Factbox – Wall Street in 2018: the biggest risks for stocks

FILE PHOTO: A street sign for Wall Street is seen outside the New York Stock Exchange in New York City
FILE PHOTO: A street sign for Wall Street is seen outside the New York Stock Exchange (NYSE) in New York City, U.S., December 28, 2016. REUTERS/Andrew Kelly/File Photo

December 27, 2017

By Caroline Valetkevitch

NEW YORK (Reuters) – Wall Street’s rally could have another leg up next year thanks to a sweeping tax cut and economic momentum, but investors are counting the risks that could abruptly end the party.

The S&P 500 <.SPX> is up about 20 percent with less than a week to go of 2017, and many strategists expect the bull run that began in 2009 to extend into next year, albeit with smaller gains. Optimism is high following sweeping tax cuts passed by Congress last week that are expected to give an added boost to corporate profits next year.

But strategists and investors highlight these risks for the year ahead:

FED GETS TOO AGGRESSIVE

The pace of interest rate hikes, particularly after stronger economic data, could derail the market, say some. The U.S. economy grew at its fastest pace in more than two years in the third quarter.

Wall Street’s top banks expect the Fed to raise U.S. interest rates three times in 2018, matching the number of rate hikes this year and the central bank’s own outlook.

“That will be a risk for the market,” said Paul Nolte, portfolio manager at Kingsview Asset Management in Chicago. “You’re going to risk inverting the yield curve at that point and provide a reasonable competition to equities.”

INFLATION ACCELERATES

Some strategists fear inflation will accelerate too quickly as economic growth picks up, creating margin pressure and putting pressure on the Fed to bump up rates faster than investors expect.

“Inflation could be a global game-changer for stock and credit markets,” Bank of America Merrill Lynch analysts said in their 2018 outlook this month, adding that wage inflation was potentially the most important factor for the stock market.

MIDTERM ELECTIONS AND POLITICAL UNCERTAINTY

Investors will pay close attention to next year’s midterm elections. Democrats are hoping to reclaim seats in Congress, now controlled by Republicans.

“If the Republicans lose the House or Senate, or both, then that would probably be a big negative for the market,” said John Praveen, chief investment strategist at Prudential International Investments Advisers LLC in Newark, New Jersey. “The market would begin to worry that… the Trump agenda will be stopped in its tracks.”

GEOPOLITICAL PROBLEMS GET WORSE

Rising tensions between the United States and North Korea rattled markets around the world in 2017, but Wall Street was able to shake off those worries. Next year, these and other geopolitical concerns are likely to come up again, strategists said.

“Tensions abound, remaining elevated with North Korea and rising in the Middle East,” Keith Lerner, chief market strategist and managing director, portfolio and market strategist, SunTrust Advisory Services, Inc, in Atlanta, Georgia, wrote in his 2018 outlook note.

Also, “the political pendulum is swinging toward populism and nationalism across the globe.”

Next year is expected to include key elections in Italy, Mexico and Brazil, among others.

VALUATIONS KEEP RISING, ALONG WITH SENTIMENT

While strategists expect U.S. earnings to get an added jolt of adrenaline next year because of the tax cuts, some worry it might not be enough to justify stretched valuations.

The S&P 500 is trading at about 18.5 times forward earnings, the highest since 2002, Thomson Reuters data shows.

Investor sentiment could raise some concerns, according to a Dec. 15 note from Citigroup’s Chief U.S. Equity Strategist Tobias Levkovich.

Citi’s panic/euphoria model is signaling a greater than 60 percent probability of a down market by this time next year, “which is akin to waving a yellow flag of caution,” he wrote.

CRYPTOCURRENCY RUN REVERSES FAST

The world’s biggest and best known digital currency, bitcoin <BTC=BTSP>, has been on a tear, and could be a wild card for 2018.

“Bitcoin is on a momentum run, and momentum plays go until they don’t anymore,” said Bob Doll, senior portfolio manager and chief equity strategist at Nuveen Asset Management, adding that investors would ask: “‘If Bitcoin can go down a multiple tens of percent, why can’t my stocks as well?'”

(Reporting by Caroline Valetkevitch; additional reporting by Sinead Carew; Editing by Andrew Hay)