The one thing that could cause market Armageddon

Ally Selby

Livewire Markets

Like many during recent lockdowns, I spent the majority of my time between the fridge and the couch, watching some of Netflix's new blockbuster productions and, of course, many of Hollywood's classics.

While it may not be scientifically accurate - and say what you will about the film - I thoroughly enjoyed 1998-smash Armageddon. For those who haven't seen it, NASA agents discover a large asteroid the size of Texas is set to hit Earth and destroy all life, all in the space of just 18 days. Like many films of the time, the world's fate rests in the hands of Bruce Willis.

But "market Armageddon"? Now that sounds particularly treacherous.

In fact, Sage Capital's Sean Fenton believes that it could become a reality in the not too distant future. All it would take is for the cash rate to rise to 2% - something that we will possibly see play out in 2023, he says.

"Achieving a soft landing is going to be very difficult because there's so much leverage in the world. It won't take as much of a rate rise to actually trigger some financial distress and potentially a hard landing," Fenton says.

In this Expert Insights video, Fenton shares what he believes to be the biggest risk to markets right now. He also shares how he is positioning Sage Capital's portfolio with this in mind, as well as why he is feeling both bullish and bearish for the year ahead.

I have a feeling Bruce Willis isn't going to be able to get us out of this one.

Note: This video was shot on Tuesday 9th of November 2021. You can watch the video or read an edited transcript below.

Edited Transcript

What is the biggest risk to markets right now?

Sean Fenton: I think the biggest risk to markets is central banks decide to worry about inflation. So at the moment, we've got higher and increasing inflation. I think hyperinflation is right out there in terms of extremes. That's something that happens to developing nations with a lot of foreign debt and a currency collapse, like Zimbabwe or Argentina. You're not going to get hyperinflation on a global level like that. It's a bit more fringe, sort of too much money printing. But you're certainly seeing higher inflation and at the moment central banks are quite calm and tolerating it because they are focusing on those transitory elements that eventually supply chains will normalise.

But the risk is that the big deflationary forces that we've had in the past - globalisation, China unleashing capital and low-cost workers, the whole world taking their supply chains, driving those efficiencies.
That's all been very deflationary and it's meant over the last 20 or 30 years, whenever the economy slowed down a bit, inflation's really dropped and it's been slow to come back.

The risk is now that people are pushing back against China in terms of raising tariffs and they themselves, their workforce is starting to shrink and their inflation's picking up. So globalisation's pulling back. And because of those supply chain disruptions, firms are looking to hold more inventories. So we're not seeing necessarily that big deflationary force, which means that if inflation persists, it gets embedded in wages a little bit more, and then central banks might be making a policy error. They might be too tolerant and when they come back and go, hang on, it's not just going away by itself, we need to do something about it. That's the risk for markets.

That's not going to happen next week or next month, it's going to take a little while. So 2022 is going to be an interesting year where we're probably going to see inflation picking up. The market will start worrying about what the central banks' are going to do, but you'll probably see central banks staying pretty calm at least for a while until there's evidence that it's really feeding through into wage growth and it's something they need to actually act upon.

That's the real danger for markets because central banks have probably overstimulated; there's so much leverage in the world and on all different levels, and it's really pumped up asset prices.
If that's taken away in a forceful manner, that's more your Armageddon scenario for markets where you're getting a hard landing, economic recessions, big falls in stock markets and those sort of things.

What kind of policy error do you foresee?

There are so many lags in these things that they start raising cash rates and inflation just keeps accelerating and keeps going up, so they've got to keep raising. It's a bit like boiling a frog. That's what happened back in the late 80s that led to the 90s recession. Central banks started trying to fight inflation, but basically, the only way you can fight inflation at that level is to actually cause a recession, put some slack back into the labour markets, get inflation down.

Achieving a soft landing is going to be very difficult. And it's even more difficult now because there's so much leverage in the world. So it won't take as much of a rate rise to actually trigger some financial distress and potentially a hard landing.

Central banks are really walking a tightrope and all their stimulus in the last 20 or 30 years has meant that tight rope has become narrower and longer. So it's a tough job.

By how much would the cash rate have to rise to cause "Armaggedon for markets"?

I think the cash rate going from 0% in most countries around the world or close enough to it, to above 2% with the current amount of leverage in the world, will start to cause a bit of distress. We will possibly see that play out in 2023.

How are you positioning your portfolio with this in mind?

In our portfolio positioning, we always try to achieve a degree of balance and not take too much of a view that's really market state-dependent because as we were just discussing, the inflation outlook is very uncertain, how central banks react is going to be uncertain, and the timeframes are uncertain as well. And the market will quite likely swing between those uncertainties and create a lot of volatility and rotation. And the winners and losers can be complete opposites.

So in an 'inflation's under control, central banks are relaxed' environment, growth stocks do really well and everything else. But if you get into an environment of 'they're going to tighten', then you want short duration and maybe cyclicals, or if it's going to be a 'hard landing', then defensives like cash proxies and the like.

They're wildly different portfolios, so we don't try and make that call. We just try and focus on individual companies and what they're doing and be really balanced between those scenarios. We look at eight broad groupings of stocks and we try and be neutral to those, but take some really interesting stock positions within those groups so we can add value to the overall portfolio.

Are you feeling bullish or bearish for the year ahead?

I feel bullish and bearish, and I change my mind several times a day. It's really hard to call at the moment.

Bullish in the sense that we've had an amazing recovery in an economic sense. In a health sense, it's actually been a pretty good recovery as well from a global pandemic that at one stage threatened to unleash financial Armageddon and something worse than the Great Depression. There's 20% unemployment in a lot of developed countries around the world. There's been a good policy response, and we've recovered from that. The impact of vaccines and everything in terms of getting people out and economies moving again is really positive and there's a lot of positive stimulus still to work its way through. There's a new infrastructure bill in the US, Australia's finally happy to run budget deficits and spend big for a while, interest rates are really low, so that's all supportive of earnings. And we've seen record earnings coming through companies everywhere.

One of the interesting things about this dynamic - the flip side of the coin of inflation - is what's driving inflation is companies putting prices up, because they can, and everyone else is as well. So it's a bit of a psychology shift there. You're seeing margins expand for companies driving profits. That's a pretty good backdrop.

But we are at stretched, record valuations and if some of that stimulus starts getting taken away, that leaves the market vulnerable.

We're feeling bullish until the party stops.

You've got to keep an eye out for when central banks are going to take that punch bowl away from the party. This seems to probably be at least a little towards the second half of next year.


Education
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Content Editor
Livewire Markets

Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...

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