As I wrote in my last article, the contraction of the U.S. economy in the 4th quarter of 2012 could be the start of another recession. With automatic budget cuts expected on March 1st, the S&P 500 (SPY) is in a precarious position. The budget cuts could lead to additional economic contraction, which would in turn further hurt our deficits issues by increasing government payouts in the form of unemployment and welfare, while reducing tax receipts.
In a previous article I wrote about what I saw to be the main risks facing the stock market within the U.S.: Inflation, regulation and problems with deficit reduction (which is just now manifesting itself with the sequestration debacle.) In this article I will be identifying what I see as the two main risk factors that the market is facing outside of the U.S. Even if Obama and Congress can work together to kick the can of deficit reduction down the road again, investors should be wary of the relief rally that would follow, as we are still facing two major risk factors that are out of the control of the U.S.
Iran: With Benjamin Netanyahu's coalition retaining control of the parliament, it seems likely that 'Bibi' will retain his position as Prime Minister for another term. While we haven't heard much about a potential strike against Iran since the U.S. presidential election (where a Romney presidency would've increased the chance of military action), the risk is still there.
While it is unlikely that Obama would support an Israeli strike on Iranian nuclear facilities, it is not too difficult to imagine Netanyahu executing a surprise attack without running it past the U.S., especially if he is feeling emboldened after winning another term as Prime Minister. Considering "extended closure of the strait [of Hormuz] would remove roughly a quarter of the world's oil from the market", any military action against Iran would have devastating effects on the world economy.
Such a strike would lead to a spike in fuel prices, which would hurt consumption in the U.S. An increase in fuel prices would lead to businesses and households cutting back on spending, which would result in a general slowdown in growth worldwide. As demonstrated in the financial crisis, our economy is unprepared for 'black-swan' events of this nature, as businesses tend to be too optimistic about their future prospects.
Europe: Despite the IMF issuing a paper detailing the problems associated with strict austerity during a recession (mainly due to the increased fiscal multiplier present during cyclical downturns in the business cycle), advocates for austerity have continued preaching the doctrine of tax increases and spending cuts. With growth rates slowing down (and even contracting in the case of the U.K.) and competitiveness falling due to a Euro that has strengthened against the dollar since its 2010 low, investors should be worried.
Any problems in the Eurozone would hurt bondholders as investors' confidence in the solvency of the monetary union would be shaken. Recent comments made by British Prime Minister David Cameron questioning the U.K.'s place in the European Union delegitimize its authority. In addition, recent defeats in the Lower Saxony section of Germany put Chancellor Angela Merkel and her political party in a more precarious position. The defeat of Merkel in September could usher in a more liberal Chancellor who might not be as dedicated to the European Union as Merkel, which would be one more possible risk factor within Europe.
Problems in Europe become problems for the U.S., as we still depend on each other enough that a slowdown across the Atlantic would hurt our economic growth. Such a slowdown could lead to a recession in the U.S., which would trigger a negative-feedback loop across the world, resulting in further economic contraction and rising unemployment.
Due to the risks posed by Iran and Europe (among others), I consider the S&P 500 to be over-valued presently. These two factors have fallen to the back of people's mind, but still remain.