How Much More Geopolitical Turmoil Can Markets Withstand? (SPY)

From Invesco: Those of us who work in offices have our own kind of occupational hazards — not the least of which is the paper cut. While hardly dangerous, a paper cut can range from harmless but annoying to mildly painful.

The good news is that we rarely get more than one paper cut at once. But what if we experienced a hundred or more paper cuts around the same time? While they may not be deadly, they could certainly cause some serious suffering.It seems that this summer’s geopolitical and economic events can be likened to paper cuts. Individually, the market can brush them off. But a significant accumulation of paper cuts over a short period of time might cause investors to suffer. Last week reminded us of that possibility. Geopolitical risks escalated, but the markets largely ignored these figurative paper cuts.

Cirque du USA

Many of last week’s key geopolitical risks centered on the United States. Over the course of just a few days, we saw the failure of the US Senate’s most recent health care bill, the release of principles around tax reform, as well as key personnel changes in the White House. The health care bill’s demise, which occurred under dramatic circumstances late Thursday night, carries with it both good and bad news. The bad news is that attempts to repeal and replace the Affordable Care Act (ACA) appear to be over. The good news is also that attempts to repeal and replace the ACA appear to be over.

Too much focus on health care?

First, the bad news. President Trump will likely have more difficulty seeing his agenda come to fruition than many had expected. Keep in mind that the proposed health care bill required only 51 votes in the Senate for approval because it was included as part of budget reconciliation. However, the threshold for normal legislation (proposed bills not included as part of budget reconciliation) to pass is 60 votes. This seems unlikely given the current composition of the Senate — hence, President Trump’s call for the Senate to change its rules and allow just 51 votes to approve a bill. (This, too, seems very unlikely to occur.) And even if the Senate moved to a 51-vote requirement, just a few swing votes could stand in the way of any legislative success for the administration, as we saw last week with health care.

However, the health care bill’s failure is good news in that Congress can now move on to tax reform, which has the potential to be far more economically impactful.

Or so we thought.

This past weekend, President Trump again attempted to revive the “repeal and replace” effort with respect to health care legislation. This could push back the timeline for tax reform and other important agenda items, such as infrastructure. I can’t stress how big a mistake I believe it would be to pursue health care legislation yet again when there are many other items the US Congress must attend to — particularly tax reform.

Legislative uncertainty could affect equity markets

Fortunately, we appear to be moving closer to a tax reform bill. Last week, the “big six” — key leaders from the White House, Senate and US House of Representatives — released a statement covering principles for tax reform. In my view, the most positive takeaway was the decision to dispense with House Speaker Paul Ryan’s proposal for a border adjustment tax. This is important, given broad consensus that a border adjustment tax of approximately 20% would be needed for the conservative wing of the Republican party to support any tax reform bill. Such a tax would negatively affect consumers — particularly lower-income consumers, for whom a 20% hike in prices on a broad basket of goods would have been extremely burdensome. A border adjustment tax could also touch off a trade war — something I believe we should avoid at all costs.

Unfortunately, the “big six” now appear committed to making the tax reform package revenue neutral. Speaker Ryan explained that Congress will need to find alternative sources of revenue, which he believes can be accomplished in part by broadening the tax base and eliminating tax preferences for “special interests.” I believe these proposals would mitigate some of the positive impact of tax cuts. And although the “big six” suggested lowering tax rates for businesses, there was no mention of lowering individual tax rates or modifying the alternative minimum tax — an area ripe for reform. I am concerned that the ultimate tax reform package could be far less generous than what is currently priced into the US stock market, which could create headwinds for US equities.

Another cause for concern is the debt ceiling, which Congress failed to address before leaving for its summer recess. Recall that Treasury Secretary Steve Mnuchin had requested that Congress raise the debt ceiling before the recess, given that the US could reach the debt ceiling in early October. That request went unfulfilled, adding to current legislative uncertainty already created by unresolved tax reform and health care issues.

Tensions in Asia

Last week also saw North Korea launch another missile, testing the patience of Japan, South Korea, the US and its allies. North Korea’s leader, Kim Jong Un, claimed that the entire continental US is now within bombing range. President Trump responded with a show of military strength by deploying bombers over the Korean peninsula for an extended period of time. He also sent out tweets urging China to intervene. There is growing concern that this situation could deteriorate quickly given North Korea’s heightening aggressiveness. Although it is hard to say for certain, at some point escalating tensions in Asia could weigh down the global stock market and drive investors into US Treasuries and gold.

Areas of concern in Europe

We can’t forget that ongoing Brexit negotiations have the potential to provide a few more paper cuts. This past week Chancellor Philip Hammond revealed that the United Kingdom (UK) would not cut taxes or regulations in order to undercut the European Union. This could add jitters to the UK stock market — especially given some companies’ high-profile declarations to move operations out of London. Conversely, negotiations could provide a boost to European equities, particularly in Germany. In addition, there have been renewed concerns in recent weeks about the health of European banks. While these concerns are nothing new, they have the potential to provide yet another paper cut.

FOMC meeting results in no monetary easing

Last week saw July’s meeting of the Federal Reserve’s Federal Open Market Committee (FOMC). Not surprisingly, the Fed took no action on interest rates. However, FOMC members suggested that Fed balance sheet normalization could begin soon. I would expect that to happen at September’s FOMC meeting — provided there is no debt ceiling crisis or other headwind facing the economy. Depending on how balance sheet normalization is executed and/or received, it has the potential to provide more than a few paper cuts. Therefore, we eagerly await the Kansas City Fed conference in Jackson Hole, Wyoming, scheduled for late August. That could be an opportunity to gain more insight into Fed balance sheet normalization, as well as plans for European Central Bank (ECB) tapering, given ECB President Mario Draghi’s presence at the conference. (ECB tapering could, of course, provide some proverbial paper cuts as well.)

Amid all these concerns, there is still plenty of positive economic news. For example, recent economic growth in China has been strong, helping to boost copper prices. And recent data from the eurozone show a drop in unemployment (to a level not seen since June 2009) and an unexpected, but healthy, bump in inflation. Thus far, all of these little paper cuts have been justifiably brushed off by investors. For the time being, we remain in an environment of relatively low volatility, with few signs of abatement. These conditions could persist, but investors should remain vigilant and consider emphasizing downside protection in their portfolios, as well as alternative investments for added diversification.

Looking ahead

This week, the Bank of England’s Monetary Policy Committee will convene, and the US Bureau of Labor Statistics will release its latest jobs report. Global economic growth may be on solid ground, but given all the political uncertainty we saw last week, don’t rule out a few more paper cuts.

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Important information

The European Central Bank (ECB) is responsible for the monetary policy of the European Union.

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

Alternative products typically hold more nontraditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Diversification does not guarantee a profit or eliminate the risk of loss.

The opinions referenced above are those of Kristina Hooper as of July 31, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

The SPDR S&P 500 ETF Trust (NYSE:SPY) rose $0.79 (+0.32%) in premarket trading Tuesday. Year-to-date, SPY has gained 11.42%.

SPY currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 117 ETFs in the Large Cap Blend ETFs category.

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