Geopolitical Risks, Market Forecasts and a Tax Reform Clause

Mark Heppenstall

By Mark Heppenstall | August 30, 2017

While trading slowed during the summer months, as it historically does, the headlines did not! From squashed healthcare reform to placing sanctions on North Korea to the Amazon/Whole Foods deal, there was no shortage of market-moving news in the last several months. Before we unofficially say goodbye to summer next week, we checked in with CIO Mark Heppenstall for his take on what’s been happening in the news cycle and its impact on markets as well as what investors can expect leading into the final quarter of 2017.

Did the second quarter earnings season fail, meet or exceed your expectations?

The second quarter earnings season exceeded my expectations and equity investors’ expectations broadly. Nearly three out of four S&P 500 companies reported positive earnings surprises. More importantly, top line growth benefitted from the weaker U.S. dollar and exceeded expectations in 70% of companies reporting earnings to date.

Is inflation a cause for concern?

Near-term outlook for inflation and wage growth is low despite continued tightness in the labor markets. Secular forces – technology, deleveraging and demographics – are outweighing any cyclical pressures for higher inflation. However, the market’s current expectation reflects the outlook for inflation to remain ‘lower for longer.’ Treasury Inflation Protected Securities (TIPS) offer fixed income investors valuable diversification benefits should inflation pressures build.

How do current geopolitical events stand to impact equity and bond markets?  

Geopolitical risks are hard to handicap but currently pose the biggest risk to markets. The recent missile testing over Japan by North Korea hit Asian markets, but left U.S. markets relatively unscathed. We anticipate the market will stay keyed in on President Trump’s reaction and comments as it relates to the North Korean situation. Markets do not want to see the conflict with North Korea escalate, but we anticipate some volatility as they react to of-the-moment commentary from the President.  

Where do you see the markets closing this year? 

The tug of war between stretched valuations and a favorable economic backdrop for investors – low inflation, synchronized global growth, patient Federal Reserve (Fed) – will translate to range bound market performance. Geopolitical risks pose the potential to upset the outlooks on the downside and signs of progress on tax reform could propel markets higher from here.

What are your expectations for monetary policy through year-end?

The Fed is likely to shift from interest rate hikes to balance sheet reduction through year-end. Geopolitical uncertainty provides the Fed even more justification to be patient with future rate hikes. Long-term yields remain stubbornly low, but unless inflation pressures build from here, the anticipated bond bear market will have to ‘wait until next year.’

What is the biggest concern to markets that is flying under the radar? 

One of the biggest concerns currently being overlooked is the potential for Republican tax reform to include an elimination of interest expense deductibility for corporations. This reform will have a meaningful impact on the supply of new corporate debt issuance and use of leverage on corporate balance sheets – especially in light of the increased use of leverage by corporations for shareholder friendly activity – share buybacks, dividend hikes & M&A activity.

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