World instability one of the five risks threatening to end the hot run of sharemarkets

An Israeli missile hits an area in the southern Gaza Strip. The broadening of the conflict to involve Iran has major ramifications for markets. Picture: AP

The Nasdaq index year to date is up in excess of 22 per cent, the S&P 500 is not far behind and the Dow Jones is up by 13.73 per cent, ex-dividends.

In Australia, the local market, including dividends, has returned nearly 10 per cent year to date. Many gains from individual equities have been multiple times larger.

Can we trust our fellow investors to stay “confident” and “relaxed” when the proverbial hits the fan?

It used to be general market wisdom that “bad things tend to happen when markets trade on elevated valuations”, but it has been a while since I heard anyone referencing it.

Markets have been strong, for sure, and overall volatility has remained low. Outside of Australian banks and the occasional hyped-up growth story, there hasn’t been too much around to genuinely worry markets.

For every profit warning that came out of nowhere, like Web Travel Group’s (WEB) on Monday, there are equally as many solid business stories around that offer lots of promise and upside.

Appeased by central bank rate cuts, and the promise of a brave new world on the back of megatrends generative Ai, GLP-1s and others, markets have firmly kept their focus on the positives.

Let’s assume, for our own general risk assessment, that bad news does tend to happen when markets only take into account the positives from the future on the assumption that no interruptions will occur.

Here are the five key risks are there we can identify:

● I suspect the immediate threat to current tranquillity resides within the Israeli war with Iran and its neighbouring proxies.

Thus far, US president Joe Biden has managed to prevent direct Israeli attacks on Iranian oil infrastructure, but general sentiment inside the US capital is that Biden’s influence seems to be waning.

A fresh update from analysts at RBC Capital concludes that “there is an expectation in Washington that Israel will indeed launch a major strike that will cause substantial damage”.

If correct, I worry Iran will equally retaliate with force. Markets will have to price in the risk of broad escalation in the region.

“While administration officials hope that Iran will opt for a more calibrated counteraction to enable an offramp, the Iranian leadership is not expected to sit on its hands and do nothing,” RBC Capital says.

“We believe that there is a corner of the market that will hit the sell button on any sign that Israel is taking a pass on hitting Iranian oil facilities, and wind the clock back by several weeks.

● I am not a political expert, but could a spike in hostilities between Israel and Iran turn into the much talked about “October surprise” that turns US election momentum decisively in favour of a second Trump presidency?

In that case, markets’ focus will turn to the most obvious intentions that have been expressed; the slapping of import tariffs as high as 60 per cent on Chinese products. Yes, there will likely be corporate tax cuts too, but those require procedure and time, while the promise is for tariffs to be applied from day one of the new Trump administration.

Right now, Wall Street has quietly accepted a win by Kamala Harris, and a divided congress the most likely outcome – and it is considered the least disruptive scenario too. But that’s assuming a non-favourable outcome won’t be challenged by Donald Trump and his loyal base, which I think is a plausible scenario.

● The US economy might escape recession this year and in 2025, but global momentum is still on a downward-sloping trajectory, also emphasised by ongoing sluggish momentum for the economy in China. This has weighed down commodity prices and share prices for the likes of BHP and Rio Tinto.

September witnessed a rapid turnaround when China indicated fresh stimulus measures will be announced to pull GDP growth up to the government-targeted 5 per cent. But that early enthusiasm is very much dependent on Chinese authorities’ ability to sustain investor confidence that all shall be rosy in the end.

● Economic disappointment in the US and/or in China is by no means off the table. A great deal of next year’s corporate profit forecasts relies on strong margins as much as it depends on robust economic momentum.

While high valuations in 2024 can be justified on those projections, needless to say they are still projections and any changes in underlying dynamics can have material consequences. One added positive (which hopefully remains just that) is next year’s margins should see the early impacts from businesses incorporating Gen AI (generative artificial intelligence).

Recent research by analysts at UBS has found virtually all of the corporate margin improvement in the US to date has come from interest rate cuts, lower taxes and technology companies. UBS struggles to find cyclicals “attractive” but also notes most of the time cyclicals and markets move in the same direction.

The Q3 reporting season in the US has only just started. Its importance in the current context can hardly be overstated.

● This final risk is of a completely different nature; it’s the melt-up that occurs after central banks have been forced to inject even more liquidity in markets. A co-ordinated policy loosening by China and the US could well provide such a trigger, analysts at UBS have suggested.

Putting it all together, and without any need for panic or outsized adjustments, the FNArena/Vested Equities All-Weather Model Portfolio is lifting its allocation to cash on the sideline where it can wait for further developments and be reallocated when opportunities start opening up.

In line with the philosophy behind this portfolio, exposure includes defensives including CSL, Woolworths and Telstra, also with a skew towards larger-cap companies, as well as gold.

Rudi Filapek-Vandyck is editor at the share market research service FN Arena