There is also the fear of recession itself. If growth is slower than expected, there may be the odd quarter when, before revisions, US GDP looks as if it has contracted. There could also be periods when unemployment ticks up slightly. At the same time, investors will also be keeping a nervous watch for signs that global trade tensions are spilling over into corporate earnings.
Equity returns have been strong in recent years, coupled with lower volatility over the most recent period. Any run of negative returns or an associated spike in volatility could spook sentiment and trigger a deeper sell-off. We would also expect commodity prices to fall and government bonds to rally especially in the US, where both the Fed and domestic demand are more sensitive to the stock market than their equivalents overseas. We see this as a low probability scenario, as discussed previously.
Eurozone break-up fears take hold
The political environment in Europe is currently both fast moving and febrile. Disaffection with the European project in general and immigration in particular are manifesting themselves at the ballot box, with populist, often anti-EU, parties making strong gains in national elections. The European Parliament could look very different following the elections next May and we will have a new EU President and EU Commission, and major changes to the composition of the ECB in 2019.
The most obvious risk to the survival of the European project is Italy. Should the country crash out of or opt to leave the single currency, which is by no means out of the question, then a disorderly break-up of the eurozone moves much closer. Italian securities could be redenominated in a new, much weaker, currency.
In the process, the euro would depreciate significantly, yields on government bonds in core Europe would likely rally, peripheral spreads would widen and a flight to quality would boost the US dollar and Treasuries. European equities would be hit, especially in peripheral countries. The reaction of individual securities would depend on how they would fare in the event of redenomination risk. For example, most credit default swaps on Italian debt issued since 2014 contain clauses protecting against redenomination risk; those issued in earlier years generally do not.
The probability of this scenario would rise if inflationary pressures in Europe were to surge. This would put pressure on the ECB to raise rates and significantly increase the risk of a recession. This scenario looks highly unlikely over the next few years.
A collapse in emerging markets
To talk about a crash in emerging markets in broad terms is problematic because, economically, the countries that come under this banner differ hugely in many cases. What hurts Mexico, for example, may have no impact whatsoever on India. That being said, the greatest overarching threat to emerging markets is arguably a sharp rise in US interest rates and a strong dollar. Higher US bond yields have the unwelcome consequence of both ramping up servicing costs of developing countries’ dollar-denominated debt and drawing investment assets away from emerging markets. This is likely to have a profound impact on confidence and place a number of already fragile currencies under considerable pressure.
Emerging economies are particularly sensitive to global trade conditions, as witnessed by the shock to markets triggered by the tariff spat between Washington and Beijing. Higher oil prices also represent a threat, particularly in the context of a rising US dollar. This double impact could be extremely negative for the balance of payments for a number of vulnerable countries. This would impact all asset classes in vulnerable EM countries and lead to a fall in commodities. Government bonds in DM would tend to benefit but equities would tend to weaken. As with other scenarios, we judge this as a low probability outcome in the next year or two.