Smooth sailing in the stock market could lead to a wild ride this fall

In July, I wrote that “the biggest factors that could influence the stock market in the second half of 2017 are interest rates, corporate earnings and geopolitical events.” In the past month, we have had developments in each of the first two categories that argue for continued market exuberance and in the third category that provide us with cautious optimism. A fourth factor has emerged that could outpace the other three.

Interest rates are low and expected to remain low for the foreseeable future. The target federal funds rate is between 100 and 125 basis points. According to the CME Group’s Fed Watch, there is less than a 50 percent chance that rates will rise by January. One has to go to March before the probability of a 25 basis-point increase in rates is probable.

U.S. corporations are enjoying the best earnings season in 13 years. Earnings among more than 450 companies in the S&P 500 have risen on average by a healthy 9.8 percent, according to Bloomberg. In addition, an astonishing 78 percent of companies exceeded earnings estimates. Taken together, low interest rates and rising earnings are rocket fuel for continuation of the stock market advance.

{mosads}On the geopolitical front, while sabre rattling with North Korea escalated, it thankfully appears tamped down for the time being. While the cataclysmic consequences of any nuclear conflict cannot be overstated, the consensus of market participants deemed that the likelihood of such an event was so miniscule that it did not roil stocks. With help from China, it appears that Kim Jong Un has at least temporarily backed down from his threat to launch missiles at Guam. Thursday’s horrific events in Barcelona are heart wrenching. But viewed solely from the narrow lens of the financial markets, that terrorist event, like others before it, is not significant to economic valuations.

The biggest threat to the markets today are unforced errors on the domestic political front by a volatile President Trump. The president needs the support of legislators, not just to advance major policy initiatives, but also to simply keep the government funded and operating. As viewed by the financial markets, this week was, without question, the worst one experienced by the Trump administration to date, and it had nothing to do with legislative failures, policy missteps or economics. The events in my former hometown, Charlottesville, and more specifically the president’s response, has focused the attention of the nation on social divisions and weakens his already compromised hand in leading important economic policy discussions.

When a supposedly business-focused administration is faced with the mass exodus of business leaders from policy advisory groups the White House established a few short months ago, it becomes clear that the erosion in support from top CEOs is meaningful. How the increasing distance the business community is putting between itself and the administration will impact policy is not yet clear, but the signs are not encouraging.

An event looming on the horizon that could highlight the president’s weakened position and lead to a significant stock market downturn is a failure, or even a significant delay, in raising the debt ceiling. By the end of September, Congress must vote yet again to allow the government to pay its bills, including interest on the debt. The fact that we even have a debt ceiling is a self-inflicted wound. It is alien to all governments in the world, with the exceptions of the United States and Denmark, whose debt ceiling is so high that it will likely never reach the limit.

Treasury Secretary Steven Mnuchin and House Speaker Paul Ryan (R-Wis.) are both on record saying that the Trump administration wants the debt ceiling raised with no strings attached. With a majority in the House and Senate, it would seem that a clear path to raising the limit exists. What was a bit alarming, however, is that Ryan has indicated that he has not yet talked to the president about raising the debt limit.

It is not inconceivable that we could witness a repeat of the theatrics of 2011, when the Republicans grudgingly agreed to raise the debt ceiling in exchange for a complex deal of significant future spending cuts. The deal was struck with a scant two days to spare. This silliness led to “Black Monday” in August 2011, when markets fell in response to the downgrade of U.S. sovereign debt from AAA to AA+ by Standard & Poor’s. That downgrade was in direct response to the debt ceiling debacle.

The bizarre aspect of this year’s debt ceiling debate is that if Trump and Congress want to increase the debt limit, it would seem to be a non-issue. However, one need look no further back than the recent failed attempt at repealing the Affordable Care Act to get nervous heading into next month. Because of the segment of uber-conservatives that exists in the House, the support of Democrats may well be required to push a debt ceiling increase through.

With a weakened hand as a result of ongoing social and partisan divisions and the “resistance” strategy in full force on the other side of the aisle, getting a compromise to increase the debt ceiling has gotten more complicated. Cooler heads will likely prevail and the debt ceiling will almost certainly be increased, but perhaps at a cost to financial markets. Political brinkmanship could roil the markets and lessen investor confidence, and investors should prepare themselves for a potentially hair-raising ride as we head back to the brink again.

Robert R. Johnson, Ph.D., CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of “Strategic Value Investing,” “Invest with the Fed” and “Investment Banking for Dummies.”

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