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.