09/05/2017
The number of distractions competing for investors’ attention is particularly high at the moment. Despite this, the S&P 500 sits within shouting distance of its all-time high. The latest round of economic data has been generally solid and inflation has remained subdued. Whether this benign combination will persist in the coming weeks remains to be seen. In the meantime, the litany of potentially market moving events that could intrude on the prevailing end of summer reverie is formidable.

Tensions with North Korea are at the top of this list because the stakes are so high. How to diffuse this situation without resorting to a military confrontation is the objective. Whether diplomacy can succeed, however, is unclear. What to do to diffuse this threat has been a growing problem for the U.S. for some time. But now that North Korea’s nuclear capabilities have accelerated to a point where it can threaten the U.S. and its allies in the region, the issue is coming to a head.

Congress gets back to work this week and must immediately deal with the fiscal 2018 budget and the debt ceiling. Administration officials have sought to reassure markets that both issues will be addressed in a timely manner with no disruptions. But investors remain anxious. Based on the track record of Congress and its inability to get much done, such pronouncements are less than reassuring. Should either of these two issues result in disruption to the government, confidence in Washington will erode further, if that is possible.

Assuming all goes smoothly, Congress will presumably turn its attention to tax reform, which is what investors most want to see. With Congress in recess, the news flow surrounding details of the tax debate slowed to a trickle, except for a few trial balloons regarding possible alteration of the mortgage interest deduction. But that should soon change, assuming the government remains open and the Treasury continues to pay its bills.

Investors Keeping a Close Watch on Central Banks

Central banks will remain in the spotlight in the days ahead as well. The heads of both the Fed and the European Central Bank (ECB) managed to avoid speaking about monetary policy at the recent Jackson Hole symposium, but that quiet is likely to be disrupted soon. The ECB meets this week and could say something about tapering its quantitative easing program, which is scheduled to expire at year-end. Many people think this subject will be addressed at a subsequent meeting, perhaps in October. Regardless, what the ECB says and does regarding policy will have significant implications for global bond yields and relative currency values.

The Federal Reserve meets on Sept. 19 and 20 and could announce the commencement of its program to slowly unwind its balance sheet. The September meeting is accompanied by a press conference, while the scheduled October/November meeting is not. So, if the Fed is intent on getting on with it, the September meeting is the most likely to include such an announcement. In the meantime, the failure of inflation to firm has diminished expectations that the Fed will be able to raise rates one more time before the end of the year. The Fed’s preferred price measure, the core PCE deflator, rose by just 1.4 percent year-over-year in July, well below the Fed’s 2.0 percent target. And problematically, the rate has fallen steadily from where it began the year at 1.9 percent. The August jobs report offered little hope that wage pressures are about to emerge and reverse the inflation trend. Average hourly wages year-over-year grew by just 2.5 percent for the third straight month in August. The odds of a rate hike in December currently sit at roughly one in three.

Can Markets Overcome Political and Geological Events?

With a few short weeks remaining in the third quarter, earnings will increasingly insert themselves into the market’s psyche. After growing by better than 10 percent in the second quarter, the pace of growth is expected to slow to 4.9 percent (according to Factset). Contributing to the expected deceleration are reduced expectations for the energy sector as the price of crude has remained below expectations. The Atlanta Fed’s GDPNow economic forecast currently anticipates growth of 3.2 percent for the U.S. economy in the third quarter. Such a pace would reinforce the acceleration of the second quarter, which was recently revised upward to 3.0 percent from the previous 2.6 percent estimate, following the 1.2 percent pace of the first quarter. Not everyone is as optimistic about the third quarter, however, even within the Federal Reserve system. The New York Fed’s Nowcast program anticipates growth of just 2.2 percent, helping to perpetuate the prevailing view of economics as a dismal science.

The economic data from overseas has been generally good as well. Recent production data from China and the Eurozone has been better than expected, and in both the Eurozone and Japan inflationary pressures have risen modestly. And the Organization for Economic and Co-operation Development (OECD) recently reported that for the first time since 2007 all 45 member countries are growing simultaneously. Developing markets have joined in as well, helped in part by the weaker dollar.

It may be wishful thinking, but if politics and geopolitics can manage to simply do no harm, economies and markets could continue to do just fine on their own.

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