×

Don't trust the market rally—a correction is coming

As the Dow flirts with hitting 20,000 for the first time ever, having risen more than 8 percent since the election, I am left thinking – SERIOUSLY?

The single biggest factor behind the market's rise over the last decade has been central bank support. That is now either being removed, or ineffective. Even if you think yields are rising for the right reasons, to expect a totally smooth and uneventful transition is hugely optimistic.

The "right reasons" would be moderate and stable inflation caused by sustainable growth. Even in the rosiest of outlooks, where we now transition to that, I would expect there to be bumps (and we are surely at the crest of one after the recent run). But I am also dubious that a significant and sustainable uptick in growth is imminent either way.

Interest rates going up do not have to be a bad thing. However, the world is MORE indebted today than it was coming into the crisis ten years ago. Yes some nations including the U.S. have cut their deficits since 2008 – but this merely slows the pace at which the national debt is increasing each year – it is still rising. In that regard, rising rates are a major headwind, and begs the added question of whether Trump's proposed fiscal expansion is coming too late (something that the low unemployment rate also suggests).

And in certain places leverage has not just continued to tick up but actually soared. China is the clear example. Last week was a great example – retail, manufacturing and fixed asset investment numbers were all encouraging. And then the following day we saw why – lending data shot up. The Chinese economy is propped up on loose policy and credit more than ever.

"The single biggest factor behind the market's rise over the last decade has been central bank support. That is now either being removed, or ineffective. Even if you think yields are rising for the right reasons, to expect a totally smooth and uneventful transition is hugely optimistic."

Plus, like many emerging markets, China is a major loser from the stronger dollar. As we were reminded earlier in 2016 the Yuan has been artificially propped up for years. On Friday, the Yuan was fixed at its lowest level in 8 years despite the PBOC's FX reserves dropping $120 billion in the last two months – the ability to continue to prop up the currency is slipping. Investors are more attuned to this particular issue than they were in January this year, but the potential for a negative China shock in 2017 is very real.

Elsewhere on the international scene there remain huge hurdles in Europe. Yes Brexit, Trump and the Italian referendum have suggested, in hindsight, that markets can overreact to political risk, but countries representing 42 percent of EU GDP face elections in the next 12 months, and that doesn't even include the UK which faces its own battles following the Brexit vote. And when it comes to the economy – and the same is true in Japan too – if the Trump optimism that has caused yields to rise globally does not sustain, what else can the ECB and BOJ do to stimulate what remains very low growth in those places?

One thing that makes me reconsider my bearishness is recent conversations with bank CEO's like Jamie Dimon and Brian Moynihan. Their tones have transformed from just a few months ago. But remember that the huge bounce in bank share prices comes in response not just to underperformance throughout 2016, but underperformance for the last decade.

Low interest rates and QE were good for many equities but not banks. Now, as rates rise it is clearly a boon for banks, and that doesn't even tackle the potential bonus if there is a change of direction in regulation. But – a positive stance on the banks does not necessarily mean good news for everyone.

Finally – even if you are upbeat about GDP growth, that doesn't necessarily mean you should be about equity markets. Correlations between the two are not in fact that strong. By definition rising rates make other asset classes like cash and bonds more attractive relative to the recent past. Plus, markets have run up sharply already – the Dow nearly doubling since 2009. Whilst it is hard to bet against the current upward momentum, a correction is due, and a more prolonged pullback is very possible too.

Commentary by Wilfred Frost, co-anchor of of "Worldwide Exchange." Follow him on Twitter @WilfredFrost.

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.