Now that the election is over and the Republican Congress has taken office, now that the stock market is close to all-time highs and confidence has ramped up to levels not seen since the dot-com boom, it’s time to think about what could go wrong.
As I’ve said before, I’m generally optimistic about 2017. I expect the economy to grow and markets to rise, and there are good reasons to adopt that as a base case. Now that some of the dust has settled, however, it’s also becoming clearer why the base case might not play out. Let’s review some of the risks that have become more apparent over the past week or so.
Risks at home and abroad
U.S. policy. One of the most interesting things about the election was that almost every Donald Trump supporter I spoke with was convinced Trump wouldn’t actually do what he said, especially in regard to trade policies. There seemed to be a general belief that he wouldn’t really impose tariffs, for example. Well, looking at some of Trump’s appointments, and taking his comments after the election as a guide, he just might. Even if tariffs aren’t on the agenda, other restrictive trade actions probably are. With both Ford and GM in the headlines for relocating jobs, it’s clear that manufacturing business models are likely to change, to the detriment of corporate earnings. It’s also clear that imports may be treated differently, increasing costs for just about everyone.
Depending on how this pans out, it could be a headwind for the stock market.
U.S. politics. Can the Republican Congress act swiftly to implement its agenda? Can the House and Senate work together effectively? And can they work with the White House? The recent attempt by the House to eliminate the Office of Congressional Ethics, immediately criticized by the president-elect and congressional leaders, may call that into question. Emerging policy differences—on Russia, trade, spending, and potentially taxation—could put the White House and Congress at odds. We particularly need to keep an eye on the debt ceiling, which is coming up for review shortly.
There’s a great deal of optimism that the new government will be effective, but markets and the economy could react negatively if we end up with the same old gridlock.
International troubles. With the focus on faster U.S. growth and a unified U.S. government, attention has slipped from very real problems elsewhere. In China, the currency continues to drop and capital flight to rise. In Europe, the Italian banking crisis and pending elections around the continent will maintain the stress on the EU. And then there's Russia, Japan, and the Middle East, among others. The world hasn’t gotten any less complicated since the election.
With U.S. investors focused on domestic issues, troubles abroad have the potential to seemingly come out of the blue. In early 2016, we saw a major market pullback based on events in China and several from political problems in Europe. Even if the U.S. does get it right, we still face real issues around the world.
Interest rates. As the U.S. economy has normalized, one of the hopes has been that the future would be largely about the economy rather than politics. With the Federal Reserve slowly raising interest rates, we are indeed moving back to normal in a monetary sense. As we've seen over the past couple of weeks, though, even if the Fed does what it says, interest rates can fluctuate far more than the market is used to. If the Fed gets it wrong, the damage could be even worse.
Given its track record of waiting too long and then acting too quickly, it’s possible that the Fed could turn from a support to a drag on both the economy and the market.
Keep an eye on the things nobody’s talking about
For markets, both here and abroad, improving economies have helped stocks and will likely continue to do so, but the political risks are largely being ignored. For years, the hope has been that politics would get out of the economy’s way, but that doesn’t seem to be in the cards for 2017.
Right now, while things look good, markets are priced to reflect both political and economic progress, without really accounting for the risks. That’s why it will be so important to keep an eye on them yourself.