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BANK OF AMERICA: Investors are about to put the global economy through a 'major stress test' — and the risks of failure are high

trader biting nail nervous
A trader in the S&P 500 stock index options pit at the Chicago Board Options Exchange in Chicago in 2008.
Scott Olson/Getty

  • The investor concerns that are plaguing the stock market are unlikely to be resolved soon, according to Ethan Harris, the head of global economics at Bank of America Merrill Lynch.
  • This will put the economy through a "major stress test" of how much it can grow alongside financial-market turmoil, he said.
  • Harris identified a feedback loop between policy and financial markets implying that investors face a long, painful slog ahead — in line with other forecasts for continued volatility in 2019.

A refrain we often hear when markets are under pressure is "the stock market is not the economy."

It's an important distinction to make: Traders, both human and electronic, do not dictate the direction of the economy based on their snap judgments of share prices. But it's equally worth remembering that the stock market has historically been an early detector of economic trouble.

The market was resilient in the summer when US trade disputes were the predominant risk. But in recent weeks, Brexit, oil sanctions, the US midterm elections, and Federal Reserve policy have joined the laundry list of concerns, leading to the market's capitulation.

Stocks are wavering now only because these investor concerns piled up quickly, according to Ethan Harris, the head of global economics at Bank of America Merrill Lynch. And it may only be a matter of time before the underlying economy starts to falter, too.

In a note to clients, Harris said the bank's view that the economy wouldn't buckle had "been largely correct thus far" but faced "a major stress test in the coming weeks."

He added: "In particular, there is a growing risk of reverse causation where 'bad markets create bad fundamentals.' The problem is that the economy can handle a short period of high policy uncertainty and market volatility, but patience has its limits."

Read more: A $2.8 trillion investor is bracing for even greater turbulence in the stock market — here's where she says you should put your money

Harris describes a feedback loop between policy and financial markets that raises the possibility of a painful slog ahead.

Take Brexit for example. According to Harris, investors are not pricing in the worst outcome — a departure without a deal — because they believe politicians will do all they can to avoid it. But the implication of this posturing by investors is that markets won't tank enough to pressure policymakers into reaching a deal.

"The result is a long period of weak confidence and a weak exchange rate, but no acute crisis," Harris said.

The same example applies to US-China trade negotiations, particularly for President Donald Trump, who has used the stock market as a scorecard of his administration. Harris estimates that negative trade news has shaved 6% from the S&P 500 this year on a net basis. But since mere positive news on trade talks is enough to rally markets, there's no strong incentive to reach a conclusive deal.

During this drawn-out negotiation process, it pays for the US and China to threaten more than they intend to deliver so as to scare the other side, Harris said. This tactic is poised to feed through to markets in the form of more volatility.

Harris remains positive that policymakers will strike deals on Brexit and trade before the economy suffers serious damage. The risk of failure outweighs the prospect of success, however, and "it could be months rather than weeks before we see the light at the end of the tunnel," he said.

In short, the message to investors is: Buckle up.

Get the latest Bank of America stock price here.

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