When the US stock market sneezes, the rest of the world often catches a cold. Worryingly for bearish investors, US stock indices have started sniffing.

Since closing at a record high on 26 January, the benchmark U.S. S&P 500 index has slipped around 5 per cent as investors weigh growing protectionism and geopolitical risks.

Billionaire investor George Soros has warned of a looming financial crisis and an "existential" threat to the European Union (EU), due to rising anti-EU sentiment, Europe-US divisions over Iran, a rising U.S. dollar and capital flight from emerging markets.

Other well-known fund managers have also joined in the bearishness.

"The ghosts of 2000 are upon us," hedge fund manager Greg Coffey told investors recently.

"Make no mistake, this is the current investment environment we are in, and will be through 2018."

Trillions of dollars were wiped out from global stockmarkets in February, following a surge in volatility caused by worries over higher interest rates.

In May, the panic resumed following political turmoil in Italy, sparking worries over the future of the Eurozone, with recent trade tensions between the United States and China also dampening sentiment.

Bond investors have plenty of reasons to be nervous too, with commentators warning of a credit crisis in the next 12-18 months.

At a recent Morningstar Investment Conference, Franklin Templeton's Michael Hasenstab predicted a "perfect storm" for interest rates and bond yields, due to increasing inflation, deficits and weaker demand for U.S. treasury bonds.

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Hasenstab also pointed to the danger of passive investments, such as through exchange-traded funds, in an environment of rising interest rates.

Morgans chief economist Michael Knox predicts the US economy could fall into recession in the second half of 2019, when its second-longest expansion in history runs into capacity constraints. A surge in wages growth is seen sparking a rise in inflation and a rapid spike in interest rates by the US Federal Reserve, plunging the world’s largest economy back into negative territory.

Bears versus bulls

However, not all analysts are bearish.

BetaShares chief economist David Bassanese points to a stronger global economy, with the "global PMI index" remaining high at 54 in April, only marginally lower than its recent high of 54.8 in January.

He noted the International Monetary Fund’s projection of increased world economic growth of 3.9 per cent in 2018 and 2019, up from 3.8 per cent in 2017, amid continuing strong performance in the Eurozone, Japan, China and the United States.

With a 10-year US bond yield of 2.97 per cent, Bassanese argues the U.S. stockmarket is "fully valued at a price-earnings ratio (PER) of 16.8 compared to its fair value of 16.4.

Yet with positive US earnings growth, the economist sees US stocks moving sideways rather than slipping into bear market territory, despite the prospect of further interest rate hikes by the Fed.

"Provided that U.S. inflation remains under control and rate rises are gradual, there’s no red rag here for the markets to pull back in a major way," he said.

Bassanese sees the U.S. 10-year bond yield rising from 3.25 per cent at year-end 2018 to 3.5 per cent next year, with the S&P 500 index finishing this year at 2,830 and 2,920 in 2019.

In a June report to clients, Nikko Asset Management said despite large geopolitical risks, "the net impulses for global economic growth and corporate profits continue to improve".

The Tokyo-based investment manager added that "this justifies a positive stance on global equities, particularly in Japan, Europe and the Asia Pacific. Meanwhile, global bond yields should rise somewhat, so we maintain an unenthusiastic stance on global bond returns"

Hold more cash, bond proxies

Morningstar’s head of equities research, Peter Warnes, cautions that a downturn "can creep up and go bang when you least expect it," such as in 2007 and in the peak of the dot-com boom in 2000.

However, he said the Australian sharemarket remained underpinned by a "relatively high" dividend yield, offering some support for the local bourse.

"I still think investors should hold more cash, but I think overall Australia will muddle through. You have to be careful though – at this stage I wouldn’t be buying resource stocks, while retailers face difficulties due to the household situation," he said.

"Some of the bond proxies with good cash flow will be OK, and there’s also opportunities with M&A in healthcare. But those with overseas operations seem to be doing better and if the Australian dollar comes down a bit, they will benefit as well."

Like former Australian Prime Minister John Howard once said, "be alert, not alarmed". This appears to be the message for investors as the financial markets party carries on.

 

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Anthony Fensom is a contributor to Morningstar Australia

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