Summary

We see five serious dangers to markets, and each of these could strike pretty soon.

A trade escalation, the first innings of what could be a more general emerging market crisis, is joined by three big unfolding problems in Europe.

There is a high probability Brexit will be botched, Italy's new budget could quite easily trigger a confidence crisis and a new refugee crisis looms.

We'll be lucky if we escape all five of these potential crisis. What makes the situation particularly dangerous is that they can infect one another.

There are always risks to stocks and financial markets, so perhaps you should not get too intimidated by the five risks that we'll briefly describe below. They are all pretty well-known anyway, although we don't think there are many who would argue they are priced in.

What makes the situation particularly dangerous, in our view, is that escalation in one of these five increases the likelihood of others playing out as well. It will be pretty hard to evade all five. And all this is happening when Citi Group's stock sentiment has just hit euphoria levels:

It can be seen in the graph above that euphoria is usually followed by below-average returns.

Endgame in Idlib

We are not going to expand on the geostrategic implications, but Russia, Iran and, of course, Syria's Assad are ready to go on the offensive on the last rebel holdout in Syria, Idlib, on the border with Turkey.

A summit between Iran, Turkey and Russia solved nothing, with Turkey's Erdogan pleading for a ceasefire. The 15,000 or so rebel fighters are trapped, and so are 3 million people. A human tragedy is in the making.

What has this to do with your stocks, you might wonder? Well, in this interconnected world, everything is connected to everything, basically. What is likely to happen is that the Russian and Syrian government forces will unleash a terrible offensive, which could move hundreds of thousands of refugees into Turkey, if not a couple of million.

Turkey already houses something like 3 million Syrian refugees. In 2015, it let many of them pass to the EU, which unleashed a political firestorm there, propelling a populist backlash in a host of EU countries.

The EU desperately tried to organize this in an ordinary fashion, but multiple countries (especially new members in the East) didn't play ball, and the EU bought off Erdogan's Turkey instead. That worked, by and large.

But now, things on the ground are changing:

  • Turkey's economy was booming in 2015, but it's now teetering on the brink of an abyss.
  • There are potentially up to 3 million new refugees arriving in Turkey.
  • Turkey's relationship with the US has worsened tremendously.

Here is the risk: Because of its teetering economy, Turkey cannot afford to take in another new refugee wave, and it's likely they will let many of them pass to Europe again. This will revive the refugee crisis and the populist backlash, threatening to weaken the EU even national governments - something which many argue is deliberate Russian policy.

And the backdrop in the EU itself is bad, with two other potential crisis that could play out in short order, to which we now turn.

Brexit

UK's Prime Minister Theresa May has a plan (the so-called Chequers plan), but without going into details, there are multiple problems with that:

  • A large minority of her own party doesn't support the plan.
  • There is likely no parliamentary majority to back the plan.
  • The EU doesn't support the plan.
  • That is, May has to compromise with the EU, but the more she compromises with the EU, the less likely she will be able to get it through her own parliament (which is already rather unlikely as it is).

Britain is supposed to leave the EU by next March, thus, some sort of agreement has to be on the table this autumn. The odds of that happening are pretty remote. Which increases the odds that Britain will crash out of the EU without any deal, and the economic disruption that causes will be substantial. This warrants an exclusive article - we'll just give you a couple of points:

  • Out of the customs union, making border inspections once again a necessity, and supply chains will suddenly rupture as parts are hit by delays (and/or tariffs).
  • Financial services automatically lose their passporting rights, which will hit London as a financial center pretty hard.

Here are some assessments from The Rand Corporation:

Nearly all the possible trading relationships between Britain and the European Union following Brexit would be less favourable than staying in the European Union, according to an influential US think tank. The Rand Corporation study said the worst option would be a "no deal". That would leave the UK economy 4.9% poorer by 2029. "No deal" would also have a negative effect on the EU economy, but it would be "relatively minor". The report said that even a "soft Brexit" involving staying in the free market would not be as positive economically as staying in the EU.

(Source: BBC)

Or Amazon:

Amazon made a bleak prediction about Brexit in a behind-closed-doors meeting with the UK government last Friday, according to The Times. Douglas Gurr, Amazon's UK country manager, told a meeting of business leaders that if Britain crashes out of the European Union without a trade deal, it will spark "civil unrest" within two weeks. The meeting was convened by Brexit Secretary Dominic Raab, and The Times said Gurr's comments "stunned those present," with some disagreeing with his assessment... It would mean the country crashes out of Europe on World Trade Organization terms, which could create chaos in terms of Britain's food and medicine supplies, as well as people's ability to travel to countries in Europe by plane.

(Source: Business Insider)

This might seem over the top, but to the people not familiar with the material (all the arcane regulations and treaties that the UK shares with the EU through its membership), we urge you to consult the list from Prospect Magazine.

That is, overnight Britain will crash out of stuff like the Common Fisheries Policy, the Common Agricultural Policy, Euratom, the Single Energy Market, European Medicines Agency, European Arrest Warrant, Common Foreign and Security Policy and dozens of others with unknown legal and economic consequences. In many cases, it will create a giant legal limbo.

The potential disruption will cut both ways - the EU, and especially parts which are most exposed (Flanders, Rotterdam port, etc.), will suffer significant consequences.

Italy's budget

We have already written a lot (here and here, for instance) about this situation, so we will be brief about something that in our view remains one of the most serious threats to the world economy. In summary:

  • Italy's public finances (130%+ of GDP) are dire, as they're effectively denominated in a foreign currency.
  • The new populist government has promised a reflationary program of some 7% of GDP (guaranteed income, flat tax, infrastructure bonanza, scrapping a pension reform, not going through with a planned VAT increase). Even a fraction of this could alarm the debt markets and lead Italian bond yields spiraling out of control.
  • Even a fraction of the proposed measures would set Italy against EU budget rules and therefore neutralize the EU defense mechanisms to deal with the situation, should bond yields threaten to spiral out of control (stuff like the EMS, ECB buying Italian bonds through the Outright Monetary Transactions, etc.).
  • This comes against the backdrop of the ECB ending its bond buying program in December, which in itself is likely to increase the Italian-German spread.
  • Italian banks are big holders of Italian debt and are already plagued by bad loans.
  • The potential for contagion to other eurozone economies is large.

The choice is either Italy forgetting its reflationary proposals, that is, betraying its electorate, or risking a market crisis and confrontation with the rest of the eurozone that can easily spiral out of control.

Even with a more conventional government, there is no guarantee that Italy will not derail sooner or later. We have not tired in pointing out that Italy's debt/GDP ratio hasn't improved during the years with economic tailwinds and ECB bond buying.

All it takes is another economic downturn for this ratio to ratchet upwards again, and where the market tolerance lies we really don't like to find out.

But we agree, we've cried wolf perhaps once too often with respect to Italy. So, if you don't want to take it from us, take it from:

Emerging Markets

The wider international climate also contains elements of grave concern. The more the US economy and its stock market keeps on growing and unemployment falling, the more inflation is creeping up and the more the Fed and the bond markets are going to raise US interest rates and the stronger the dollar is likely to become.

Basically, the better the order at home, the greater the potential for chaos abroad, as many emerging markets have a large amount of dollar-denominated debt outstanding, from Argentina (public debt) to Turkey (private and bank debt), and now a host of other emerging markets, like South Africa, Indonesia, Philippines, Brazil and even India, are coming in the crosshairs.

Contagion works through currency and financial markets and banks at first, followed by trade flows and real economic growth.

A good deal depends on whether the Fed sees itself as a "US-first" institution only or as the de-facto liquidity providing bank for most of the world. Whatever its view, continuing good economic data out of the US itself can simply force its hand, whatever the consequences in EM-land.

Trade

Then, there is the escalating trade war with a host of countries, but most notably with China, as that's the one that bears the most significant consequences. Again, we'll be brief, as we've written more extensively about it previously here.

We've been highly critical of Trump's zero-sum game approach to trade (see, for instance, here and here), and we're not the only ones (see, for instance, here and here). Here is former chief economic adviser Gary Cohn:

"Several times [chief economic adviser Gary] Cohn just asked the president, 'Why do you have these views [on trade]?' 'I just do,' Trump replied. 'I've had these views for 30 years.' 'That doesn't mean they're right,' Cohn said. 'I had the view for 15 years I could play professional football. It doesn't mean I was right.'"

(Source: Esquire)

Basic trade theory, what causes trade deficits and surpluses and how much they matter (or not), whether a trade war can be "won," let alone the intricacies of complex international supply networks or even the correct trade balance figures, are wasted on the president (and we've all covered that in previous articles, especially here).

To the contrary, he is liable to double down, promising tariffs on another $200 billion of Chinese goods and then another $267 billion worth of Chinese imports - basically covering all Chinese exports to the US.

As US economic figures have come in strong and the stock market recovered from its February lows, Trump is likely to feel emboldened, especially as China's markets and its currency have tanked. Some of the implications:

  • US and world economic growth will slow down, and millions of jobs will be lost. Retaliation alone threatens 11 million US jobs.
  • Tariffs are taxes on US consumers and producers, i.e., US inflation is going to increase, which could very well lead to higher interest rates and a higher dollar.
  • The higher interest rates, a higher dollar and lower growth will potentially worsen the EM crisis.
  • It might unleash, or force, China into a more robust depreciation of its currency, which could have dire consequences for world economic growth.

While China has certainly been a trade violator in the past, specialists in the field argue that it has considerably cleaned up its act, and in fact, the country's trade surplus has shrunk enormously since the financial crisis:

In fact, it even swung into deficit in H1 2018, the first in 20 years.

Conclusion

US equity prices are now quite detached from most equities abroad and keep on rallying, entering euphoria territory, according to some. This is understandable given a stellar earnings season and large buybacks, but how long the US can remain in blissful isolation from the deteriorating picture and increasing risks abroad remains to be seen.

The most immediate threat is the trade front with China. If the proposed tariff on $200 billion of Chinese imports gets ahead, this is in quite a different league compared to what has been going on so far.

There will be numerous companies affected, with their stocks taking an immediate hit, and sentiment will take down many others. Then, there will be a Chinese retaliation, hitting more US companies. The turn in sentiment itself could be enough to make investors flee to save haven investments, the most prominent of which will be the US dollar.

With a higher dollar and the prospect of lower world economic growth, the EM crisis could get into a next phase where the contagion spreads and some countries are getting into serious trouble.

Then we have Europe, where any renewed refugee crisis, a botched Brexit or, especially, an Italian budget which lacks market credibility and puts it on a collision course with the rest of the eurozone could quickly alter sentiment first, followed by a slower deterioration of economic conditions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.