risky Debt

There are heightened risks associated with the scale and composition of U.S. corporate-sector debt, according to Roubini. This is largely due to the “prevalence of leveraged loans, high-yield junk bonds, and ‘fallen-angel’ firms whose bonds have been downgraded from investment-grade to near-junk status,” he wrote.

In addition, Roubini wrote that the commercial real estate sector is “burdened with overcapacity,” as developers overbuilt and e-commerce sales have undercut demand for brick-and-mortar retail space.

“Against this backdrop, any sign of a growth slowdown could lead to a sudden increase in the cost of capital for highly leveraged firms, not just in the U.S., but also in emerging markets, where a significant share of debt is denominated in dollars,” according to Roubini.

3. Surprising Fed Decision

“Assuming that U.S. economic growth holds up, market expectations of more Fed dovishness will likely prove unfounded,” Roubini wrote. “Thus, a Fed decision not to cut rates could come as a surprise, triggering an equity correction.”

4. Trade Tensions

According to Roubini, hopes of a resolution to the U.S.-China trade war may be misplaced.

“Even with a deal, the conflict could escalate again if either side suspects the other of not holding up its end,” he wrote.

Or, he added that other “simmering trade tensions could boil over.” For instance, the U.S. Congress could fail to ratify the Trump administration’s revised North American Free Trade Agreement, or Trump could follow through with import tariffs on cars from Europe.

5. Fragile European growth

European growth is “very fragile,” according to Roubini. This could lead to another potential trigger.

European growth could be hindered by any of a number of developments, from a strong showing by populist parties in the upcoming European Parliament elections to a political or economic crisis in Italy, Roubini wrote.

“This would come at a time when monetary and fiscal stimulus in the eurozone is constrained and eurozone integration is stalled,” he wrote.

6. Political and Policy Risks

Many emerging-market economies are also heavily exposed to political and policy risks.

“These include (from least to most fragile): Mexico, Brazil, Argentina, Turkey, Iran, and Venezuela,” Roubini wrote. “And China’s latest round of stimulus has saddled its already indebted corporate sector with even more financial risk — and may not even suffice in lifting its growth rate.”

7. Trump Tantrum

Another potential trigger, according to Roubini, is that Trump may react to the Mueller report with “bluster, not prudence.”

“With an eye to the 2020 presidential election, he could double down on his fights with the Democrats, launch new salvos in the trade war, stack the Fed Board with unqualified cronies, bully the Fed to cut rates, or precipitate another government shutdown over the debt ceiling or immigration policy,” Roubini wrote.

In addition, Roubini said that the Trump administration’s approach to Iran and Venezuela could put further upward pressure on oil prices to the detriment of growth. Oil prices have rallied since last fall.

8. “New Mediocre”

“We are still in a world of low potential growth — a ‘New Mediocre’ sustained by high private and public debt, rising inequality, and heightened geopolitical risk,” Roubini wrote.

Roubini thinks that the widespread populist backlash against globalization, trade, migration, and technology will have an eventual negative impact on growth and markets.

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