How America's crazy politics could finally rattle the markets

Greg Valliere is the chief global strategist at Horizon Investments.

Valliere appeared at Yahoo Finance’s All Markets Summit on Wednesday, Oct. 25. You can watch the full event here.

Nothing is as it seems in Washington — it’s a challenging environment for investors to understand. Being cynical helps, and not accepting anything on face value helps also.

First and foremost, the spectacular economic fundamentals are far more important than all the tweets and palace intrigue and scandals Inside the Beltway. For the stock market, what’s not to like? Decent GDP growth, a healing labor market, modest inflation, steady interest rates and solid corporate earnings.

What worries us is that these spectacular fundamentals have been well factored into the markets — while there are plenty of looming negatives, mostly in Washington, that lurk in the months ahead. Here are five things we worry about:

Uncertainty surrounding tax cuts

1. The stock market has roared on the likelihood of tax cuts, but we think this is an increasingly close call. The GOP can afford to lose only two votes on taxes, and there are two Republican Senators — Bob Corker and Rand Paul — who may vote against a tax bill that they consider too expensive. That could produce a 50-50 tie that theoretically would be broken by Vice President Mike Pence — which means there’s no room to spare.

Moreover, there’s still no agreement on key ingredients in the tax bill — should the rich pay more; what about the state and local tax break; will deductions get curbed, etc.? Ironing out these issues could take several more months; the idea that tax cuts could get enacted in 2017 looks increasingly far-fetched. We think a bill will pass in the spring, retroactive to Jan. 1, 2018 — but that’s a close call.

A ballooning deficit

2. No one cares about the budget deficit any more. Not only will the tax cuts cost $1.5 trillion over five years — even when using “dynamic scoring” — there is no stomach in Congress to tackle entitlement programs, which will drive the deficit much higher, and there’s little sentiment to cut spending. In fact, spending will surge for some programs like defense.

Trade protectionism

3. Trade protectionism may become a market irritant as prospects diminish for saving NAFTA. The Trump populists and the Democrats’ labor supporters want to end free trade deals, and the prospect of retaliation from Asia, Canada, Mexico, etc. could begin to worry the markets.

Political parties in upheaval

4. The parties are in terrible shape. Republicans are now in an all-out civil war between the pro-business establishment and the Steve Bannon populists. This will not make Mitch McConnell’s life any easier; obviously, it will make it even more difficult for him to get things done. As for the Democrats, the party’s elderly leadership seems to have run out of new ideas. With Bernie Sanders and Joe Biden among the 2020 favorites, this is a party in need of fresh blood.

And hanging over the political environment as we enter 2018 will be Special Counsel Robert Mueller, who has interrogated many of Trump’s top aides, some of whom could consider plea bargains. We don’t anticipate impeachment, largely because the votes aren’t sufficient in the House to indict or the Senate to convict. But this could become a huge distraction for the politicians and the markets.

Deadly serious geopolitics

5. Geopolitics are deadly serious, with the prospect of more saber-rattling by North Korea and the U.S. An uneasy stalemate between the two countries probably will persist, but the chances of a conflict are not zero. And as relations between the U.S. and Iran continue to deteriorate, we worry about skirmishes in the Persian Gulf.

It’s possible that all of these five negatives could resolve without any market damage; the great economic fundamentals may persist for another year or two. But we suspect that the unstable Trump Administration, seemingly in over its head on many issues, will require careful scrutiny from investors who cannot expect the markets to continue going straight up.

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