The U.S. doesn't usually rise to the top of the list of major markets with political risk, but with stocks near record highs and volatility low, analysts say one of the biggest threats to the bull market currently comes from Washington.
"There are political risks in this country because of uncertainty," said Paul Christopher, head global market strategist at the Wells Fargo Investment Institute. He said the last time he felt U.S. political risk this much was in 2008 when Washington was attempting to resolve the financial crisis. Now, he's finding it's risk of a different sort, but it's a new concern for some investors, who are used to weighing political risk in Europe and emerging markets.
"What about political uncertainty in this country? If Trump and Congress don't deliver tax reform or health care by the midterm election, is the Republican majority in the House or Senate at risk? I would say possibly. It's not like leaving the euro zone but there's certainly more risk that would impact the economy going forward," said Christopher.
Analysts say the loss of the Republican majority would be a concern for markets, since it is viewed as having an opportunity to make unimpeded pro-business and pro-growth decisions. The markets are supported by those expectations, though many of the Trump-specific trades, such as small caps and infrastructure plays are no longer as hot as they were after the election.
Christopher said investors are increasingly concerned about the timing of tax reform, and that it could be kicked into next year. "The closer we get to the [2018 midterm] election, the more likely you get nothing done," he said.
Christopher said if there's a lack of action, his other worry — concern China's economy could be slowing — becomes more worrisome. "The prospect you're not going to get reflation in the U.S. and China might slow further, that's something where people would have to evaluate the magnitudes," he said.
"Maybe, it's just that we can't get used to the fact that someone's president whose going to act in ways we're not comfortable with, and is not easy to predict. Even if you like Trump, sometimes his tweets get you off guard. Maybe if you like Trump, you're surprised by his slapping of a 20 percent tariff on Canadian lumber," said Christopher.
Julian Emanuel, equity and derivatives strategist at UBS, said the market has been pricing improved earnings but also the expectations of better growth due to tax reform, stimulus and other pro-growth policy. He says political risk is not all that uncommon in the U.S., but now market expectations are high that there will be action.
Confidence measures have soared based on the idea Washington policy will boost growth and profits. "There is a definite expectation that those are in the works. The political risk is not any discrete event in and of itself. It's the whole idea that if there is a perceived delay or perceived incremental difficulty on what the market believes is coming. That's where confidence is affected. What we've shown in our work is when confidence is affected and starts to turn down, that's when multiples and stock prices are vulnerable," Emanuel said.
Investors had been pricing in an 80 to 85 percent chance of some tax reform this year, but that has fallen. "We now think they're pricing the likelihood of tax reform is on the order of 55 to 65 percent and they think it could be late 2017 or early 2018," said Emanuel. If there's no signs of action before the summer congressional recess, that could pressure on confidence and possibly stock prices.
Some of those indicators have begun to fall off the highs reached postelection. The NFIB small-business optimism index for instance, edged down to 104.5 after reaching a high of 105.9 in January.
Both Christopher and Emanuel said President Donald Trump's firing of FBI Director James Comey this week so far was not a big concern for markets, but there is the perception it could create distractions that would take focus off policy and potentially cause a delay in legislation for tax reform.
Keefe Bruyette Wood analysts said the Comey firing is indicative of other issues that could slow tax reform.
"While we do not think there is a direct link between the firing and tax policy, the way it was handled by the White House reinforces a narrative that the White House and the president are impulsive and reactive and that the president still does not fully appreciate the way Washington works," they wrote in a note. The analysts said the announcement "undercuts confidence that the administration can see a complex issue like tax reform through to completion."
Strategas Research policy analyst Dan Clifton said some of the chaos in Washington could actually spur tax reform efforts if Republicans believe they are at risk of losing congressional seats. In a note, he pointed to how success in midterm elections is tied to the approval rating of the president.
Trump's approval rating has fallen to 38 percent, according to Gallup.
Some analysts take as positive the fact that the House was able to finally approve health-care legislation, but the fact that the Senate will propose a whole new bill worries them that the road to tax reform will become even longer.
Christopher said the economy is now growing at a good pace after the first-quarter lag, but he said a risk is that as time drags on, the Federal Reserve could be hiking interest rates with no boost from tax breaks or fiscal spending to offset the impact on the economy.
Some analysts say the market is reflecting its doubts even as stocks hold near highs.
"I'm concerned that small caps are not doing anything. It's an indictment or skepticism this policy will occur. I think people are starting to discount what Trump says. Why is Mexico outperforming the U.S. so much with all ? Why are municipal bonds keeping pace with taxable bonds. I thought they were supposed to go down with tax reform," said Jack Ablin, CIO at BMO Private Bank.
"Investors are reading the tweets but not believing them," he said.