Catalysts that could trigger a market sell-off
Disappointing European growth
The Covid-19 pandemic is yet to be fully controlled across the world. In Europe, slow vaccine rollouts could cause extended lockdowns while new strains of the virus threaten full economic reopening. In Britain for example, there are fears of a second summer write-off due to the uncertainty over when Covid-19 rules will end, a situation faced in much of Europe. Credit Suisse’s pharmaceutical analysts believe Europe will only have 20% of its population vaccinated by end of the first quarter, which may affect its employment rate.
And while the EU’s Recovery Fund is key to economic recovery, it will be slow to disburse. The majority of corporate borrowing in Europe is from banks where lending conditions are tight, compared to the US where most borrowing is from individuals. Furthermore, European fiscal policy is less generous than it was during the first lockdown, a further contrast to the US. All these are likely to slow economic growth and recovery in Europe, and could result in stock sell-offs.
Risk of overheating or Fed tapering
Credit Suisse analysts noted that there is a medium risk of a sell-off if the central bank allows inflation to overshoot to around 2.7% core CPI. The investment bank noted that “not only has the Fed hinted that it would allow an inflation overshoot to compensate for the undershoot but recently it has sounded even more dovish.”
In December 202, the Fed highlighted that even an unemployment rate of 3.7% in 2023 would still result in rates being unchanged. The main risk would be a tapering brought by a stronger-than-expected recovery in growth, larger pick-up inflation, and some form of financial excess.
But another crucial factor is the gross domestic product growth in the US. Here the bank noted that a growth of 7% would be 3% above the Fed’s 4.5% forecast. This could lead to unemployment ending close to 4% this year (2021).
Fed tapering could also be triggered by the sizable fiscal package in the US as Democrats prepare to pass President Joe Biden’s American Rescue Plan to relieve families affected by COVID-19 and support economic recovery, a larger infrastructure package, and inflation expectations rising beyond the comfort zone. Should this happen, Credit Suisse noted that the Fed might be forced to tighten monetary policy.
Margin squeeze on earnings
Business operations have been greatly affected by the pandemic. Due to the pandemic-related lockdowns, there is a possibility of a sharp rise in some input costs such as commodities and freight rates, which can lead to a margin squeeze. Corporate earnings from the holiday period have been overwhelmingly better than expected so far; more than three-quarters of the S&P 500’s market capitalization have reported fourth-quarter results as of Tuesday. In aggregate, these results have topped expectations by 17%, and 81% of companies beat their own projections.
The three major indexes in the US have performed strongly for February to date. Meanwhile, the small-cap Russell 2000 closed at a record high on Tuesday, extending its winning streak to seven sessions.
But the bank noted that ‘markets have not fully factored in the current level of earnings revisions,” and ‘only 73% of PMIs have to be above 52 to justify the current market performance.’ Indeed, amid strong earnings and supportive monetary and fiscal policy, analysts are already debating whether the recent market surges can be sustained in the very near-term.
“We’ve seen a very strong phase of what I’d call fast markets: A strong rally the last six months in risk assets across the board,” Joseph Little, HSBC Global Asset Management global chief strategist, told Yahoo Finance. “And what that means in practical terms for investors is that a lot more is now discounted. And the story around recovery, around faster economic improvements, around the vaccines is now, at this point, well-known to investors and other market participants. And that poses the question of what could happen to markets next.”