At this moment, economic conditions are favorable for stocks, but markets could get derailed by four different factors. This is according to hedge fund billionaire Daniel Loeb, the founder of Third Point LLC.
Third Point typically takes a bottom-up and fundamental approach to picking stocks, but the fund does pay attention to global market dynamics. For now, it’s Loeb’s view that the economy will remain strong and stock prices will move modestly higher.
“We believe the risk of recession in the next year remains low”
“[Our] view of the current economic backdrop is: 1) US growth will remain buoyed at a high level due to fiscal stimulus impulse from spending increases coming into the system. Barring an escalation of trade conflict, most of the deceleration in the global manufacturing cycle is likely behind us; 2) inflation has remained stable in the first half of the year, with little sign of impending acceleration, despite a record low unemployment rate; 3) the cycle can extend longer than people think as companies are in good shape, particularly in the US, and the consumer is wrong while carrying only modest debt levels; and 4) equities are not expensive at 16x forward earnings,” Loeb wrote in a letter to investors. “We believe the risk of recession in the next year remains low and, without this concern weighing heavily on the markets and with the tailwinds we have described, we believe equities should go higher but at a moderate pace.”
While a recession isn’t expected in the next year, Loeb recognizes that “the calculus is more fragile than a year ago.” Specifically, the risk is that the Federal Reserve could “kill the patient” with aggressive rate hikes.
“If the Fed continues at its current pace, it will have tightened by ~3% (or even ~4% if one includes its roll-off of quantitative easing measures) by the end of 2019. Tightening of that magnitude has always resulted in recession. While we believe this well-seasoned Fed understands exactly the tightrope it is walking, the risk of destruction action is not zero.”
It’s not just the Fed putting markets at risk
Of course, the Fed isn’t the only thing that could derail the market. Loeb gave a laundry list of risks.
“[Markets] could be upset by several factors, including: 1) an escalating trade war. At this point, we are not concerned about the impact on the economy from the current tariff tit-for-tat, but an out-of-control battle could inject fear and caution into the markets. More important, and less well-understood, is that a trade war threatens the margin structure of the S&P500. Since 2000, 100% of margin expansion has been driven by manufacturers (e.g. technology, capital goods, etc.) We estimate that global value chains have driven between one-quarter and one-third of this expansion. thus, a trade war that results in substantial increase in labor costs or even disruption to the current system could meaningfully reduce a key element of corporate profitability; 2) any growth acceleration will be less strong in 2017 and is likely to be concentrated in the US, an unfavorable comparison to the previous year that may encourage pessimism; and 3) increasing signs of inflation, given the tight labor market.”
“We see parallels between PayPal and other best‐in‐class internet platforms like Netflix and Amazon: High and rising market share, untapped pricing power, and significant margin expansion potential,” he said in the letter.
Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.