The US economy continues to hum along as evidenced by the latest bit of good news out last Friday. The 0.5% increase in the latest durables goods orders report adds one more item to the solid economic news we have been seeing all year, and this, combined with strong corporate profit growth, has allowed investors to ride the market to all-time highs. Momentum has dissipated this summer, however. Since summer’s official start (June 21), the S&P 500 has returned just 0.3% appreciation and likely reflects a growing nervousness over valuations and upcoming political risks.
Political uncertainty appears likely to return to center stage as Congress returns to Washington next week. On the docket are two key fiscal issues: raising the debt ceiling and avoiding a government shutdown. To resolve these issues, they will try to set federal spending allocations and this will also inevitably encompass global questions concerning trade policy, North Korea, China, and the Middle East. Failing to raise the debt ceiling or even allowing the decision to get down to the wire could once again trigger a credit downgrade of U.S. federal debt and undermine the government’s credibility in international financial markets. We expect the GOP to resolve this issue fairly quickly even if that involves some sort of funding for a border wall. In the grand scheme of budgetary issues, there is likely a compromise that would create some sort of victory for the president with minimal outlay, and allow the government to continue to function. The stakes are simply too high to be playing a game of chicken. But the simplest solution is to raise the debt ceiling without any other legislative complications.
The setting of budgetary spending allocations is likely to be more tricky, given the contradictory goals of raising infrastructure and defense spending, while trying to cut corporate and personal income taxes. While stock prices immediately following the election surged on the potential for a corporate tax cut and other fiscal reforms, those expectations have largely receded. Stocks facing high domestic tax rates rallied early, but have since underperformed. Current valuations have largely discounted the possibility of a substantial tax cut and remain cautious regarding other major reforms. Nevertheless, look for budgetary negotiations through the fall to cause gyrations in market expectations which could then amplify volatility in stock prices.
Trade policy will also command media attention through the fall as negotiations on revising NAFTA begin to get into the details of rules of origin and specific tax rates on everything from sugar to car parts. NAFTA is 23 years old and entirely new sets of products have been invented since it was conceived. We are long past due for terms of the trade agreement to be revisited, and while rhetoric has been a touch heated, we do expect cooler heads to prevail. We should expect negotiations mostly to reinforce policies which have enabled international supply chains to flourish, but companies hurt by trade will certainly press the politicians for some relief and that could muddy the waters. Extensive research has shown that the decline in manufacturing jobs in the U.S. over the last quarter century has had more to do with labor-saving technological change than it has had to do with NAFTA, and negotiators know this. As the process unfolds, renegotiations should be able to avoid creating onerous new barriers to trade, but look for companies most heavily reliant on the continued free flow of goods between the US, Mexico, and Canada to ride some rough seas as news highlights track the ebbs and flows of the discussions.
Beyond these key U.S. policy issues, geopolitical risks continue to develop – North Korea’s missile launch over the weekend after some weeks of relative calm may require further diplomatic responses and may move us toward a military one. North Korea’s behavior may adjust in response to U.S. and global pressures, but the consequences if it does not are much more difficult to quantify than the upcoming US policy issues. These are just some of the risks investors are facing heading into fall, but prior years have presented investors equally unnerving sources of uncertainty. Heading into the final months of 2017, U.S. stock markets enjoy a solid underpinning in economic fundamentals and this can help smooth out the impact of a rise in policy risks.