investment insights
Eight key risks for investors in 2024
With global equity markets hovering around new all-time highs, investors are questioning what could go wrong in 2024. We examine eight key risks, with the caveat that big disruptions often come from overlooked or hard-to-model areas.
Key takeaways
- Geopolitics, threats to tech sector returns, more persistent inflation, credit events and public debt sustainability are some of the major risks for investors in 2024
- We expect tense geopolitics, but localised conflicts and hence contained financial market risks. The risk of an inflationary rebound in the US is low but rising. Tech stocks’ outperformance should moderate in time
- Strong investor demand for yield and easing financial conditions should help keep credit risks contained. Commercial real estate exposures look manageable systemically for banks and insurers, but are harder to assess at asset managers
- We judge known market risks to be either low or medium, supporting the current risk-on backdrop and our decision to keep portfolio risk exposures at strategic levels.
1. Geopolitics: an escalation in conflict scenarios (Medium risk)
Geopolitics have risen as a source of economic and financial risk since the introduction of tariffs by the Trump administration in 2017. The Ukraine war has entered its third year; conflict in the Middle East could escalate. Taiwan’s status remains a source of US-China tensions, alongside the global race to dominate the future of technology. The world has become more belligerent, and indicators of geopolitical risk have risen. In a broader historical context, however, they still look contained, while perceived market risk as measured by the VIX index also remains low.
As long as conflicts remain regionalised and do not pose global issues, they do not alarm global financial markets. Geopolitics become a source of market risk when they involve chain reactions that create market instability. But the willingness and/or ability to escalate current regional wars look relatively contained, in our view, despite rhetoric that may suggest the contrary. Meanwhile, a hypothetical second Trump administration could bring a different dynamic to the broader global geopolitical scene, with more emphasis on domestic US issues.
2. Economics: a recession or an inflationary rebound (Low/Medium risk)
The resilience of the US economy has led markets to price in far fewer US interest rate cuts than they had predicted in late 2023. Of course, monetary policy works with a lag. A still-inverted yield curve, a historically reliable recession indicator, is a key reason to not discount recession risks yet. However, for now, macroeconomic data point to the US economy steering towards a soft landing. Fiscal stimulus, a lack of prior credit excesses and tight labour markets are all shielding the economy from tighter bank lending.
We believe that the probability of a US recession is just 10%, compared with a 70% chance of a soft landing, and a 20% likelihood of either mild stagflation or an economic reacceleration. The latter risk has risen in recent weeks. This could lead to more persistent inflation and prevent the Federal Reserve from cutting rates this year. If the market comes to expect fewer cuts, or even if hikes begin to be priced in (a very low risk in our view), risk assets would reprice quite sharply.
3. Credit cycle: a major default/credit event (Low risk)
Almost half of outstanding US high yield bonds were issued in 2020 or 2021 when rates were at multi-decade lows. About 8% of outstanding debt will mature in 2024-25, with a peak in 2028/2029. We foresee a gradual credit deterioration in coming years as a result.
While default rates have already increased, they remain low by historical standards and concentrated in lower-rated credits and a few industries. Financial conditions have recently eased. Assuming policy rates do not revert to decade lows, interest costs will begin increasing as debt matures.
Strong investor demand for yield should continue, outweighing slowly deteriorating credit fundamentals, keeping spreads from widening much. We expect 2024 default levels to be similar to 2023, likely in a 2.5-3.5% range on a par-weighted basis, and overall manageable.
Of course, risks still remain, including a hard landing, stickier inflation that forces monetary policy to stay tighter for longer, and/or another credit event. Here, commercial real estate (CRE) exposure at financial institutions could be an important source of volatility (see risks 4 and 6).
4. Real estate: a market shock emanating from banks (Low risk)
Concerns around the CRE market had already come to the fore with higher vacancy rates during Covid. Higher interest rates added further pressure, leading to worries about banks’ exposures, especially after some negative surprises from lenders in the US, Japan, and Switzerland.
We believe banks’ CRE exposures are by and large manageable. While some will likely need to book additional loan provisions, we think this is an earnings, not a capital issue. Smaller US banks tend to have higher CRE exposures, but this should not lead to systemic risk. However, fast-changing customer and depositor behaviour can lead to unexpected consequences, as seen in March 2023. Given poor disclosure, including outside banks, (see point 6) there is also the risk of surprises and potential contagion.
Insurers are heavily exposed, with more than USD 360 billion of commercial real estate and USD 220 billion of commercial mortgage loans on the balance sheets of the 16 largest US life insurers. Median loan-to-value ratios of US life insurers fell to around 65% at end-2023, from 50-55% historically, due to pressure on shopping mall and office valuations and higher interest rates. However, insurers are long-term investors that match assets and liabilities carefully. Rate cuts and a soft landing could also help a slight recovery in LTVs this year.
5. Corporate: Tech bubble bursting (Medium risk)
The technology sector has been a key driver of equity market returns in 2023 and year-to-date, leading to one of the most concentrated periods in US equity market history. The other two comparable degrees of concentration were observed during the dotcom bubble and in the early 1930s. Historically, the S&P 500 has shown a trend toward mean reversion, and we would anticipate either market breadth to increase or the degree of tech outperformance to subside going forward.
While the first development could coincide with still favourable overall equity dynamics, the second could be a more worrying scenario for investors. Current revenue and earnings growth expectations for tech stocks are around twice those of the general market. If the macroeconomic backdrop deteriorates and confidence in achieving these is challenged – or if interest rates do not start to fall as expected – the absolute and relative valuation premium could narrow, posing a clear risk to the broader market.
6. Financial system: stability risks (Medium risk)
The best defence for financial stability risks comes from a strong banking system, which we believe is largely the case in North America and Europe. Balance sheets have been de-risked, and solvency and liquidity strengthened since the global financial crisis. Central banks have more tools in place to support the sector and have shown a willingness to act quickly and decisively.
As discussed in point 4, we believe CRE exposure should be largely manageable for banks. However, a considerable chunk of this lies with non-banking financial institutions, including pension funds, private equity, credit and hedge fund managers, which tend to be less-well regulated.
These institutions have often picked up activities abandoned by banks given the impact of regulation. The The transfer of balance sheet risks – including books of life insurance policies and collateralised loan obligations1– to these institutions, and their increasing share of total financial assets, is a source of potential concern. Their rapid rise as lenders of private credit also warrants close monitoring, especially given the lack of publicly available data on such loans and default trends. Leverage, liquidity, and maturity mismatches at non-bank institutions could lead to vulnerabilities which could spread shocks to banks.
7. Public finances: a debt crisis (Low risk)
Developed market public debt to GDP levels are another potential source of concern as global growth slows. The latest projections from the Congressional Budget Office see the US debt-to-GDP ratio rising to 160% of GDP, and the deficit doubling to 10% of GDP by 2050 under current policies. In 2025, tax credits from the Inflation Reduction Act and the related healthcare budget are set to expire, as are several personal and corporate tax cuts enacted by Trump in 2017. The national debt will likely increase further to finance the continuation of one or the other.
This may generate some volatility in the US bond market. However, we view a US default as very unlikely. The interest rate on US debt is likely to remain below the economy’s growth rate, allowing some modest fiscal deficits to be sustainable. The starting level of taxes relative to GDP remains the lowest among G7 countries, meaning the US could raise taxes if concerns on its debt sustainability should escalate. In the euro area, debt dynamics and fiscal deficit projections are less worrisome, although debt levels are at historic post-war highs for Italy, France and Spain.
8. Public health: another pandemic (Low risk)
Four years after Covid, it is fair to worry about when the next pandemic will strike. A recent analysis of novel disease outbreaks over the last 400 years estimates that the probability of a pandemic with an impact similar to Covid-19 is around 2% in any given year. Statistically extreme events are therefore not as rare as we think. The increase in the world’s population, international travel, climate change, the destruction of animal habitats and an increase in human-animal interactions are major factors contributing to the increased risk of a new pandemic.
The number of potential pathogens is very large, with 26 virus families known to infect humans. Since 1900 all pandemics have been associated with either influenza or a coronavirus. But we should not underestimate the capacity of many other viral diseases to cause outbreaks. In the 21st century alone, there have been epidemics of SARS-CoV-1, MERS and Zika.
In summary, the known sources of risk in markets today are low to medium in our assessment. This comparatively favourable risk backdrop helps explain the current risk-on mood of financial markets.
Of course, history has shown time and again, however, that it is the unexpected developments – the ‘unknown unknowns’ – that wrong-foot markets. This is why we remain particularly vigilant to emerging sources of risk and continue to closely monitor those that are already on our radar.
1 Collateralised loan obligations are pools of loans packaged up as single securities
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