A Risky Year in Global Markets Is Coming

Like many economists, I think timing the market is a pretty hopeless task. Buy-and-hold has been a reliable strategy for increasing wealth over the past several decades, so why waste a bunch of effort trying to predict something that, if markets are truly efficient, ought to be unpredictable? But once in a while I get a little antsy. Now is one of those times.

Looking forward into 2015, I see some worrying signs. It may seem odd to say that, with the world’s biggest economy having recently completed its best quarter since 2003. But the signs are there — and most of them are hiding in plain sight.

First, let’s consider the things that didn’t happen in 2014. The European Central Bank didn’t do enough to stop deflation in the eurozone. The Japanese economy wasn’t saved by Abenomics. Forecasters didn’t stop lowering their predictions for China’s growth. And two of the conflicts with the potential to disrupt the global economy, in Ukraine and Syria, didn’t wind down; from an economic perspective, they probably became even more dangerous.

In other words, none of the big risks that were present a year ago are any less formidable today. Now, the markets must also worry about the possibility of a Russian default, the resulting contagion spreading to other countries in the region (which may already have begun), and the spillover effects on the assets of emerging economies around the world. And I almost forgot: Argentina’s default went from “technical” to “disastrous” in just a few weeks.

To make matters worse, the markets will face a new challenge as this year begins. The prices of securities respond to supply and demand, as well as to changes in the values of their underlying assets. When oil and gas prices were high and East Asia was riding the Chinese boom, sovereign wealth funds plowed billions into the major investment markets. Slowing growth in China and lower commodity prices will cut this source of demand; the money that would have ended up in Chinese trade surpluses and petroleum profits may find other destinations instead.

There are potential hints at a coming downturn in the United States, too. Nobel laureate Robert Shiller’s ratio of share prices to historical earnings is close to where it was before the last crash, suggesting stocks may be inflated. Unconventional measures of sentiment are also replicating patterns that have preceded earlier dips in the markets. And the greatest harbinger of recession, higher interest rates, is arriving soon.

That last tip-off should be the least surprising of them all. Since September 2012, the Federal Reserve has been consistently signaling that it expected to raise short-term interest rates in mid-2015. The only question now is the exact timing. Three months on either side of June might make a difference to people who trade frequently, but for most investors the long-term implication will be the same: the beginning of the end of the boom. Recessions in the United States usually follow periods of high and rising short-term interest rates; when the economy dips, the Fed slashes rates as well.

How long until the United States enters recession? The last few cycles of economic growth have averaged 106 months from peak to peak, and this one is now 84 months old. A recession could begin any time in the next two years, and the other risks around the world may well accelerate its arrival.

If the United States slows down, the rest of the world will feel the pain as well. With China stumbling and the European Union still struggling to grow, the United States has lately been the main engine of the global economy. Lower demand among American consumers and businesses will be particularly bad news for the European Union, Canada, Mexico, and manufacturers in developing countries around the world, to say nothing of oil and gas exporters.

So will the markets plunge before the global economy loses its footing, or vice versa? In the past, stock markets have been leading indicators of the economy, which makes sense if share prices are based on future profits. But lately, there’s been a departure from this relationship. As I pointed out last year, this change is likely the result of companies receiving profits from countries around the world, not all of which have the same economic cycles. If all those economic cycles do line up as the world enters a period of slower growth, however, then the effect on the markets could be dramatic.

I’m not confident — or foolish — enough to predict exactly when the markets will drop, so I won’t be getting much credit or blame for my forecast. But I can offer one certainty, and one silver lining: As long as human beings continue to innovate and create valuable products, what goes down will go up again, reaching even greater heights.

VASILY MAXIMOV / AFP