Fve risks — including NAFTA and North Korea — that could get in this bull market's way

  • Stocks are expected to see another up year in 2018, but with more a more muted single-digit gain.
  • Strategists say there are plenty of things to worry about.
  • Domestic politics, a tailwind with this year's tax reform vote, could become a headwind next year as Congress deals with some tough issues and an election.
Jumping bull
Burak Akbulut | Anadolu Agency | Getty Images

As the bull market heads into its ninth year, the list of potential risks that could stop its run is growing.

The wall of worry starts in Washington, but the sources of potential risk come from around the globe — including North Korea, China and the Middle East.

Domestically, the Alabama U.S. Senate vote this week suggests that the 2018 midterm elections may not go smoothly for congressional Republicans and President Donald Trump as they try to hold onto the GOP majority next year. That threatens the Republican agenda and makes it possible that the tax reform vote, expected next week, could be the final big GOP initiative to make it through Congress.

"I think the most enduring risks that investors face tend to come from domestic forces," said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman.

On the geopolitical front, markets could face bouts of nervousness in the new year as the Trump administration is forced to find a way to deal with North Korea's nuclear ambitions, which increasingly threaten global security.

However, there is a solid list of positives, and analysts expect another up year for the market in 2018, but with more modest gains. Strong earnings growth, a new corporate tax plan and a stronger global economy should help provide fuel for the bull market for another year. CNBC's survey of Wall Street strategists shows a median forecast of 2,800 on the S&P 500, a gain of about 5 percent from current levels, versus 2017's 20 percent gain.

The economy and market are heading into late cycle, which should be a good period for both.

"You have the possibility of a record-long expansion," said Steven Wieting, chief investment strategist at Citi Private Bank. He said there are "the seeds of a decent late-cycle environment which is not producing any signs of future catastrophes so far. We should enjoy these."

Yet, for all the good news there are a few potential time bombs for markets.

Protectionism and trade

When President Trump was still candidate Trump, one of the biggest fears about his presidency was that he would be protectionist and start trade wars. Aside from targeted skirmishes — like Canadian lumber or Chinese aluminum — that largely has not happened, though he did keep his promise to pull the U.S. out of the Trans-Pacific Partnership.

The president also threatened to drop out of NAFTA, the 23-year-old agreement between the U.S., Mexico and Canada because he views it as unfair to the U.S., which has a more than $60 billion trade deficit with Mexico.

Talks have been underway to renegotiate the agreement, but there are few signs of progress and talks could fail.

"The risks to NAFTA are increasing," said Chandler. He said there will be an economic hit, and government data show 2 million U.S. jobs are tied to trade with Canada and Mexico.

Trump has complained that Mexican factories have stolen U.S. jobs, and Canada's dairy farmers are unfair to Americans. "It could be problematic for the economy. If you listed for each state which is the largest market, you'll find either Mexico or Canada in almost every state," said Chandler.

If the North American Free Trade Agreement is ended, there likely would develop new bilateral agreements, but the fear is that the Trump administration will have unleashed the start of a bigger trade war that could spread.

"If you unwind that, you're going to hurt of a lot of American companies," said Jim Caron, fixed income portfolio manager with Morgan Stanley Investment Management. Caron said supply chains and economic links between the three countries are complicated. "How that goes, and the knock on effects ... it could be messy. It's definitely one of the risks out there."

Polarized politics

The GOP sweep in November 2016 was expected to bring in an era where Republican initiatives would easily roll through Congress. But the deep divide on some issues, like health care, has proven that's not the case. Now, there are threats to the GOP's ability to hold onto its majority.

"The Alabama Senate race is another data point, pointing [to] a tsunami election building against the Republicans in 2018. They have no other choice but to pass major pro-growth tax reform with the hope that growth overcomes their current political headwinds," said Dan Clifton, head of policy research at Strategas Research. Republicans have a tentative deal on the bill and are heading toward a vote next week.

Clifton said the election is the number one risk in politics for next year. "Number two, you have the Mueller investigation and number three, you have the debt ceiling," he said. The investigation by special counsel Robert Mueller into the Trump campaign's ties to Russia has so far ensnared Michael Flynn, the former national security adviser, and former campaign manager, Paul Manafort. Markets would get nervous if the investigation appeared to get close to Trump.

As for the debt ceiling, Congress will have to vote to raise it during the spring, something that could kick off a battle within the GOP ahead of the midterm election.

"I think the environment we could have for a midterm election could be ugly," said Michael Arone, chief investment strategist for State Street Global Advisors. He said business and consumer confidence could be harmed by polarized politics, and if the Democrats win, there could be fear that the tax cuts could be temporary.

"Right now the environment is as bad as I've ever seen for congressional Republicans," said Clifton. He said if the election were held now, then the GOP could lose 34 seats in the House. One issue is whether the public's perception improves about the tax legislation once it goes into effect and provides tax cuts for many individuals in addition to business.

"The question is, does this tax bill start to change that equation? Does that tax bill start to improve peoples' outlook? Do they start to give Trump credit? We're watching Trump's approval rating. We're watching GDP. We're watching consumer confidence. We're watching the retail price of gasoline," Clifton said.

Fast forward the Fed 

Most Fed watchers expect the Federal Reserve to continue its slow march to higher interest rates, and so far that appears to be what will happen in 2018 under the new leadership of Jerome Powell. The Fed expects to raise interest rates three times in 2018.

The Fed has also taken steps to unwind other easing implemented because of the financial crisis, and it will continue that program next year. The Fed has reduced the amount of bonds it will replace on its balance sheet, as its Treasurys and mortgages mature. That, in turn, reduces the size of the Fed's more than $4 trillion balance sheet.

But one risk some strategists see is that if inflation starts to pick up, the Fed could stop its slow walk to higher interest rates and increase the pace of hiking.

"I'm seeing anecdotal evidence of higher inflation," said Peter Boockvar, Lindsey Group's chief market analyst.

But he said an even bigger risk for markets is the fact that a number of the world's central banks are moving away from their easy policy and will continue to do so in 2018.

"Central banks are the biggest risk to asset prices, just as they were the biggest boost to asset prices in the last seven years," Boockvar said. Between the European Central Bank and the Federal Reserve, he said, there will be $1 trillion less liquidity, as the ECB and the Fed cut back on asset purchases.

He said easing by the ECB and Bank of Japan in 2017 had helped offset the Fed's rate hikes and the start of its program to slow down asset purchases.

"We had an extraordinary amount of money printing int 2017 and that was a big boost to asset prices around the world," Boockvar said.

 'Goldilocks' economy 

With a pickup in growth in 2017, a very strong labor market, low inflation and an easy Fed, the economy in late 2017 feels almost too good to be true.

The stock market has surged alongside a rebound in the global economy, but some investors are worried that bonds are not sending the same rosy message as stocks.

The flattening Treasury yield curve is a cause of worry for some who see it as a warning the economy could be heading for trouble. The so-called "flattening" is the narrowing of spreads between the yields of Treasurys at both ends of the curve. In the case of the 2-year to 10-year spread, the difference in yield is the lowest — or flattest— it's been in 10 years.

A flat curve by itself does not necessarily signal danger, but if the curve inverts, history shows that could be a sign of a pending recession. Some bond strategists expect to see the curve invert sometime next year.

"I don't think it's a sign we're going to go into a recession anytime soon," said Caron. "The flattening of the curve I think is more of a manifestation of QE [quantitative easing] ending."

One worry that could impact the global economy is a potential slowdown in China

"One of the things that might be underappreciated is the fact China had done much better than many people expected," said Arone. "There were all these concerns going into 2017, regarding a hard landing in China and credit blowing up. As we headed toward the party congress, it was clear China was not going to let that happen."

At the congress in late October, Xi Jinping was reaffirmed as Chinese president for five more years. "Now that they consolidated power, you're starting to see some of the data roll over," Arone said.

Boockvar said China remains a concern. "China certainly is a risk, just difficult to quantify. China has made attempts to slow the excessive credit growth they've had," he said. "There's a risk there, too, if they continue with their attempts to slow credit growth."

Chandler said China is a concern every year. "The most likely scenario is China continues to chug along and if anything, growth moderates a bit. ... There's this constant fear that China is going to implode, slow down, stop buying Treasurys. Every year we go through this, and every year it doesn't turn out."

Geopolitical hot spots

North Korea with its unpredictable leader, Kim Jong Un, tops the list of sources of potential anxiety for markets. As North Korea has tested its missile capability, the war of words between Trump and Kim has accelerated.

"I suspect now that North Korea says they have an intercontinental ballistic missile that can hit the U.S., now they can talk. Now they can have negotiations," said Chandler.

The Middle East is also on the list as Iran is increasingly viewed as a threat by its neighbors.

Saudi Arabia has taken on a more aggressive role, with its war in Yemen and threats to Qatar. Crown Prince Mohammed bin Salman has assumed leadership and has purged his rivals in a "corruption probe" in which he has detained about 200 royals, businessmen and military leaders.

Europe could also be the source of political risk as Brexit talks continue between the European Union and the U.K. In the biggest EU economy, German Chancellor Angela Merkel has been having a hard time forming a coalition government.

Politics are also creating nervousness in the bond market. Italian yields jumped Wednesday. Italy's parliament is expected to be dissolved at the end of the month ahead of a March election.

Correction: An earlier version misstated the trade volume between the U.S. and Mexico. The U.S. has a $60 billion trade deficit with Mexico.