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The New Frontier of Political Risks

How the prospect of tax reform and other political issues will affect corporate investments, and what that means for pension plan sponsors.

By Jodan Ledford, Jason Shoup | Updated on May 16, 2017
The behavior of markets so far this year may seem to be at odds with the notion that political uncertainty is both rising and increasingly relevant. Record-low equity volatility, rates that are moving sideways, and the narrow range in which investment-grade credit spreads have been trading are factors that would normally suggest a benign outlook. But looks can be deceiving. Too much uncertainty can also create paralysis among investors. Markets may be balanced precariously, even if they are trading as if all were well. One need look no further than the U.S. interest rate environment to see the policy knife-edge at play.

When considering how an administration’s proposals will affect markets, the question is as much about how companies and consumers will respond to the possible changes as it is about the exact policy details. Since President Trump took office, confidence indicators have moved sharply higher, into territory that would typically suggest increased spending by businesses and consumers. Yet after years of disappointingly weak business investment and rising consumer savings, most investors and economists are taking a wait-and-see approach.

This show-me-the-spending stance on the economy is clearly reflected in the rates market. Nearly all of the move higher in nominal yields in the past several months has been the product of a rebound in inflation expectations, whereas real rates remain low. If the Fed surprises us on the hawkish side this year, it will likely be because wage inflation has accelerated on the back of an improvement in real GDP, telegraphed by the confidence indicators. If the Fed then follows through on discussions to unwind the SOMA [System Open Market Account] portfolio, or the newly appointed members of the FOMC [Federal Open Market Committee] are considerably more hawkish, then rates are unlikely to stay anchored at current levels.

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