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Here are the top 10 biggest market risks right now: Wells Fargo

The S&P 500 (^GSPC) has marked a 100% gain since its March 23, 2020, closing low of 2,237.40, closing at 4,479.71 this past Monday. Amid this bull market for equities, however, a recently published State of the Markets report by Wells Fargo (WFC) Investment Institute (WFII) President Darrell L. Cronk lists 10 current risks that could pose a threat to markets and create the “possibility of a near-term correction.”

“It is often said that bull markets climb a wall of worry, and today, there are many bricks stacked in that wall,” the report reads.

Here is WFII’s top 10 list of market risks along with its assessment of whether the risk will fade, should be closely followed, or should be feared:

1. Inflation: The inflation risk continues to remain at the top of investors’ minds going into the fall season, with some experts even warning of the risk of stagflation in 2022. The Fed continues to reassure the country that the current levels of record core inflation remain “transitory” as supply constraints and the rapid pandemic recovery have lifted prices significantly, especially in areas like housing and consumer durables. WFII believes this should be followed.

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2. Delta variant: The Delta variant of COVID-19 is a growing health concern and appears to be slowing spending in key areas such as air travel and retail. However, the number of deaths compared to positive cases remains relatively muted. WFII believes “the economic consequences are likely to be contained given progress on vaccinations across major economies.” WFII believes this will fade economically, but should be followed from a health standpoint.

3. Debt ceiling: Congress is set to have a busy fall season, with the bipartisan infrastructure bill currently running on a parallel track to the budget reconciliation, which may amount, in total, to over $2 trillion in new spending. As the country has reached its $28.5 trillion cap, Congress will also need to face the debt ceiling by mid-to-late fall. WFII expects some “white-knuckle policy moments in September'' due to the fiscal 2022 budget lacking an attached debt ceiling resolution. WFII believes this should be followed, trending towards fear.

4. Everything peaking: Amid headlines warning of peaks in metrics such as GDP, growth, fiscal spending, and liquidity, a concern that investors may have is that the music will soon come to an end. Ultimately, WFII remains unconcerned for three main reasons: It believes many of these metrics will “remain at multi-decade high levels for some time to come,” the market has already priced in this news accordingly, and because the global inventory collapse is “unprecedented outside of a recession,” and may even generate a boost to growth in the long run. WFII believes this will fade.

5. Fed tapering: In a CNBC interview last week, Dallas Fed President Robert Kaplan announced that the Fed will release its tapering plan in September.

“Let’s be clear, with the U.S. experiencing the fastest nominal GDP growth since the 1950s and what looks to be the best ever S&P 500 earnings beats on record, we agree that it is time to begin removing emergency monetary policy,” the report reads.

Although WFII believes that the taper itself may be less consequential due to the general consensus that it is indeed on the horizon, the timing of the taper will cause a repricing of the path that the federal funds rate takes and it is this that markets care the most about. WFII believes this should be followed.

Federal Reserve Board chairman Jerome Powell testifies on the Federal Reserve's response to the coronavirus pandemic during a House Oversight and Reform Select Subcommittee on the Coronavirus hearing on Capitol Hill in Washington, Tuesday,  June 22, 2021. (Graeme Jennings/Pool via AP)
Federal Reserve Board chairman Jerome Powell testifies on the Federal Reserve's response to the coronavirus pandemic during a House Oversight and Reform Select Subcommittee on the Coronavirus hearing on Capitol Hill in Washington, Tuesday, June 22, 2021. (Graeme Jennings/Pool via AP)

6. Tax increases: The aforementioned infrastructure bill and budget reconciliation has coincided with the largest tax increase proposal since 1968, according to WFII. Treasury Secretary Janet Yellen holds the view that the Biden administration’s spending plans are “fiscally responsible,” with the coming tax hikes targeting the wealthy and corporations.

“Our base case is that top-tier individual income tax rates revert back to pre-2017 levels, corporate income taxes get reset to 25% or 26% (from a 21% effective level), and capital gains rates land in the upper 20% range after intense negotiations,” the report reads. “Anything higher than these levels would be market negative, in our view.” WFII believes this should be feared.

7. Equity valuation and rotation: As earnings growth has outpaced price appreciation over the past several quarters, WFII believes many analysts on Wall Street are lagging behind when it comes to updating their earnings estimates. However, the real story of 2021, WFII argues, is the “style rotation” seen in the market.

“The shift toward cyclicals, then to growth, and then to bond proxies and back again has left many managers scrambling to keep up,” the report reads. “We believe positioning should remain tilted toward cyclicals as early-cycle dynamics continue to reign supreme into the back half of 2021.” WFII believes this risk will fade.

8. China slowdown and crackdown: China’s increasing regulatory pressure on corporations, in conjunction with its credit slowdown (which placed a drag on second-quarter growth) serves as one of the biggest headwinds coming out of Asia and emerging market equities. The risk/reward ratio for Chinese securities looks to be turning “more positive,” WFII said, following the large market correction caused by investors demanding a higher risk premium. WFII believes this should be followed.

9. Complacency: Although WFII said that complacency always remains a concern to markets, it can be difficult to time and measure. In their current view, the risk of being too bullish on future outlooks remains greater than becoming too complacent regarding emerging risks. While fiscal support of the economy and markets will begin to fade within the next year, WFII believes capital markets “may be underestimating the magnitude and persistence of the demand shock created by back-to-back years of extraordinary liquidity and stimulus.” WFII believes this should be followed.

In this Wednesday, May 19, 2021, photo, pump jacks extract oil from beneath the ground on the Fort Berthold Indian Reservation east of New Town, North Dakota. On oil well pads carved from the wheat fields around Lake Sakakawea, hundreds of pump jacks slowly bob to extract 100 million barrels of crude annually from a reservation shared by three Native American tribes.  (AP Photo/Matthew Brown)
In this Wednesday, May 19, 2021, photo, pump jacks extract oil from beneath the ground on the Fort Berthold Indian Reservation east of New Town, North Dakota. On oil well pads carved from the wheat fields around Lake Sakakawea, hundreds of pump jacks slowly bob to extract 100 million barrels of crude annually from a reservation shared by three Native American tribes. (AP Photo/Matthew Brown)

10. Commodity exposure: Commodities such as crude oil (CL=F) and natural gas (NG=F) have been some of the best-performing risk assets in the past year, demonstrating significant rebounds from pandemic-era lows, although precious metals like gold (GC=F) and silver (SI=F) have slouched as of late. WFII believes that investors remain underexposed due to the decade-long bear market.

“The upcycle that began late last year has structural momentum supported by post-pandemic supply/demand imbalances, inflation-hedging tailwinds, and energy transition policies reducing fossil energy capacity faster than demand can convert over to renewables,” the report reads. WFII believes this should be followed.

Ultimately, the report states that Wells Fargo remains optimistic about the second half of 2021 and 2022. However, it urges a “clear-eyed” approach to assessing and monitoring the risks currently underscoring capital markets.

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