As the Federal Reserve prepares to shut down the nearly decadelong quantitative-easing program and President Trump ramps up pressure on North Korea, some analysts are heralding the dawn of a new era where investors will have to grapple with unknown risks and uncertain rewards.
“Even though the Federal Reserve already started raising interest rates slowly, the unwind of the balance sheet marks the start of a new postcrisis era,” said Bill Stone, global chief investment strategist at PNC Asset Management Group.
In the months following the U.S. financial crisis that saw the demise of storied Wall Street banks, the Fed pumped trillions of dollars in financial support into the economy that was instrumental in stabilizing the financial markets.
On Wednesday, Chairwoman Janet Yellen announced the Fed will begin to unwind its gargantuan balance sheet starting in October.
“With the Fed’s balance sheet growing from about $1 trillion in 2008 to $4.5 trillion now, this is a significant step to step away from the accommodation in the wake of the Great Recession and financial crisis,” said Stone.
Now investors must navigate a stock market where easy money is no longer the rule even as geopolitical uncertainties loom large.
That may mean that the halcyon trading that has dominated the market this year is likely to be a thing of the past as central banks’ loose monetary policies were largely credited with muting volatility in risk assets such as stocks, according to Stone.
Data show that 2017 has been the least turbulent year for the stock market in over 50 years with the CBOE Volatility Index VIX, -0.83% hovering near all-time lows.
Even so, the Fed’s move to trim its balance sheet may not be the death knell for the bull market that some fear.
Richard Hastings, macro strategist at Seaport Global Securities LLC, stressed that the Fed will be cautious in its tightening cycle, partly to support reconstruction of the states affected by the recent hurricanes.
“All of that means is a slightly weaker U.S. dollar and better revenue translations for U.S. stocks that sell overseas,” he said.
Investors are also learning to live with North Korea’s sabre-rattling as Trump and Kim Jong Un continue to trade insults and threats.
At the United Nations General Assembly this week, Trump reiterated his hard stance on North Korea, warning that he will “totally destroy” the country if it continues on its belligerent path. “Rocket Man is on a suicide mission for himself and for his regime,” said Trump.
Pyongyang responded by threatening to conduct a nuclear test of “unprecedented scale” by testing a hydrogen bomb over the Pacific Ocean.
Like most things about North Korea, it is unclear how far Kim is willing to go to defy the international community to fulfill his nuclear ambitions and this unpredictability is what makes North Korea such an enigma both in politics and in investing.
“It all comes down to one question in my opinion: Is Kim Jong Un homicidal or suicidal? If you think he [is] only homicidal, carry on. If you think he [is] suicidal and has no goals other than to blow things up, then prepare for a major catastrophe,” said Ian Winer, head of the equities division at Wedbush Securities, who predicted a 10% to 15% plunge in the latter scenario.
To be sure, the market has remained fairly stoic despite the escalating tensions, which Hastings credits partly to the fact that North Korea is largely a mystery for Wall Street.
“The situation with North Korea cannot be priced-in because it is too external to fundamentals and economics. So the market and institutional investors just ignore it,” he said.
Against the backdrop of a tighter monetary policy and tensions with North Korea, investors will also look to Congress for elusive tax reforms, which are the centerpiece of Trump’s pro-business agenda.
Senate Republicans are considering drafting a budget that would allow up to $1.5 trillion in tax cuts over the next decade, according to The Wall Street Journal this week. Budget talks are still in progress.
The impact of tax cuts on the market are hard to gauge given the dearth of details and Morgan Stanley does not expect any tax reforms until next year.
“We’re skeptical of bipartisanship and fourth quarter is a logjam, but tax reform should make slow progress toward 2018 passage even as failure risks remain. Deficit expansion is part of the deal, but limited in scope and stimulus. Yet this may be enough for risk assets near term,” according to a team of strategists led by Michael Zezas.
The S&P 500 SPX, +0.06% closed up 1.62 points at 2,502.2, notching a weekly gain of less than 0.1%. The Dow Jones Industrial Average DJIA, -0.04% ended down 9.64 points, or less than 0.1%, to 22,349.59. The average eked out a weekly gain of 0.4%.
The Nasdaq COMP, +0.07% closed up 4.23 points, or less than 0.1%, to 6,426.9, but ended the week slightly lower.
Read Market Snapshot: Dow, S&P 500 eke out small gains, post second weekly advance