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One reason why we may not be seeing more aggressiveness is our final risk – politics. Multiple failures in the US to pass healthcare legislation, despite single-party control, raise questions about a whole host of other issues, from the debt ceiling, to the budget, to taxes. Meanwhile, news reports suggest that the ongoing probe by Special Counsel Robert Mueller is widening.

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks. But on the other issues, we’re more relaxed. The Senate’s Healthcare bill had an approval rating of 17%, so we doubt its failure would be a hit to consumer confidence. The Special Counsel’s investigation, whatever the outcome, will likely take considerable time. Our economic baseline was already cautious with regard to fiscal stimulus, a long-held view of our policy team. And while tax cuts could boost the market temporarily, they could also lead to a more hawkish Fed, a classic ‘be careful what you wish for.’

What Breaks the Egg?

I didn’t win the 4th of July egg-toss, and never really came close. Our egg cracked easily, which couldn’t be a worse analogy for markets over the last three weeks if I tried. The S&P 500, Russell 2000 and NASDAQ have hit all-time highs. Volatility has plunged back down near all-time lows. Credit is tighter and yields have been stable. So what rattles this market? What breaks the egg?

We remain constructive, with longs concentrated in DM equities and EM fixed income. But no one wants to be that complacent investor at the highs, and good times are always the best time to think about what can go wrong. What follows is where we see risks, and why we don’t think they warrant a defensive view (yet).

Let’s start with growth. I believe, with high conviction, that markets have passed the point where bad data can be offset with promises of further easing. But so far this doesn’t matter, because growth in 2017 has been surprisingly good. Our economists see 2Q global GDP at 4.3%Q, the highest reading since 4Q10. Weaker growth will crack the egg, but we’re not seeing it yet.

This brings us to a second risk: valuations and earnings. High stock valuations and strong earnings can be OK (see the early 1960s and late 1990s). High valuations and poor earnings is trouble. A disappointing 2Q earnings season would be a clear catalyst to push the market lower. But there are a few reasons why we don’t think that happens.

First, strong 2Q global GDP should be a tailwind to revenue. And where that growth has been most disappointing (the US), a weak dollar should provide a tailwind. My colleague, Graham Secker, has specific concerns in places like European cyclicals, where inflows have been high, a stronger EUR is a challenge and early earnings misses have been punished. But broadly, we see earnings as more likely to be a positive than negative global catalyst this year.

Strong global growth usually means policy tightening, another candidate to break the egg. But for now, soft inflation is giving DM central banks cover to keep real rates deeply negative. This won’t last forever; our economists forecast the trough in US core PCE in September, inflation in Japan and the eurozone to pick up materially in 1H18 and China CPI to climb steadily over the next 12 months. Our base case is that rising inflation is next year’s problem, but markets could react sooner than we expect. We’re watching this closely.

Strong growth and easy policy, of course, present another risk: aggressiveness. Growth with easy money is a cocktail for all manner of problems, from ill-advised M&A, to excessive bond issuance, to extended investor positioning. All are potential egg-crackers. But again (and you may sense a theme here) we don’t think they’re negatives yet.

M&A volumes in the US and Europe are still only half the 2007 peak. US credit has yet to show strains from oversupply (although we remain cautious, seeing poor risk/reward). Our prime brokerage team tells me that hedge fund net positioning remains near its 10-year average. We’re watching all these closely.

One reason why we may not be seeing more aggressiveness is our final risk – politics. Multiple failures in the US to pass healthcare legislation, despite single-party control, raise questions about a whole host of other issues, from the debt ceiling, to the budget, to taxes. Meanwhile, news reports suggest that the ongoing probe by Special Counsel Robert Mueller is widening.

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks. But on the other issues, we’re more relaxed. The Senate’s Healthcare bill had an approval rating of 17%, so we doubt its failure would be a hit to consumer confidence. The Special Counsel’s investigation, whatever the outcome, will likely take considerable time. Our economic baseline was already cautious with regard to fiscal stimulus, a long-held view of our policy team. And while tax cuts could boost the market temporarily, they could also lead to a more hawkish Fed, a classic ‘be careful what you wish for’ per my colleague Michael Wilson.

Weaker growth, disappointing earnings, hawkish policy, over-aggressiveness and political mistakes are all candidates to break the current tranquility. We like long EURAUD as a combined hedge against tighter policy or weaker growth than we otherwise expect. Our rates strategists like owning long-dated US vs. EU duration, given attractive risk/reward heading into a debt ceiling fight. Against that, we’d maintain a positive overall stance, with longs concentrated in DM equities and EM fixed income.