Experts have warned that investors may be underestimating several risks, including a potential hard landing, the return of inflation or a crisis in the commercial real estate sector.
While those risks are not necessarily base case scenarios, investors should not ignore them.
Below, experts highlight four risks that the market has not fully priced in.
Reflation
Tom Hibbert, investment analyst at Canaccord Genuity Wealth Management, said the market is understating the risk of reflation. While an uptick in inflation is not his base case scenario, neither does he believe that central banks have got inflation fully under control.
While many economists forecasted an unavoidable recession in 2023 as a result of the rapid surge in interest rates, the global economy has proven to be more resilient. Yet, continued above-trend GDP growth in the US and persistently tight labour markets mean inflation has not been entirely defeated.
Hibbert said: “The risk is that following central bank rate cuts, inflation rears its head again towards the end of the year. It’s also worth pointing out the parallels with the 1970s. High inflation was driven by oil price shocks on the back of tensions in the Middle East (Arab oil embargo and Iranian Revolution).
“With recent events in the Red Sea and broader tensions in the Middle East, there are parallels which have already impacted shipping costs in Europe and led to volatility in energy markets. Further escalation of these geopolitical risks poses a threat to the disinflationary trajectory.”
Hard landing
A hard landing scenario is another risk the market may not be fully appreciating, as the lagged effect of interest rate hikes are only starting to take hold of the economy.
As a result, Hibbert foresees a more significant economic downturn than anticipated.
He said: “Some of the most significant economic indicators are showing warning signs. If we look at the Conference Board Index of 10 Leading Economic Indicators for the US, which has a fantastic track record of signalling downturns and includes data on the jobs market, slope of the yield curve, consumer sentiment, new orders and more, this has recently been at levels not seen since the global financial crisis.
“The risk of a more severe economic downturn is not fully reflected in certain assets, notably credit spreads and more expensive parts of the equity market.”
Concentration risk in the US market
Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla account together for nearly 30% of the S&P 500.
While many investors remain bullish on the prospects for artificial intelligence (AI), Isaac Stell, fund research manager at Parmenion, finds this level of concentration unhealthy.
He said: “It is at eyewatering levels with shares of the Magnificent Seven pricing growth into perpetuity. The advent of AI will clearly be a game changer but with price to sales ratios of 40x and price to earnings ratios of 174x (Nvidia), there could be serious implications for market sentiment if there is one earnings miss.”
Stell is particularly worried about retail investors who may think they are getting a diversified portfolio by investing in a passive fund tracking the performance of global indices, as they have become increasingly skewed towards the US.
For instance, the US accounts for 70% of the MSCI World, while just 10 US stocks make up 20% of this index.
Stell added: “If the tide changes, which it can rapidly, many of these investors may suffer some painful losses.
“Is it a coincidence that Jeff Bezos and Nvidia executives have been offloading shares more recently? We usually take CEO buying as a show of confidence, so what does the opposite demonstrate?”
Commercial real estate
Finally, Stell sees significant risks in the commercial real estate space that have been building over the past four years.
Commercial real estate has been struggling since the first Covid-induced lockdown in 2020, as the democratisation of the working from home culture has led to a decline in office usage.
“We’ve seen in recent weeks these risks filtering through to New York Community Bancorp that stated it is hoarding funds in anticipation of loans going bad. What percentage of these loans will go bad is the three-trillion-dollar question,” Stell said.
“The issues regional banks are facing (where the majority of the commercial real estate loans are held) are very real and are prevalent enough for Jerome Powell to publicly state that the US Federal Reserve is working on a plan to work through expected losses.
“Any losses will of course create impairments, which may cause liquidity to dry up. The Fed may jump in and undertake some form of quantitative easing to ensure liquidity remains, but this will just add even more debt onto the ever-growing pile.”