Bank of America: The Nine "Black Swans" of 2024

In 2023, the US stock market had a remarkable year, defying the most aggressive interest rate hike cycle in decades. The predicted economic recession and market crash by the bears did not materialize.

On the contrary, fueled by expectations of interest rate cuts and a soft landing, the US stock market saw eight consecutive weeks of gains on a weekly basis. The "Santa Claus rally" during the holiday season continued, with the S&P 500 index rising over 24% year-to-date and the Nasdaq soaring by a staggering 44%.

However, looking ahead to 2024, Bank of America believes that beneath the seemingly celebratory surface of the US stock market, there are still hidden risks. The market may face nine major downward risks next year:

Risk 1: The Federal Reserve ends its tightening measures too early, leading to a resurgence of inflation. The loose financial conditions in the US, which have been the most accommodative since May 2022, may trigger another rise in inflation, forcing the Federal Reserve to turn hawkish again. This would be equivalent to dropping a nuclear bomb on the US stock market.

Risk 2: Excessive optimism in believing that the economy can fully recover to pre-pandemic levels. While economic data and interest rates indicate a post-pandemic landscape, other markets, such as foreign exchange, certain stocks, and credit markets, have already priced in the belief that the US has returned to pre-pandemic days. Overly optimistic expectations themselves pose a risk.

Risk 3: The lagging impact of higher interest rates. The volatility of equity assets lags behind short-term interest rates by approximately two years. The impact of the Federal Reserve's interest rate hikes has not fully materialized yet.

Risk 4: Higher interest rates affecting the junk bond market. The increase in interest expenses may have spillover effects, leading to a reduction in corporate capital expenditures. Additionally, the peak of junk bond maturities may trigger a wave of corporate defaults.

Risk 5: The US falling into an economic recession. Just like the boy who cried wolf, when investors no longer believe in a recession, it may be just around the corner.

Risk 6: The bursting of the tech stock bubble. Similar to the bubble of the 1970s, the valuations of tech giants are now too high, and the market concentration of the overall market is excessively high.

Risk 7: Geopolitical conflicts. In addition to uncertainty affecting investor confidence, the escalation of geopolitical tensions may slow down or reverse the inflationary downturn in 2023.

Risk 8: The resurgence of sovereign debt crises. Some economies, including the United States and Italy, are on an unsustainable fiscal trajectory, especially considering the persistently high interest rates. This may increase market volatility and impact stock markets.

Risk 9: Zero-day options triggering volatility doomsday. Some investors are shorting zero-day options, similar to the "Volmageddon" in February 2018 that caused a market crash. This scenario may repeat itself.

Risk 1: The Federal Reserve ends its tightening measures too early, leading to a resurgence of inflation

The Federal Reserve has previously made serious judgment errors in 2020 and 2021. After the COVID-19 pandemic evolved into a global outbreak, the Fed implemented zero interest rates and unlimited quantitative easing. As a result, the prolonged accommodative policy led to an overheated US economy. By the time the Fed started raising interest rates, it was already too late. By 2022, US CPI inflation had reached 8% to 9%, while the federal funds rate remained at 2.25% to 2.50%. The Federal Reserve was severely lagging behind the market curve. And now, the situation may be similar, and the timing of the Fed's shift to easing may be wrong again.

Bank of America analysts wrote:

"As the market increasingly believes that the Fed has completed its rate hikes, especially after the release of the October CPI report, an obvious risk will be the unexpected reacceleration of inflation or difficulty in cooling it down, ultimately leading to another round of rate hikes by the Fed."

Financial blog ZeroHedge pointed out that US financial conditions are currently at their most accommodative since May 2022, and loose financial conditions could trigger another rise in inflation, forcing the Fed to turn hawkish again, which would be like dropping a nuclear bomb on the US stock market.

Risk 2: Over-optimism, believing that the economy can recover to pre-pandemic levels

After 8 weeks of strong rebound, the market's belief in the US economy has become increasingly optimistic. Bank of America pointed out that the stock market rebound implies that the market has priced in the Fed's quiet end to rate hikes, and the US is returning to a stable low inflation environment similar to pre-pandemic times.

Analysts emphasized that although economic data and interest rates indicate a post-pandemic landscape, other markets (such as foreign exchange, some stocks, and credit markets) are pricing in the idea that the US has already returned to pre-pandemic days.

Analysts believe that this kind of thinking may be too optimistic. Overly optimistic expectations themselves are a risk.

Risk 3: Lagging impact of higher interest rates

Another major risk is that the market has overestimated the progress of the Fed's easing, and the impact of higher interest rates lasts longer than expected.

Bank of America stated that research since 2005 has shown that the volatility of equity assets lags behind short-term interest rates by about 2 years. Analysts pointed out that the lagging relationship between equity asset volatility and interest rates, first discovered nearly 20 years ago, has never been invalidated and still holds true today.

In other words, the impact of Fed rate hikes on the stock market has not really started to ferment yet. With the Fed starting rate hikes in 2022 and expected to start cutting rates in 2024, volatility will rise in 2024 and peak in 2026.

Risk 4: High interest rates affecting the junk bond market

Bank of America pointed out that by 2026, over $600 billion of high-yield bonds will mature globally, accounting for nearly one-third of the global market.

Affected by rate hikes, these soon-to-mature junk bonds will have to pay higher yields. The yield on high-yield bonds is currently around 9%, more than double what it was two years ago. At the same time, a large amount of debt will mature in the coming years.

According to S&P Global Ratings, the issuance of junk bonds reached $1.2 trillion in 2021, but only about $200 billion will mature in 2023. However, in 2026 and 2027, a large number of junk bonds will mature. The increase in interest expenses may have a spillover effect, leading to a decrease in corporate capital expenditures. At the same time, the peak of junk bond maturities may also trigger a wave of corporate defaults.

Risk 5: The United States falls into an economic recession

With the aggressive rate hikes by the Federal Reserve, whether the US economy can avoid a recession has been a mystery in the market this year.

However, as the US economic data continues to show strong performance, the possibility of a soft landing seems to be increasing, and the market has gradually put the recession narrative behind.

Bank of America warns:

Just like the boy who cried wolf, when investors no longer believe in a recession, it comes.

Analysts say that looking back at the market performance of the past 100 years, once a recession occurs, it will bring devastating blows to the market and it is difficult to foresee in advance. As shown in the chart below, 81% of losses in sell-offs related to economic recessions occurred during the actual recession period.

Risk 6: Bursting of the tech stock bubble

In 2023, driven by the AI boom, the seven leading tech stocks that led the US stock market had a brilliant year.

Apple, Amazon, Alphabet, Meta, Microsoft, NVIDIA, and Tesla have an average increase of 112% so far this year, creating $5.2 trillion in new market value.

The concentration of the overall market is at a historical high. Currently, the concentration of the largest 100 stocks in the S&P 500 index is close to a 30-year high.

Bank of America analysts wrote:

Artificial intelligence will undoubtedly have a profound impact on economic productivity, but the same can be said for the invention of personal computers and the internet. History has shown that the initial euphoric reaction is often misguided, and the bubble will fade away with the recession and the emergence of the ultimate winners. The dot-com bubble in the 1970s taught us the importance of valuation - the seven giants are already too expensive.

Bank of America believes that the bursting of the seven giants' bubble may trigger a market collapse. The bank suggests buying S&P put options to hedge against the downside risk of tech stocks.

Risk 7: Geopolitical crises

In Bank of America's Global Fund Manager Survey released in November, most institutions listed geopolitical crises as the biggest downside risk to the market next year. The ongoing conflicts between Russia and Ukraine, as well as between Israel and Palestine, have already had a significant negative impact on the global economy. The recent disruption of the Red Sea shipping route due to the Israel-Palestine conflict may further push global inflation higher.

Bank of America points out:

In addition to uncertainty affecting investor confidence, the escalation of geopolitical tensions may slow down or reverse the downward trend of inflation in 2023. This could once again constrain central bank governors.

Risk 8: Sovereign debt crisis resurfaces

In November, international credit rating agency Moody's announced that due to the continued rise in US interest rates and the intensification of political polarization in the US Congress, the agency decided to downgrade the outlook for the US sovereign credit rating from "stable" to "negative." Sovereign credit risk has resurfaced.

It is obvious that a development path supported by high deficits is destined to be unsustainable. Bank of America points out that a healthy fiscal path refers to a country's debt-to-GDP ratio remaining stable or decreasing over time. However, some economies, including the United States and Italy, are on an unsustainable fiscal trajectory, especially considering the persistently high interest rates.

If sovereign credit risk erupts again, it will also have a detrimental impact on the stock market and increase volatility.

Risk 9: Zero-day options trigger volatility doomsday

Zero-day options (0DTE) are options products that have less than 24 hours until expiration. They provide investors with a way to hedge short-term risks and make short-term bets, allowing retail investors to make large bets with small amounts of capital. It is a high-risk investment tool known as "picking up coins in front of a steamroller."

Wallstreetcn previously pointed out that trading volume of zero-day options has been hitting new historical highs and recently accounted for half of all S&P 500 index options trading volume.

There has been ongoing debate about the dangers of zero-day options in the market. Bank of America points out that even just people's fear can turn into bigger risks. It is speculated that some investors are shorting zero-day options, and a "volatility doomsday" similar to the one that caused a market crash in February 2018, known as "Volmageddon," may happen again.

In February 2018, a fund tracking volatility was sold off as the market fell close to the redemption line. This crisis led to a sharp decline in the Dow Jones Industrial Average and the S&P 500 index, known as "Volmageddon" in the market.

However, analysts believe that in reality, the scale of zero-day options on the S&P 500 remains well balanced.

A comprehensive analysis of ETF positions shows that despite the large trading volume, zero-day options trading on the S&P 500 has remained well balanced - not overwhelmed by sellers or buyers.

Nevertheless, one potential risk we see is that over time, some investors may start adopting large-scale one-sided zero-day options strategies or "weaponize" zero-day options to chase significant gains or declines, leading to significant position imbalances. Especially the latter, the unpredictable liquidity of zero-date options changes may trigger investor liquidation and affect market makers who provide such products.