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5 risks that could surprise markets in the second quarter

Stocks are setting up for a solid start to the second quarter, but there are more than a few potential pitfalls that could make investors eager to "sell in May" this year.

After a rip-roaring 10 percent decline in the S&P 500 early in the first quarter, stocks have snapped back, erasing all losses, and the S&P 500 was up nearly 1 percent for the year at 2,063 going into the final day of the quarter.

The second quarter kicks off with March's jobs report Friday, expected to show that job growth continues to grow at about 200,000 a month. Then there is the start of the first-quarter earnings season early in April, expected to be the worst profit decline since the depths of the financial crisis.

There is also the U.S. presidential election, but one of the biggest risk factors cited by analysts is the June 23 "Brexit" vote where British voters will decide whether the U.K. will stay in the European Union. In fact, if the polls appear to signal a positive vote, some Fed watchers believe it would be a factor that could keep the Fed on hold when it meets the week earlier.

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Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

Brexit

If the U.K. were to vote to exit the EU, it would take several years to work out the details but analysts expect an immediate market reaction. The uncertainty is expected to create a risk off move and a flight to safety into things such as Treasurys and gold.

"It would reverberate in ways we don't necessarily appreciate," said Bruce Kasman, chief economist and managing director, global research at J.P. Morgan. "It could help spark campaigns in terms of independence in regions like Scotland or Catalonia. It could push some members that are unhappy with parts of the agreement to push apart. It could have some consequences."

David Bianco, chief U.S. equity strategist at Deutsche Bank, said a yes vote would bring a currency reaction and there could be a flight to safety into the dollar. "I think everyone believes this is a lengthy process. I think it initially weighs on the euro, too, not just the pound. I think the negotiations then begin and the U.K. starts asking for more carve-outs, and that could start other members asking for market carve-outs," he said.

According to a recent Financial Times poll of polls, 46 percent favored staying and 42 percent supported leaving. The Bank of England, meanwhile, has warned about the risks of a credit crunch should Britain exit.

"It's about a whole host of relationships on a whole host of issues. Trade is one of them but it's not the only one. The two sides are connected and the two sides are symbolically linked in terms of what their arrangements mean in terms of European integration," said Kasman. "It will ripple through the whole European landscape in ways we can't really predict." Kasman said one impact may be to diminish London's role as a financial center.


U.S. election

The Republican field in the presidential race could continue to narrow in the second quarter, but analysts say the market may wait to react until closer to the November election and possibly around the time of the conventions this summer.

The second quarter should be when it becomes clear whether GOP front-runner Donald Trump gets the nomination or not, and whether there will be a brokered convention.

Kasman said the markets may already be pricing in a race between Hillary Clinton and Trump, where Clinton is viewed as the likely winner.

But if that expected outcome shifts, analysts say the markets could react. Trump is seen as a more unpredictable candidate than Clinton and some Wall Street strategists say that as an unknown entity, he could be a negative for markets. Bianco said he would like to see more substance around tax plans. "At this stage, I don't see him as a positive or a negative," said Bianco. He did say a Clinton win would not be viewed as negative for stocks.

Samuel Stovall, chief equity strategist at S&P Global Market Intelligence, said the market could start to worry about the election later in the year. "Traditionally it's more worry about the third quarter," he said, adding that if the market is down in the July-through-October period, there has been a negative outcome for the incumbent party 82 percent of the time since World War II.


Earnings

According to Thomson Reuters, S&P 500 earnings are expected to decline 6.9 percent in the first quarter, the worst performance since 2009 and the thick of the financial crisis.

"We don't expect to exit the profit recession until the second half of the year," said Bianco. He expects earnings to be up 2 to 3 percent, if energy is excluded. Thomson Reuters said the expected decline in energy profits is 99 percent.

"I think Q1 reporting season is a reminder that we're not in a recession but we're still in many industries in a profit recession. Even in the healthier industries, things are very slow," he said. The earnings decline would be the third-straight quarter of year-over-year declines," he said.

Bianco expects the market to remain rangebound between 1,925 and 2,100, and earnings are one factor holding back gains. "We think that's what keeps the market from shooting above 2,100," he said. He does see stocks moving to 2,200 at the end of the year.

Stovall said the earnings could affect performance just as they did in the past year.

"If we continue to experience additional earnings erosion then it could be like 2015 all over again when we went from an 8 percent expected gain to a near 1 percent loss," he said. "I also think analysts are human, and when they saw the market decline by 10.5 percent through Feb. 11, they said maybe something was wrong here and 'I'll have to adjust my earnings expectations.' "

Bianco said there could be a "sell in May" effect this year, the seasonal trend when stocks are weaker from the May-through-October period.

" 'Sell in may' technically happens every year, in that the market has gained an average of 6.8 percent from November through April, since World War II, versus 1.4 percent in May through October," Stovall said.


Fed Ahead

The Fed meets twice in the second quarter, and the markets are putting low odds on a rate hike at either the April meeting or June meeting.

Fed Chair Janet Yellen's comments this week that the Fed sees risks and will be cautious reinforced that belief, though Kasman said the Fed should hike midyear based on the strength of the economy. He said the timing, however, could be affected by Brexit, and if it looks like the European Union could be voted down, he thinks the Fed would wait a month and hike in July.

Bianco also does not see any action until the second half of the year. "I do think the market is going to be stable for the next six to eight weeks, for the most part. People are comfortable that the Fed is not going to be hiking until the second half," he said.

Dana Saporta, director of economic research at Credit Suisse, said she expects the next hike in September. "Given the tone of the chair's comments, we feel even more confident in our September call," she said.

But a divergence from this view, particularly if there are more signs of inflation, could create volatility around Fed expectations.


Oil

Oil has been a major driver of the stock market in both its collapse and run up. Therefore, an April 17 meeting of OPEC and non-OPEC producers to discuss a production freeze will be key, as will OPEC's June meeting.

"I think it will be volatile. They'll have another chance at making comments to open mikes and running cameras. They love doing that, so there's going to be some headline risk around the whole thing. If it falls apart, it will be quite the sell-off. It will be watched for sure," said John Kilduff of Again Capital.

Kilduff said oil prices could fall into the low $30s again based on global oversupply. West Texas Intermediate was at about $38 late Thursday.

"Our guys are not believing that anything exciting is going to happen, even if the Saudis agree to a freeze production at current levels," Kasman said.

Even if oil is not going to keep edging higher for now, many analysts believe it put in a bottom in the mid-$20s in February. Kilduff, however, believes it could revisit that level and analysts say stocks are still tethered to oil.

There are also other factors that can shake the markets, and China remains the big worry always in the background. While analysts say it has improved its communications around policy, the Chinese economy remains soft and it is not seen turning up soon. Yellen said this week that the Fed is watching the changes in China as its economy shifts and it manages policy around its currency.


Analysts are also watching the situation in Brazil, where President Dilma Rousseff could be impeached. Despite the uncertainty, some analysts see it as a positive as it would bring in a new government but it would also bring uncertainty. On Tuesday, Brazil's Democratic Movement Party voted to break with her government, making an impeachment more likely.

"I think people look at it as helping to clear up some of the logjam and gridlock," Kasman said.

Kasman said there's also a chance that the Japanese government could call for new elections in May. Japanese Prime Minister Shinzo Abe could call an election around some fiscal stimulus program and, if he's successful, it would energize his so-called Abenomics initiative.