Biggest Risks for the Markets in 2018

Biggest Risks for the Markets in 2018

Wall Street is gearing for another record year on the equity market. On January 2^nd Nasdaq crossed 7,000. A day later S&P 500 reached 2,700. Dow Jones followed by passing over 25,000. Who can ask for a better start?

However, with S&P 500 earning +22% and Nasdaq gaining 32% in 2017, many are wondering if the equity market has any fuel left for another big run. With momentum on its side, the recent corporate tax cuts, and president’s promises for deregulation we have the foundation for another record high year. But not everything is perfect. In times of market euphoria, investors tend to ignore warning signals.

Surely, there is no shortage of potential threats that can trigger another significant market correction or an economic recession. In my view, here are the biggest risks for the market in 2018 and beyond.

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Government shutdown

With the start of the year, both Republicans and Democrats are gearing for a battle as the current government funding bill expires on January 19.

Republicans are invigorated after winning their most important battle of 2017. The GOP voted for the most extensive tax overhaul in 30 years which promises to cut taxes for corporations and middle class but also introduces additional $1.5 trillion to the budget deficit in 10 years without counting for growth. Their 2018 agenda includes cutting entitlements, building a border wall, financing a new infrastructure plan, increasing the military budget and maybe repealing Obamacare.

On the opposite end, after their win in the Alabama senate race, Democrats are slowly recovering from their knockdown phase after the US 2016 Presidential election.  Democrats will try to push their agenda on the Dreamers Act and save the government healthcare subsidies.

With a slim Senate majority and traitorous rifts inside the party, the GOP will have a hard time passing any significant legislation. The Senate leadership already expressed their desire to work with Democrats on the next bill on avoiding a government shutdown. While the public may appreciate a bi-partisan agreement, both parties have shown an enormous resistance to compromise on any level.

Geopolitical crisis

There is a growing number of geopolitical threats that can compromise the global growth. The world is becoming a treacherous place where one miscalculation can lead to a human disaster. From cyber-war with Russia to nuclear tension with North Korea, ongoing unrest in the Middle East, shutting down NAFTA, populist governments taking over Europe, and hard Brexit negotiations.

China is looking to fill the vacuum left by the US after scrapping the Trans-Pacific Trade Agreement.  Russia and President Putin want to play a bigger role in the world affairs. The remnants of ISIS are spread around the world and planning the next terrorist attack. The 16-year war in Afghanistan is still going with no resolution in sight. The tension between Iran and Saudi Arabia is on its highest level for years. The president must maneuver carefully in the dangerous waters of world politics where governments are becoming more and more protectionist and populist.

Health Care Chaos

The GOP was unsuccessful in repealing the Affordable Care Act. However, they were able to remove the individual mandate as part of the recent tax cut bill.

With the penalty going away in 2019, there will be no incentive for healthier individuals to sign up for health insurance.  Furthermore, this will lead to a lower number of insured participants and drive higher their cost of health care.

US has already the most expensive health care among all OECD counties. The average cost per individual in the USA is $10,000 versus $6,700 for Switzerland and $5,100k for Germany. The Congress and Senate must find a solution to address the climbing health care cost. The alternative will lead to more healthy people dropping from the system, skyrocketing medical bills, social unrest,  and even economic slowdown.

Retail meltdown

US retail is in danger. In 2017, 19 retailers including Toys R US, Aerosoles, Perfumania, True Religions and Gymboree filed for bankruptcy protection. Many others like Teavana, Bebe, and Kenneth Cole closed all their physical locations to focus on online expansion. Despite rising consumer confidence and record-high holiday shopping spree, traditional brick-and-mortar retailers are struggling to stay afloat.

Apart from a few big names, US retailers are loaded with debt. According to Bloomberg, $100 million of high-yield retail debt was set to mature in 2017. Furthermore, this figure will rise to $1.9 billion in 2018 and will average $5 billion between 2019 to 2025. With rising interest rates and permanent drift towards online shopping, many retailers will continue to close down unprofitable locations. Local economies relying heavily on retail jobs will suffer high unemployment rates in the coming years.

Consumer debt crunch

The US household debt has reached $13 trillion in the third quarter of 2017, according to the New York Fed. Driven by low-interest rates, the mortgage debt increased to $8.7 trillion. Student debt has reached $1.36 trillion. Auto loan debt is $1.2 trillion. While mortgage delinquencies are stable at 1.2%, bad auto loans have risen to 2.4%, and student debt delinquencies have reached 9.6%.  The rising interest rates can lead to more people failing on their loans, which can potentially trigger another crisis similar to 2008.

Interest hikes and hyperinflation

The US fed is planning for three rate hikes in 2018. Oil has slowly passed $60 a barrel. And US dollar reached 1.20 against the euro. Moreover, U.S. manufacturing expanded in 2017, as gains in orders and production capped the strongest year for factories since 2004.  While around the world factories have warned they are finding it increasingly hard to keep up with demand, potentially forcing them to raise prices.

While CPI hovers around 1.7%, global markets have not priced in the prospects for higher inflation. Therefore, unexpected spike in prices can lead to more Fed rate hikes.

Additionally, the lost corporate tax revenue can jeopardize the ability of the US Treasury to issue debt at lower rates, which can drive the budget deficit even further. Historically, uncontrolled inflation combined with growing budget deficit has led to periods of hyperinflation, higher credit cost and loss of purchasing power.

Retirement savings going down

Only half of US families have a retirement account. The 401k plan patriation is only 43%. Of those with retirement savings, the average balance is just $60,000. Social Security ran $39 billion deficit in 2014 and will be entirely depleted by 2035.

With rising interest rates and GOP plans to cut entitlements, many Americans will face enormous retirement risk and suffer substantial income loss during their non-working years. Without an urgent reform, the US social security system is a time-ticking bomb that can hurt both businesses and families.

Mueller investigation

The former FBI chief investigation is at full speed as more revelations about the Trump campaign appear almost on a daily basis. You might need a crystal ball to predict what will be the exact outcome. However, it is virtually certain that there were people in the Trump circle who were pursuing their own personal interests. The initial theory of collusion and obstruction of justice is leading to allegations about money laundering. If the Mueller investigation proves those accusations, we could experience a political crisis not seen since Watergate.

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.