The post-election rally that began after the Republican sweep in November has largely continued, albeit at a reduced pace through the 1st half of this year. Since the beginning of 2017, the S&P 500 index has increased nearly 8.9%. The increase is largely dominated by pro-market policy expectations from Washington and Q4 earnings results that exceeded expectations.
The political headwinds facing markets may make any meaningful gains unlikely in the near term (next 1-3 months). The failure of Republican efforts to repeal and replace Obamacare revealed how challenging it is to pass major reform. Although the market shrugged off the defeat, we doubt it will take a setback on tax reform in such a passive manner. Going forward, the administration is either going to win over the conservative Republicans or it will have to reach across the aisle to moderate Democrats. Working with the Democrats would likely result in a more watered-down tax reform (cuts) package than the market expects. We don’t view this negatively for the equity market as successful policy advancement should suffice as long as the economy holds up and earnings continue to recover.
Bigger picture (12-18 months): The political process is likely to present the market with emotional moments as the year progresses. We would not be surprised to see the economy provide periods of uncertainty for the markets given how far above sentiment readings have become versus actual data flow. For these reasons, greater volatility in the coming months will be greater than what we have seen recently. Yet through all the noise, we feel economically positive reform will eventually be realized. We also feel the economy will generally be favorable even if not as robust as sentiment readings currently imply. These outcomes along with a continued recovery in earnings will support higher equity prices through the rest of the year.
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