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Market rocket fuel will run out. Back to Reality

By William R. Rhodes – President & CEO, William R. Rhodes Global Advisors, LLC 

President Donald Trump’s new tax legislation is adding rocket fuel to the U.S. equity market. And excesses have spread well beyond stocks. There’s a bubble in Bitcoin and other crypto-currencies, art prices are soaring, and valuations for collectibles like fast cars, as well as real estate, are becoming ever more staggering. But a fear of missing out on the boom means that investors are paying little regard to an array of warning signals, just as they did in early 2007. Prudent considerations are being pushed aside in an ever more frenzied reach for yield.

The most recent gains in U.S. stock prices anticipate that Trump’s tax cuts will lead major corporations to buy back shares on a record scale and boost dividends, as well as to invest. But the valuations of many individual stocks are also starting to reflect overly optimistic earnings expectations. The situation now is similar in some respects to early 2007 when I publicly warned of the dangers of a major market correction. Another such correction is coming, and a decline in the U.S. stock market of between 10 and 20 percent is probable before the end of 2018.

One reason is a shift in the accommodative central bank policy that has buoyed all assets. As the United States enters the ninth year of economic recovery, the Federal Reserve is clawing back the excessive liquidity that at first mitigated the real risk of a depression and then secured gradual economic recovery. The Fed is likely to raise interest rates three or four times this year and has begun shrinking its $4.4 trillion balance sheet. The European Central Bank will start winding up its asset purchases and the Bank of Japan may possibly follow suit later this year.

Any inflation concerns the Fed may have will be heightened by full employment and tax cuts that are going to rapidly swell the budget deficit. Also, global inflationary pressures will grow in the coming months as improved economic activity pushes up demand for commodities and their prices. Oil, in particular, may be boosted given special factors, such as a continuing decline in oil output in Venezuela, where there is increasing political chaos.

Another major concern relates to the sustainability of 6.5 percent annual GDP growth in China. Necessary financial reforms have been delayed. When they are enacted, the pace of growth could slow to 6 percent or even lower. President Xi Jinping put off dealing with the difficult financial issues in the country before the 19th Communist Party Congress, which enabled him to consolidate power. A decline in Chinese reserves and in the currency’s value have been avoided by the imposition of capital controls, but this is a short-term fix.

China will also have to implement policies to curb debt, which has reached around 280 percent of GDP, and must address excessive borrowing by state-owned enterprises, zombie companies, municipalities, and real estate developers. Beijing is also going to have to restore sound risk management to the financial sector, where both the commercial banks and the shadow banking sector have sharply expanded credit growth. The big uncertainty is not if China will act, but when.

Politics also pose risks to global markets and the world economy. The U.S. Congressional elections in November may see the Republicans lose power. That would fuel concerns of a confrontation between President Trump and the Democrats on Capitol Hill and increase uncertainty about the outlook for a host of fiscal and regulatory policies. There is also the confrontation between North Korea and the United States, the impact of Brexit on Britain and the European Union, clashes between Saudi Arabia and Iran, and terror threats.

Most investors have so far ignored all the warning indicators and pushed stock markets to new record highs. At some point in 2018, the euphoria will be punctured, just as it was in mid-2007. International financial markets are even more connected than they were a decade ago and a major U.S. stock market correction will now be even quicker to infect other bourses. It is time for the Fed to at least issue a warning that “irrational exuberance” is with us again.

William R. Rhodes – President & CEO, William R. Rhodes Global Advisors, LLC and author of “Banker to the World: Leadership Lessons from the Front Lines of Global Finance.”

Compliments of William R. Rhodes Global Advisors, LLC , a member of the EACCNY