- North Korea may be scary, but the situation is not yet at the stage where markets would get spooked, as a diplomatic solution remains possible.
- Central banks moving away from easy policy is more of a threat to stocks, analysts say.
- The markets could also react negatively if Washington cannot push through a budget or raise the U.S. debt ceiling before it hits its limit at the end of September.
The escalating war of words between the U.S. and North Korea is nerve-wracking, but other events like a possible debt-ceiling crisis and a hawkish Federal Reserve could create a bigger reaction in financial markets.
Stocks have been in a slow drift higher this summer, with valuations getting to lofty levels as the indices hit new highs. Solid earnings growth and low expectations for Fed interest rate hikes have been positive catalysts for stocks.
The has declined modestly in the past two sessions, as President Donald Trump threatened to bring "fire and fury" to North Korea. In turn, North Korea said it could attack Guam. On Wednesday, the S&P traded lower for most of the session before closing flat at 2,474.
"The rhetoric was pretty fiery on both sides," said Paul Christopher, head global market strategist at Wells Fargo Investment Institute. "We don't know that much about Kim Jong Un, but we see from the president that he likes to tell you what he thinks in plain English. When you have this kind of exchange without the benefit of diplomatic service to go in between, the markets don't know what to think momentarily."
More than a few strategists have been warning of a stock market pullback in late summer or early fall, but equities have been resilient, with volatility low and complacency at a high.
While the friction with North Korea sent investors into safe havens, such as bonds and gold, the move is expected to be temporary unless there is further escalation.
A number of firms have been warning that a market correction could be coming, but they point to other reasons. They include Doubleline and Bank of America. Wells Fargo's Christopher says there could be a selloff of 5 to 10 percent, and he's been expecting it for a while.
"To me, the fall and late August is all about what the Fed does and what the [European Central Bank] does," said Peter Boockvar, chief market analyst at Lindsey Group. "You have the potential for two major central banks that are pulling back. I think that is the biggest deal for markets. That is quantifiable in terms of psychology. Trying to game the North Korean situation is impossible."
Analysts say North Korea would have to show that its nuclear capabilities and launch ability have improved to get the markets really scared. "You would have to see the sides give up the possibility for a diplomatic conversation, even if it's not between the U.S. and North Korea. If the U.S. and China were to publicly break over North Korea, that would be a significant negative," said Christopher.
But for now, strategists see a bigger potential upset for the markets coming from Washington, depending on how Congress handles budget legislation and raising the debt ceiling in September. Treasury Secretary Steven Mnuchin has warned the debt ceiling will be reached Sept. 29 and if no action is taken the U.S. could be in default by October. Congress also has to pass a budget by Sept. 30 or the government will shut down as it did in 2013.
While many analysts expect Congress to move ahead on both, there could be battling that takes it down to the last minute and that could upset markets.
"They could pass extensions, but the bottom line is what we've seen with the Republican House, Senate and presidency is that they've accomplished nothing," said Michael O'Rourke, chief market strategist at JonesTrading. "To think they'd come back from their recess and it will be smooth sailing is hard to believe. Other years, we'd be worried about this."
The other big market force that could ruffle markets is clearly the Fed, which is expected to begin the untested task of unwinding its $4.5 trillion balance sheet in September. The Fed also has forecast another interest rate hike for later this year, but markets are skeptical it will actually take action.
The Fed meets Sept. 19 and 20, but investors may also hear hawkish comments from Fed officials and even European Central Bank President Mario Draghi at the annual Jackson Hole Fed symposium later in the month. The ECB is also expected to start pulling back from its easing policies.
"Not only do central banks have less room to ease in order to blunt the impact of the next recession, many are declaring victory on the major dislocation from the financial crisis and have already begun to reduce accommodation. This change in central bank behavior is one of the major pivots investors need to focus on," wrote Pimco analysts, who also say investors should reduce risk in view of the potential for more aggressive central banks.
Citigroup also warned its clients a correction could be coming amid high valuations and central bank tightening.
The market view of the Fed shifted dramatically this summer after Fed Chair Janet Yellen seemingly changed her message on the softening of inflation this year. Fed officials had said weaker inflation was transitory, but Yellen said the Fed was concerned about the weakening when she testified before Congress last month.
That pushed back market expectations for rate hikes, and now futures show there is just one expected next year and the odds for a December rate hike this year hover around 50/50. That contrasts with the Fed forecast for three hikes next year and one more this year.
Therefore any reading on inflation has become critical. Recent PCE inflation data was a weak 1.5 percent, and the July jobs report showed no sign of a meaningful boost to wage inflation.
The market is looking forward now to the CPI consumer inflation data Friday.
Christopher said he expects inflation to pick up in the next several months, and at that point, the Fed's forecast and market expectations for fewer interest rates will need to be reconciled. That could cause market volatility if the Fed's view wins.
Christopher said he remains positive on stocks into 2018, even with his expectation for a pullback.