The four risks that could derail Wall Street and don’t forget the unexpected ‘cockroach’
Money continues to flood into AI with no signs of slowing. The prospect of lower US interest rates promises further momentum. Even as parts of the market show bubble-like characteristics, the rally seems unstoppable.
The S&P 500 is up more than 13 per cent this year, on top of the 23 per cent it notched up last year. Nasdaq is up 17 per cent. Australia’s gains are more modest, but still up a robust 10 per cent this year.
Yet Goldman Sachs chief executive David Solomon this week sounded a note of caution. While he felt good about the outlook, his investment bank was “especially vigilant” in times like these to identify risks.
“There is no question there’s a fair amount of investor exuberance at the moment,” Solomon told an investor briefing, adding a reminder that the market “operates in cycles”.
We’ve identified five key risks that could derail the party. To be clear, these aren’t forecasts or predictions – they’re an attempt to highlight where the probable threats come from.
The Australian’s Wealth Editor James Kirby, gave valuable input into the list.
Hot trade wars
This is the big macro risk. The most dangerous economic Cold War started heating up again this month, deflating Wall Street’s enthusiasm. Relations between China and US President Donald Trump will continue to drive the sentiment of markets and investment.
Global shares were hit when Trump last week threatened to slap an additional 100 per cent tariff on imports from China in retaliation for Beijing imposing tighter export controls on rare earths and critical minerals.
This would cripple both economies. China argues its export controls responded to US trade restrictions on Chinese companies.
The skirmish comes as China could be even more fragile than we think; US Treasury secretary Scott Bessent claims China is already in a recession, if not depression.
Trump has since cooled the temperature and markets: “Don’t worry … it will all be fine!” But investors are highly exposed and economic relations could deteriorate quickly.
Trump and Chinese Premier Xi Jinping are due for their first meeting in six years in South Korea on October 29 at the APEC forum. The stakes couldn’t be higher.
‘Credit cockroaches’
The world got its first real taste of a serious private credit shock with the collapse of two US car financing players that had significant linkages to Wall Street and private investment funds.
US auto parts supplier First Brands went bankrupt after amassing $US12bn in debt, mostly in off-balance sheet financing. Weeks earlier, subprime car financier and dealer Tricolor fell with a $US1.4bn debt exposure. Both had been able to expand rapidly through private credit funding.
Fallout was felt across Wall Street. JPMorgan took a $US170m hit on Tricolor, prompting chief executive Jamie Dimon to this week warn that more “cockroaches” would likely emerge from the private credit boom.
“When you see one cockroach, there are probably more. Everyone should be forewarned on this one,” he said of the credit cracks.
UBS was also exposed. Hardest hit has been Wall Street bank Jefferies, whose shares plunged 30 per cent since it confirmed an exposure to First Brands. Last week it disclosed a $US715m exposure. It’s a long way from being a Bear Stearns or Lehman Bros GFC-inducing moment, but it’s a reminder that private credit represents significant risks to the system.
The International Monetary Fund was the latest authority to issue warnings about growing linkages between private credit and banks, which could result in contagion risks or amplify shocks to the global financial system.
Even modest shocks in private credit could trigger rapid repricing of debt, putting more stress on corporate borrowers who have so far enjoyed cheap loans in a market characterised by easy access to financing.
BIS estimates the global private credit market at $US2.5 trillion, although not all private credit carries the same risk profile. The market here is estimated at about $200bn, largely made up of superannuation funds. Australia has had its own taste of pain from the $1bn in investor losses through First Guardian and Shield superannuation schemes.
Fed policy shift
Forget Australian interest rates – the real driver of markets is the US Federal Reserve. Currently, two more rate cuts are fully priced into the Fed’s upcoming meetings, scheduled for later this month and in December. Fed chair Jerome Powell has hinted at room to keep cutting, which should help spur a sluggish economy.
However, nagging doubts persist that US inflation hasn’t been tamed as the economy is running stronger than expected, driven by AI spending. Meanwhile, Trump’s immigration crackdown is causing supply squeezes in parts of the labour market, even as jobs growth continues to be sluggish elsewhere.
The big unknown is the impact of Trump’s tariffs, which are starting to push up consumer goods prices. It’s unclear how this will filter through the economy, or whether the increases will be a one-off or persistent.
The Fed’s 25-basis-point rate cut in September wasn’t a sure thing as several board members were reluctant to support the move. Any shift from the current expected path for US rates will trigger a dramatic sell-off in shares and investment.
Crypto Winter
Bitcoin, NFTs and all things crypto got a rude shock last week thanks to a mini crash. Bitcoin is now down 14 per cent, inching toward bear market territory.
Many are prepared to shrug it off. This is the nature of crypto, which is inherently volatile.
Since November and the election of crypto-friendly President Trump, bitcoin had surged 60 per cent, including several all-time highs. There’s a loose correlation between financial market liquidity and exuberance in crypto markets.
However if liquidity dries up, this could threaten another crypto winter like through 2022 and 2023. Except this time, any severe downturn could have an acute impact on consumer confidence as crypto is overwhelmingly held by retail investors. It could also have knock-on effects on the broader non-bank financial system.
As always, crypto is an asset that needs to be respected.
AI doesn’t deliver
AI is clearly the momentum trade, driving shares in the biggest names in tech and fuelling infrastructure spending. Combined, the largest US tech players have committed more than $400bn to AI infrastructure. Every week it breaks new ground.
This week the world’s largest asset manager, BlackRock, and three tech giants – Nvidia, Elon Musk’s xAI and Microsoft – acquired Macquarie Asset Management’s Aligned Data Centres for $40bn, with promises of a $100bn expansion.
Last month, chipmaker Nvidia committed $100bn to AI leader OpenAI. Sydney-based Nasdaq-listed data centre play NextDC has surged 500 per cent to be valued at more than $26bn.
Investors have tolerated this massive spending and likely long payback periods, betting on substantial productivity gains for the global economy.
There’s also a land grab for control of the market where the winner will take it all. Nvidia, whose powerful chips sit at the heart of the AI boomhas been propelled to become the biggest US company with a market cap of $US4.4 trillion.
Call the AI spend what you want, but the boom is increasingly drawing comparisons with the dotcom bubble – although this time the market and customers are clearer about the opportunity.
“But as students of history we know that following periods of broadbased excitement around new technologies, there will ultimately be divergence where some ventures thrive and others falter,” Solomon said this week.
The momentum is built on the idea that generative AI will be a game changer for productivity, allowing organisations to automate rudimentary, low-value tasks and focus on higher outcomes. Data will be leveraged at a scale never seen before. The next phase, agentic AI, promises even more, with serious implications for costs, including labour.
But what if it doesn’t deliver, or the returns are incremental and pushed much further into the future?
A recent MIT study examining AI’s impact in business found the revenue gains from businesses adopting the technology had been disappointing so far. The vast majority of those using AI applications were yet to see an impact on the bottom line.
This was enough to rattle tech stocks – briefly. The next Nvidia update quickly made everyone forget. US shares have added more than 6 per cent since the study was released in August.
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