Last month the biggest risk of the year turned into reality when the UK voted to leave the EU. In the aftermath of this momentous decision, we turn a spotlight on what other hazards could catch the market unawares.
But before that, how will UK politics and hence Brexit evolve from here? Our working assumption is that Theresa May becomes prime minister on 9th September after a contested leadership election and then invokes Article 50 early next year after preparatory work. There are details to consider but they may not matter much here. The bottom line is that the markets will likely accept Mrs May as a safe and competent pair of hands to guide the UK out of the EU.
We also assume that the direction of travel will be either EEA-lite or EEA-plus where “lite” is limited single market access but some immigration controls and “plus” is full access and a broken immigration promise. The former seems more likely; the latter would go down better with financial markets. And, finally, we reckon that UK growth will slow sharply but avoid a full-blown recession.
More importantly, perhaps, what other risks threaten investor portfolios? We would highlight three of the above. First, Donald Trump wins the US presidential election. If Hillary Clinton wins, then it looks like business as usual, much along the lines of the current Obama administration. If Donald Trump wins (and few thought he would win the nomination), then it is less clear what he would do in office. However, he appears to have a reckless fiscal policy (tax cuts and spending increases without regard for the budget deficit) and protectionist instincts on overseas trade. Neither is likely to be market-friendly.
Second, US profits growth worsens. It has turned negative this year both on a stock market basis and in the national accounts but we take this as mainly a reaction to the 25% rise in the US dollar against the major currencies between mid-2014 and late 2015. The US dollar has levelled off this year and the economy has picked up so we think profits growth will turn positive. However, this is a hazard worth watching.
Finally, the global expansion is seven years old and looking tired, especially in the US and the UK. Rudi Dornbusch famously quipped that expansions do not usually die of old age but are murdered in their beds by the Federal Reserve. Thus, in normal circumstances a bias to tighten by both the Federal Reserve and the Bank of England earlier this year might have signalled the next downturn. Both have backed away from interest rate hikes for now but there is not much fuel in the global economy’s tank. This is our third key risk.