During her Congressional testimony, Fed Chair Janet Yellen painted a fairly bright picture of the US economy, stressing a rebound in consumer spending, which should allow the central bank to gradually raise short-term interest rates over the next few years. Investors were heartened to hear that message and drove stocks higher, with the Dow closing at a new all-time high after Yellen’s first day of testimony. What could undo this rosy picture? There are a number of risks to the US and global markets that persist, though three rise to the top of the list. Their existence does not mean that long-term investors should change their game plans, but they are a reminder to guard against complacency and to always approach investing with caution.
Federal Reserve: In her testimony, Yellen said, “We are watching inflation very carefully” because it remains so low. Previously central bankers have attributed the recent slow down in prices to transitory factors, but Yellen acknowledged that because “inflation has been running under our two percent objective [core inflation dropped to 1.4 percent year over year in May], that there could be more going on.”
Translation: The Fed is not so sure what the heck is going on and that lack of clarity might put the central bank at risk for allowing rates to stay too low for too long, which in turn might foster asset bubbles. As we know from the past decade, bubbles have a nasty way of popping.
Conversely, if the Fed, as well as the Bank of England, the European Central Bank and the Bank of China all move away from ultra-loose monetary policy too quickly, the combined effect could cause a global slowdown/recession or at least a stock and bond market sell-off. For a taste of what that could feel like, check out the performance of the bond market over the past few weeks.
Bonds: Much has been written about how the bond market could spark a stock sell off, because if bond prices go down and yields rise, investors might finally bail out of stocks and instead choose to invest in the bond market. What could make the bond market sell off? The easiest answer is that if global central banks are no longer creating massive demand in the market, prices will drop. Of course if bond yields rise because the economy is firming, then both the stock and bond markets should be fine.
Political Upheaval: Although politics has not impacted markets yet, a ratcheting up of anxiety and uncertainty might very well negatively impact them. That goes for the US, Great Britain and its Brexit negotiations with the European Union, as well as unforeseen events in the rest of the world (remember Greece?).