Remember how 2017 was going to be the year that fiscal policy took over from monetary policy in fueling economic growth and, presumably, corporate profits? It took a while, but that central expectation is now subject to growing doubt, and some investors say that’s why stocks are finally suffering a long overdue pullback.
“I think stock prices were bid up on the idea monetary policy and fiscal policy would be working together. What’s happened now is you have monetary policy tightening through the Federal Reserve and fiscal policy is looking less certain,” said Michael Arone, chief investment strategist at State Street Global Advisors in Boston, which has $2.4 trillion in assets under management, in a phone interview.
Read: What’s next after stock market’s drop? Here’s what history says
Ending a 109-day streak—the longest since the 1990s—without a drop of 1% or more, the SP 500
and Dow Jones Industrial Average
both posted hefty losses on Tuesday. Stocks ended mostly higher on Wednesday. All three major indexes, including the Nasdaq Composite Index
which have gained sharply since Donald Trump’s presidential election victory in November, are on track for their first monthly declines since October.
See: Stock-market technical analysts watch these key levels as ‘Trump trade’ wobbles
Fiscal policy doubts center on the stiff resistance by conservative Republican lawmakers to legislation backed by President Donald Trump and congressional Republican leaders to legislation repealing the Affordable Care Act, also known as Obamacare. The conservatives argue the controversial legislation doesn’t go far enough. A crucial House vote looms Thursday and it remains unclear if the bill will pass.
Outside of the health-care sector, stock-market investors aren’t too hung up on the ACA repeal itself. But there are fears that the backup could signal that previous enthusiasm over the notion that a Republican-controlled Congress would quickly enact a Republican president’s calls for substantial corporate tax cuts and infrastructure spending was misplaced.
On the monetary-policy front, the Federal Reserve last week delivered a widely expected rate increase and reaffirmed its forecast for two more hikes in 2017. Around the world, other central banks have signaled that they’re moving closer to ending their own extraordinary monetary-policy efforts. In other words, monetary policy is on the verge of tightening around the globe.
See: Central banks are taking off the market’s training wheels
With central banks heading for the exits, it’s no wonder investors have placed their faith in fiscal policy.
“U.S. equities have been priced for perfection since the start of 2017 and [Tuesday] was a rude reminder that the legislative process is imperfect on even its best days,” said Nicholas Colas, chief market strategist at Convergex, a global New York-based brokerage firm, in a Wednesday note.
In addition, the “low volume/low volatility melt-up” for U.S. stocks had lulled market participants into a temporary complacency that is now shattered, Colas said. The “Trump trade” had grown to resemble the “Fed put” that was previously credited with underpinning the stock market in the eight years since the financial crisis, he said. The Fed put reflected the idea that the central bank would step in to loosen policy to soothe any market turmoil.
Colas and others have argued that Tuesday’s trade marked an end to the first phase of the Trump trade, which will now give way at some point to “Trump Trade 2.0.” That will happen when either valuations “retreat to the point where they reflect the reality of a legislatively driven set of catalysts, or Washington will (in its own time) deliver on a pro-growth agenda as the market treads water,” Colas said.
Read: Get ready for Trump Trade 2.0—a ‘deeper pullback’ for stocks
Of course, the stock-market rally can’t be fully attributed to expectations for tax cuts and other business-friendly items. Stocks were in rally mode ahead of the election and global economic growth was already picking up steam.
And not all investors are putting the blame for the market’s recent wobble on politics, either. Marko Kolanovic, head of derivative and quantitative strategies at J.P. Morgan Chase, argued in a Tuesday note that selling pressure was almost entirely technically inspired, with the path cleared by the expiration Friday of options on stocks, stock indexes, stock-index futures and single-stock futures.
Kolanovic sees further vulnerability for stocks in the near term, with a likely pickup in volatility expected to spur equity outflows.
For investors focused on this week’s legislative showdown, much could obviously depend on the outcome Thursday of a House vote. If the legislation passes muster, the market “could get back on track fairly quickly,” Arone said.
Defeat, on the other hand, could lead to a “normal correction” of 5% or more as investors revise their expectations on the timing of tax cuts and other measures, he said.