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This market has a massive ‘wall of worry’ to climb in the second quarter

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The stock market logged a solid first quarter of 2017 but as the second quarter kicks off, a bit of a chill seems to have fallen over the market as investors worry that the Federal Reserve is going to start shrinking its balance sheet in addition to raising rates. So, what should we expect for the second quarter?

It is often said that the stock market climbs a "wall of worry," but the sheer volume of our current "worries" does seem elevated by historical standards. This is especially true given today's lofty valuations, which, by some metrics approach levels only seen on the eves of some very nasty market volatility. The vulnerabilities to pay attention to in this market fall into four key buckets: policy, the economy, geopolitics and valuations.

When it comes to policy, we're talking about monetary policy by the Federal Reserve and fiscal policy by the Trump administration and Congress.

The Federal Reserve has only just begun to "normalize" its monetary policy through three modest

interest-rate increases over two years. Continued policy normalization through rate hikes and asset sales could lead to meaningfully higher interest rates in the not-too-distant future — a significant drag on economic growth if we hold all else equal.

Meanwhile, President Trump has outlined many policies designed to boost economic growth, and they include lowering corporate and individual tax rates; allowing the repatriation of corporate cash trapped overseas; spending up to $1 trillion on infrastructure improvements; increasing investments in defense and homeland security; repealing and replacing the Affordable Care Act; and reducing regulatory burdens on business. The administration also supports trade restrictions (tariffs) designed to boost domestic production and jobs.

Although it's still early, no progress has been made on any of the initiatives outlined by President Trump. In fact, the political climate only seems to be worsening, especially following the failure of the American Health Care Act initiative. At some point in the not-too-distant future, we may be discussing the possibility of another government shutdown due to Congress' inability to agree on a budget. It doesn't seem like an environment conducive to sweeping tax reform. And then there's the ongoing congressional investigation into possible collusion with the Russians over the election.

"It is often said that the stock market climbs a 'wall of worry,' but the sheer volume of our current 'worries' does seem elevated by historical standards."

Given the surge in stock prices since the election, the markets seem to be pricing in a relatively seamless transition from eight years of unprecedented monetary stimulus to an aggressive series of fiscal initiatives. Is this a reasonable assumption? In my opinion, there are several issues that call this premise into question. First, how likely is it that a Republican Congress worried about deficits will rubber stamp large-scale spending increases without revenue to pay for them? Second, if and when these initiatives do get through Congress, will the legislation be enough to offset the removal of eight years of ultra-loose monetary policy? And finally, will there be any negative side effects resulting from this transition?

The U.S. economy has been unable to break out of the current 2-percent growth trend despite near-zero interest rates for 8-9 years. The current expectation is that GDP will grow at around 1 percent in the first quarter of 2017, to be followed by a sharp acceleration beginning in the second quarter. This seems to be an annual ritual.

From where I sit, there are two glaring risks related to economic growth. First, we have not yet begun to address the problem of economic inequality that has plagued the economy since the Great Recession. Despite big gains in income, wealth, and spending by the relatively well-to-do, a sizable majority of Americans continues to struggle with scant income growth combined with sharp increases in the cost of necessities like health care, housing, and education. Second, sectors like education, housing, autos, and other durable goods would likely see dramatically reduced activity in the event of moderately higher rates. Why? Because the Fed's suppression of interest rates has effectively pulled forward future demand for goods and services that are bought using credit. In a nutshell, we have all been enjoying tomorrow's prosperity.

It is tempting to buy into the notion that congressional initiatives can make up for interest-rate increases. But even if we assume smooth passage of current proposals (a BIG assumption), there could be a whole host of negative repercussions resulting from fiscal stimulus. Among the side effects could be sharply higher deficits, a spike in the dollar, higher inflation and interest rates, and financial-market crises like a correction in stock prices or abrupt capital flight from the emerging markets.

To boot, the protectionist trade policies favored by the Trump administration could backfire in the form of dramatically lower exports — an additional drag on economic growth. And last but not least, the administration's efforts to limit immigration and deport illegals could have dramatic implications for economic growth over the longer term. If economic growth equals growth in productivity plus growth in the labor force, it sure seems like efforts to slow population growth through stricter immigration policy could backfire.

Not to mention, there are a variety of geopolitical hot spots that have implications for growth, both in the U.S. and around the world: The UK as it plans to exit the European Union, China, North Korea and Russia. And, the threat of terrorism adds another layer of uncertainty.

Meanwhile, in the market, stock prices are full, volatility is low, and complacency is high. The S&P 500 now trades at over 18x the consensus estimate for 2017 earnings. This isn't too far from the long-term average.

Throughout the economic recovery, there has been one overriding justification for high stock valuations – interest rates. Because interest rates are well below long-term averages, stock valuations should be well above long-term averages to reflect the lack of investment alternatives. This is a variation of the TINA ("There Is No Alternative") argument, and those adhering to this argument have done very well over the past eight years. But what happens now that interest rates are rising due to the Fed's normalization activity? And what will be the effect on corporate profits and margins if and when wage inflation picks up, interest rates rise, the dollar appreciates and opportunities for cost-cutting and stock buybacks wane?

The answer, according to the bulls, is that earnings growth is about to accelerate due, in no small part, to a one-time boost to earnings from lower tax rates, infrastructure spending, and regulatory reform. But this takes us back to the policy risks. Republicans in Congress are loathe to pass any legislation that results in higher deficits. Up until recently, most in Congress were operating under the assumption that tax cuts and infrastructure investments would be funded through: 1) savings generated from the repeal and replacement of the ACA; 2) tax revenue derived from a border-adjustment tax (BAT); and 3) revenue generated as companies pay taxes (at a lower rate) on repatriated foreign cash. Do any of these sources of funding appear more likely today? Is it likely that Congress will pass massive tax cuts without the initiatives in place to fund those cuts? Seems unrealistic to me.

A lot is riding on Congress and President Trump. The outlook deteriorated significantly with the defeat of the new health-care bill, but the markets didn't budge. There are clearly solutions to our predicament, but the most powerful and obvious – addressing the problem of entitlements – is a political non-starter. As such, we think it remains wise to maintain a somewhat defensive posture as the politicians go through the ugly process of making the sausage.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.

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