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Dow Jones NewsFeb 14, 8:38 PM UTC
MW The stock market is ignoring what could be its No. 1 threat
By Cam Hui
How 'tail risk' - uncertainty over inflation, tariffs, political chaos and other unknowns - could trigger a chaotic market downturn
Stock prices have held up remarkably well in the face of worries about DeepSeek, tariffs, geopolitics and other economic developments. But U.S. stock-market investors seem to be ignoring tail risk, and that is an increasingly disturbing development.
Wednesday's hot CPI report is an example. Core CPI came in higher than expected, dampening any expectations for the U.S. Federal Reserve to cut interest rates in the near future. But both the Dow Jones Industrial Average DJIA and the S&P 500 SPX fell only slightly, while the Nasdaq Composite COMP was basically flat.
Read: Hot CPI reignites stagflation fears. Here's why that would be disastrous for your 401(k).
Moreover, the most recent University of Michigan inflation-expectations report had a glass half-full and half-empty quality to it. Inflation expectations rose overall, but expectations were highly bifurcated depending on the political views of the respondents. In general, Republicans expect zero, or near-zero, inflation, while Democrats expect inflation to surge.
The glass-half-full interpretation is that this sentiment survey has become useless, as it just reflects political partisanship. The more ominous glass-half-empty interpretation is that inflation expectations are becoming unanchored to the downside for Republicans and to the upside for Democrats - an unwelcome development for Federal Reserve policymakers.
Sleepwalking into a trade war
The market also seems to be ignoring the risks of a trade war. When President Trump announced a 25% tariff on Canada and Mexico and 10% tariff on China, stock prices fell, recovering when Trump walked back and delayed those tariffs for a month. The market barely budged when Trump announced additional tariffs on aluminum and steel imports and reciprocal tariffs on U.S. trading partners. This was in the face of a warning from the CEO of Ford Motor Co. that aluminum and steel tariffs would cause chaos for the auto industry.
Read: This is why Trump's tariff plan has upended the car industry - and it's not over yet
Market strategist George Pearkes said that "markets are really bad at pricing binary outcomes," such as the prospect of a tariff-induced trade war - until it happens. He cited the example of the COVID-19-triggered crash: "We had cases in the U.S. in January, the first public death Jan. 9, the genome was sequenced Jan. 10, and markets kept rising until Feb. 19."
Similarly, as the chart below illustrates, the stock market didn't react to Trump's trade war in 2017-2018 until it stared the news in the face.
U.S. government spending cuts to pay for tax cuts pose a headwind to stock prices.
The stock market seems to be ignoring other key risks. The U.S. House and Senate can't seem to agree on a budget. Even if Congress were to agree on a bill that extends the tax cuts from the Tax Cuts and Jobs Act - an important Trump legislative priority - its passage doesn't inject additional economic stimulus because it represents the status quo. Not known is the extent of spending cuts to pay for the tax cuts, which represents fiscal contraction that poses a headwind to stock prices.
As well, Trump threatened that "all hell would break loose" if Hamas doesn't release all of its hostages by Feb. 15. The president's belligerent remarks put the Israeli government in a difficult position. Conceivably, the tail risk of an attack on Iran could grow if the Saturday deadline comes and goes without a satisfactory resolution.
Not incidentally, markets are approaching a seasonally positive period for the VIX Index, which raises the odds of a volatility spike in the near future.
Meanwhile, the SKEW Index, which measures the price of hedging downside tail risk, has risen to elevated levels since the U.S. presidential election last November. Readings aren't extreme, but still, it's a time when investors should be prepared for anything.
Cam Hui writes the investment blog Humble Student of the Markets, where this article first appeared. He is a former equity portfolio manager and sell-side analyst.
More: CPI and Treasury yields warn the market's bull run could be in trouble. Here's how to read it.
Plus: The Fed is going to be even more cautious about inflation after CPI report
-Cam Hui
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02-14-25 1538ET
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