Bank of America: The global market will face nine "black swans" in 2024

In 2023, U.S. stocks have come out of a year of soaring progress with the most aggressive interest rate hike cycle in decades. The recession and the broader market plunge warned by the bears did not happen in the end.

On the contrary, catalyzed by expectations of interest rate cuts and a soft landing, U.S. stocks have risen for eight consecutive weeks, and the "Santa Claus market" has continued during the holiday season, with the S&P 500 up more than 24% so far this year and the Nasdaq up 44% this year.

However, looking forward to 2024, Benjamin Bowler, an analyst at BofA Securities, believes that under the festive appearance of U.S. stocks, there are still turbulent undercurrents, and the market may face nine downside risks next year:

Risk 1: The Fed ended its tightening too soon and inflation returned. U.S. financial conditions are at their easiest since May 2022, and loose financial conditions could trigger another rise in inflation, forcing the Fed to turn hawkish again, which is tantamount to dropping a nuclear bomb for U.S. stocks.

Risk 2: Overly optimistic that the economy will return to pre-pandemic levels. Economic data and interest rates show a post-pandemic landscape, but other markets, such as foreign exchange, some equities and credit markets, are pricing in a return to pre-pandemic days in the US. Overly optimistic expectations are a risk in themselves.

Risk 3: The lag of high interest rate shocks. The volatility of equity assets lags short-term interest rates for about 2 years. The impact of the Fed's interest rate hikes hasn't really fermented yet.

Risk 4: Higher interest rates ripple through the junk bond market. The increase in interest expenses may have a spillover effect and lead to a reduction in corporate capital expenditure, while the peak of junk bond maturity may also trigger a wave of defaults.

Risk 5: The U.S. is in recession. Like the boy who shouted wolf, a recession may be on the horizon when investors stop believing in it.

Risk 6: The tech bubble bursts. Similar to the Bubble 50s of the 70s, the valuations of tech giants are now too expensive and the market concentration of the broader market is too high.

Risk 7: Geopolitical conflict. In addition to uncertainty weighing on investor confidence, rising geopolitical tensions could slow or reverse downward inflation in 2023.

Risk 8: The sovereign debt crisis has resurfaced. Some economies, including the United States and Italy, are on an unsustainable fiscal trajectory, especially given the persistently high interest rates. This could have a positive impact on driving up the volatility of the stock market.

Risk 9: Zero-date options trigger a volatile apocalypse. Some investors are shorting zero-date options, and a repeat of the "Volmageddon" that triggered the market crash in February 2018 could be repeated.

Risk 1: The Fed ended its tightening too soon and inflation returned

The Fed had previously made serious errors of judgment in 2020 and 2021, after the new crown epidemic turned into a global pandemic, it enabled zero interest rates and unlimited easing, and as a result, the continued easing policy caused the U.S. economy to overheat, and then it was too late to start raising interest rates, and by 2022, the U.S. CPI inflation has reached 8%~9%, but the federal funds rate is still 2.25%~2.50%, and the Fed is seriously behind the market curve.

Now, the situation may be similar, and the timing of the Fed's pivot to easing may be wrong.

BofA analysts write:

"As the market increasingly strongly believes that the Fed has finished raising interest rates, especially after the release of the October CPI report, there is a clear risk that inflation will unexpectedly re-accelerate or struggle to cool down, ultimately leading to another Fed rate hike. ”

Financial blog ZeroHedge pointed out that U.S. financial conditions are at their most accommodative since May 2022, and loose financial conditions may trigger inflation to rise again, forcing the Federal Reserve to turn hawkish again, which is tantamount to dropping a nuclear bomb for U.S. stocks.

Risk 2: Overly optimistic that the economy will return to pre-pandemic levels

After an eight-week strong rally, the market's belief in the U.S. economy has become increasingly optimistic, and BofA pointed out that the stock market rally means that the market is pricing in the Federal Reserve has quietly ended its interest rate hikes and the U.S. is returning to the stable and low inflation environment before the pandemic.

Analysts highlighted that while economic data and interest rates show a post-pandemic landscape, other markets, such as foreign exchange, some equities and credit markets, are pricing in a return to pre-pandemic days in the US.

Analysts believe that this idea may be overly optimistic. Overly optimistic expectations are a risk in themselves.

Risk 3: The lag of high interest rate shocks

Another big risk is that the market is overestimating the pace of Fed easing, and the impact of higher interest rates will last longer than expected.

BofA said its research from 2005 showed that the volatility of equity assets lagged short-term interest rates by about two years. Analysts point out that since the link between the two was first discovered nearly 20 years ago, the lagged relationship between equity asset volatility and interest rates has never broken down and still holds true today.

In other words, the impact of the Fed's interest rate hikes on the stock market has not really begun to ferment. If the Fed starts raising interest rates in 2022 and is expected to start cutting rates in 2024, volatility will rise in 2024 and will not peak until 2026.

Risk 4: High interest rates ripple through the junk bond market

BofA noted that by 2026, more than $600 billion of high-yield bonds will mature globally, accounting for nearly one-third of the global market.

These maturing junk bonds have had to pay higher coupons due to interest rate hikes, with yields on high-yield bonds now around 9%, more than double what they did two years ago. At the same time, a large amount of debt will mature in the coming years.

According to S&P Global Ratings, the issuance of junk bonds reached US$1.2 trillion in 2021, but only about US$200 billion will mature in 2023, but by 2026 and 27, a large number of junk bonds will mature in a concentrated manner. The increase in interest expenses may have a spillover effect and lead to a reduction in corporate capital expenditure, while the peak of junk bond maturity may also trigger a wave of defaults.

Risk 5: The U.S. is in recession

With the Federal Reserve raising interest rates aggressively, whether the U.S. economy can avoid a recession has been an unsolved mystery for the market this year.

But as U.S. economic data continues to be strong, the likelihood of a soft landing seems increasing, and markets are gradually putting the recession narrative behind them.

Bank of America warns:

Like the boy who shouted wolf, a recession comes when investors stop believing in it.

Analysts say that looking back at market performance over the past 100 years, a recession can be devastating to the market and difficult to foresee in advance: as shown in the chart below, 81% of the losses in recession-related sell-offs occurred during the actual recession.

Risk 6: The tech bubble bursts

In 2023, driven by the AI boom, the seven major technology stocks that led the U.S. stock market have written a brilliant year.

Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla have risen by an average of 112% so far this year, creating a new market capitalization of $5.2 trillion.

The concentration of the broader market is at an all-time high, with the 100 largest stocks in the S&P 500 now trading near a 30-year high.

BofA analysts write:

Artificial intelligence will undoubtedly have a profound impact on economic productivity, but so can it be said that the invention of the personal computer and the Internet is also true. History shows that the initial carnival reaction is often misguided, and that the bubble will subside with the depression and the birth of the final winner. The pretty 50's bubble of the '70s taught us the importance of valuation – the Big Seven are already too expensive.

BofA believes that the bursting of the Big Seven bubble could trigger a collapse in the broader market, and the bank believes that buying S&P put options can hedge the downside risk of technology stocks.

Risk 7: Geopolitical crisis

In BofA's global fund manager survey released in November, most institutions cited the geopolitical crisis as the biggest downside risk to the market next year.

The current Russia-Ukraine conflict and the Palestinian-Israeli conflict have already had a significant negative impact on the global economy, and the recent blockage of the Red Sea route due to the Palestinian-Israeli conflict is more likely to push global inflation back.

BofA noted:

In addition to uncertainty weighing on investor confidence, rising geopolitical tensions could slow or reverse downward inflation in 2023. And once again tie the hands of central bankers.

Risk 8: The sovereign debt crisis has resurfaced

In November, Moody's, an international credit rating agency, announced its decision to downgrade its U.S. sovereign credit rating outlook to "negative" from "stable" due to rising interest rates in the U.S. and heightened political polarization in the U.S. Congress. Sovereign credit risk has resurfaced.

Clearly, a development path supported by high deficits is doomed to be unsustainable. BofA noted that a healthy fiscal path is when a country's debt/GDP ratio flattens or falls over time, but some economies, including the U.S. and Italy, are on an unsustainable fiscal trajectory, especially given persistently high interest rates.

A resurgence of sovereign credit risk could also adversely affect equities and increase volatility.

Risk 9: Zero-date options trigger a volatile apocalypse

Zero-date option (0DTE) is an option product less than 24 hours away from the exercise date, which provides investors with a way to hedge short-term risks and ultra-short-term bets, allowing retail investors to bet large amounts with a small amount of money, and is a high-risk investment tool known as "picking up coins before the steamroller".

According to a previous Wall Street Insight article, zero-day options continue to hit record highs and have recently accounted for half of all S&P 500 options volume.

There has been a lot of controversy in the market about the dangers of the zero-date right. BofA notes that people's fears alone can create greater risks. Presumably, investors are shorting zero-date options, and a repeat of the "Volmageddon" that triggered the market crash in February 2018 could be repeated.

In February 2018, a fund tracking volatility was sold off as the market fell close to the call line. The crisis caused the Dow Jones Industrial Average and the S&P 500 to plummet, dubbed the "Volmageddon"

However, analysts believe that in reality, the size of the S&P 500's zero-date options is well balanced.

A thorough analysis of ETF positions shows that, despite the huge trading volumes, S&P zero-date options trading has been well-balanced – not overwhelmed by sellers or buyers.

Nonetheless, one potential risk we see is that over time, some investors begin to adopt unilateral zero-date options on a large scale, or "weaponize" zero-date options to chase large up/downs, to the point that there are significant position imbalances.

In particular, the volatile liquidity of zero-date options can trigger investor liquidations and affect market makers who offer such products.

This article does not constitute personal investment advice, does not represent the views of the platform, the market is risky, investment needs to be cautious, please make independent judgment and decision-making.