Just two days after hitting a new record high last Monday, stocks hit an air pocket midweek on worries that the Trump administration would become crippled by developments in Washington. On Wednesday, the S&P 500 dropped 1.8 percent. It was the single worst day for the index in eight months. The dormant VIX index of implied volatility, which had become a focal point of investor complacency in recent weeks, surged 46 percent to 15.6. And the pullback in stocks was seen around the globe as the MSCI World index fell 1.2 percent. The yield on the ten-year Treasury note tumbled 11 basis points from 2.33 to 2.22 percent.

But markets didn’t stay down for long. Stability, if not confidence, returned the very next day. Over the final two days of the week, the S&P managed to claw back more than half of its Wednesday loss. Stocks still lost 0.4 percent on the week, but the damage had been contained, at least for now.

Political Drama Weighs on Markets at Home and Abroad

As volatile as markets were in the U.S., it was nothing compared to Brazil, where the current president was implicated in the bribery scandal that drove his predecessor from office. On Wednesday and Thursday of last week the Bovespa index plunged a combined 10.3 percent, including an 8.8 percent drop on Thursday. A semblance of stability returned on Friday as stocks rose 1.7 percent. The selloff slowed the year-to-date rally in emerging market equities, which suffered their first weekly loss in the past five, although the harm was limited to a loss of just 0.7 percent for the MSCI Emerging Markets index. On the year, it remains higher by 15.5 percent.

The drama in Washington leaves investors searching for the next catalyst to push stocks higher. The Trump agenda of tax reform and fiscal stimulus has likely stalled, but to what extent? The administration continues to insist that work on these priorities continues, but there is certainly a chance that what gets accomplished is less than markets hope, or is perhaps derailed entirely.

Still, notwithstanding last week’s turbulence, stocks have managed to tread water since early March while events in Washington have unfolded. That is certainly a positive. The best quarter for earnings growth in six years no doubt helped. But if the Washington policy machine grinds to a halt, it is less clear that economic growth and expected earnings are likely to be strong enough to push stocks higher on their own.

The dollar has reflected this uncertainty. The DXY index has been in steady decline since early March, losing 5 percent of its value. This is beneficial to U.S. exporters, whose earnings growth has exceeded more domestically reliant companies. But it has also contributed to strong outperformance in foreign markets for dollar based investors. For example, in local currency terms, stocks in the Eurozone have risen 5.6 percent since early March, as measured by the EuroStoxx 50 index, with strength following the recent election in France. However, in dollar terms those gains have totaled 12.4 percent.

Investors Remain Skeptical of Three 2017 Rate Increases

Back home there is also the issue of the Federal Reserve. As expected, the Fed left rates unchanged at its May meeting. It meets again in three weeks when it is widely expected to raise the overnight rate once again. The Fed has said it believes that the first quarter economic weakness was temporary. This week we will receive the minutes from the May meeting, which may provide further insight into the Fed’s mindset. Since that meeting the economic data has mostly firmed, especially the April reports on job growth and industrial production.

The Bloomberg world interest rate probability function ascribes a near certainty to another rate hike at the June Federal Open Market Committee (FOMC) meeting. But the market is more skeptical beyond that, indicating roughly just a one in three chance of a third rate hike this year, which the Fed has said is its expectation. If it becomes apparent that the Fed remains of that view, markets will need to adjust. The yield curve has flattened significantly. The spread between the two and ten-year Treasury notes stood at 125 basis points in mid-March. It closed last week at 96. Inflation has remained subdued, as has wage growth. Since then stocks have meandered, while the leaders early in the reflation trade, financials, have languished.

Stocks need a jolt. Here’s hoping for some accelerating economic activity while we wait for Washington to find its way.

Important Disclosures:   
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Indexes are unmanaged and are not available for direct investment.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.
The MSCI World Index is a free-float weighted equity index. The MSCI World Index (MXWO) includes developed world markets, and does not include emerging markets.
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 Emerging Markets (EM) countries. With 837 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Bovespa Index is a gross total return index weighted by traded volume & is comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange.
The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.The EURO STOXX 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Supersector indexes, from which members are ranked by size and placed on a selection list. 

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