With the global economy enjoying steady growth, one of the biggest risks to Wall Street in 2018 is seen as coming from the political arena, although the primary catalyst for selling may not be the most visible threat.
Geopolitical issues are widely considered one of the biggest potential headwinds facing markets in the new year. In addition to ongoing tensions between the U.S. and North Korea, the investigation currently being conducted by special counsel Robert Mueller has been cited as a factor that could lead to volatility. Political issues are seen as harder to predict than the economic factors that drive market action, and, because of this, the sudden emergence of such an issue can have a pronounced impact on trading, at least in the short term.
BlackRock’s Geopolitical Risk Indicator is currently at its highest level since March 2015, “and well above early 2017 levels, when markets were digesting Donald Trump’s election win, worrying about the French election outcome and fearing the potential for a hard Brexit,” wrote Richard Turnill, BlackRock’s global chief investment strategist.
Turnill noted that the indicator, while at a multiyear high, was still below other recent peaks, including spikes related to the events that came to constitute the Arab Spring, concerns about the integrity of the eurozone, and the conflict between Russia and Ukraine over Crimea.
Despite that, he suggested the issue was still a cause for concern. “We are starting 2018 with geopolitics clearly on the radar screen,” he wrote, adding that “we believe risks such as a more muscular U.S. approach on trade bear watching.”
President Donald Trump has been vocal about trade policy. In November, he said the U.S. “won’t be taken advantage of any more” on trade, and that the country wouldn’t enter into multilateral trade agreements that “tie our hands.”
In particular focus is the North American Free Trade Agreement, which Trump has talked about renegotiating.
BlackRock’s Turnill wrote that he was “most worried about the potential for a protectionist U.S. approach to trade” in 2018, calling it “a risk that could shake up global growth and earnings prospects—and call into question our economic outlook.”
He added, “any breakdown in North America Free Trade Agreement talks would be an ominous sign for global trade, we believe, and hit emerging market stocks in the short term. Increasing trade tensions with China are another worry. We are closely watching next steps in the ongoing U.S. reviews of China’s trade practices in industries such as technology, steel and aluminum. We do not expect a trade war, but investors should beware of trade-induced volatility in 2018.”
Trade was also cited as a risk by other analysts. Ben Phillips, chief investment officer at EventShares ETFs, called Trump’s views on protectionism “a significant policy initiative.”
“All trade deficits are bad in Trump’s mind,” he wrote. “We’ll be watching the negotiations closely, as there is some uncertainty whether President Trump can unilaterally withdraw the U.S. from NAFTA without Congress’s input. As a result, we continue to think there may be some headline risk for companies exposed to trade with Mexico.”
Phillips cited Kansas City Southern KSU, +1.00% as an example, noting the railroad operate generates about half of its revenue from Mexico.
BlackRock’s indicator tracks the frequency of geopolitical risk mentions in both media and brokerage reports, and then adjusts that data for sentiment. Based on one measure, bullish investor optimism is currently at a seven-year high, leading retail investors to up their exposure to equities to record levels. Repeated records in major indexes like the S&P 500 SPX, -0.20% have also kept traders in stocks.
Geopolitical risk has largely been taking a back seat of late, with stocks shrugging off all manner of potential headwinds as investors instead focused on improving corporate profits, a strong labor market, and the recently passed tax-reform legislation in Washington, which is seen as supporting stock prices by cutting corporate tax rates, among other changes.
For this reason, Turnill wrote that while political issues were in focus, “the economic backdrop is solid … [and] we do not expect geopolitics to disrupt this trend.”
He added, “Our base case: Geopolitics do not disrupt markets’ risk-on tone in 2018 other than briefly.”