If tax reform ends up stimulating the economy, the Fed is more likely to proceed with monetary tightening, said McMillan.
McMillan says that interest rate increases, combined with growing labor costs, will eat into corporate earnings growth and most likely business confidence. At the same time, many of the positive economic and market trends of the past several years will persist.
“The Fed sees that we’re moving toward the end of the economic cycle and they want to reload their bullets so that they’re able to cut rates when we hit the next recession,” said McMillan. “We think that a new Fed chair will want to establish their bona-fides as an inflation fighter right away, and thus they will lean towards higher rate increases faster.”
Russell sees the risk of a recession in 2019 if the Fed’s tightening inverts the U.S. yield curve, which could happen as soon as late 2018. As short-term interest rates are raised, long-term rates lag and remain low, causing the curve to flatten, then invert, an event that typically precedes recessions.
“The flattening of the yield curve is in progress; it’s something we’re watching,” said Wood. “This is an amber light for U.S. equities: Looking outward, we think there will be good but not spectacular economic growth, but with the flattening of the yield curve, one gets a less optimistic view pushing into 2019.”
Political Impacts
Political turmoil might also disrupt financial markets. With Republicans pinning their hopes on the success of tax reform, Democrats have been buoyed by victories in the 2017 governors’ races and the Alabama senatorial special election, possibly signaling a sea change in the 2018 midterm elections.
“We expect there to be more political disruption, not less, as we approach the midterms,” said McMillan. “So far, the markets have virtually ignored domestic politics, but the possibility of politics becoming a headwind is quite real.”
It’s unlikely that domestic politics negatively impact the markets, but geopolitics are more concerning. McMillan identified North Korea as a potential source of international discord, as the U.S. will likely have to go to war to prevent the state from becoming a nuclear power.
Yet Wood says that North Korea’s ability to impact markets with its bellicose behavior has already waned, noting that during the recent crescendo of tensions between Western allies and the North Korean government, the economy and markets of South Korea grew unconcerned.