Policy risks a distant second to the real economy

In this article, Russ Koesterich discusses the resilience in the U.S. economy and why he believes stocks will continue their climb higher thru year-end.

Key takeaways

• While policy-related risks remain ever-present in the current geopolitical climate, investors are bidding an already expensive stock market even higher.
• Against the backdrop of a strong U.S. economy – including lower yields, calmer markets and rosier GDP forecasting – investors continue to fade geopolitical risk and buy the dip.

The list of policy-related risks is long, varied and growing, including lingering tariff uncertainty, a government shutdown with the potential to exacerbate an already soft labor market and rising geopolitical tension in Europe. And of course, these risks are occurring against the backdrop of a stock market that is not exactly cheap.

The collective response of equity investors? Bid stocks to record highs. While more bearish investors can rightly point to high valuations and unpriced tail risks, a rising market is not as irrational as it might seem. Three factors support investors downplaying policy risks. The economy and earnings are solid; rates are moving lower amidst a collapse of volatility; investors have generally been paid to fade geopolitical and policy risks.

Returning to Trend

One of the main reason investors are looking past the tariffs and government shutdown is the ongoing resilience in the U.S. economy. Last spring, at the peak of tariff uncertainty, economic expectations collapsed. At that time, the average expected 2025 GDP forecast of a Bloomberg survey of economists fell from 2.3% in February to 1.4% in May. It has subsequently rebounded to 1.8%, a level broadly consistent with trend growth. And as economic expectations have risen, so have earnings expectations. After plunging in the first half of the year, analysts now expect better than 12% growth for S&P 500 earnings over next year.

Calmer Waters

Recently, investors have derived further support from the bond market.

10-year bond yields are approximately 0.50% below the spring peak, with the decrease mostly a function of lower real rates, indicating easier financial conditions. Not only are yields lower, but markets are calmer. The MOVE Index, which measures volatility in the Treasury market, is roughly 50% below its spring peak and at the lowest level since early 2022 (see Chart 1).

Chart 1

U.S Treasury Volatility

While headlines may rattle markets, during the past several decade’s investors have been conditioned to fade geopolitical risk, from North Korean missile launches to government shutdowns. In most instances, buying any dip proved a profitable strategy. It is also helpful that few of the economic transmission mechanisms that can accompany a potential crisis, such as higher oil prices, are currently an issue.

What the market would not look through

None of which is to suggest that investors will or should ignore any shock. What events would have a higher likelihood of derailing the market rally? Three potential flags to watch: geopolitical tension leading to higher oil prices, tariffs causing a more meaningful spike in inflation and/or a prolonged government shutdown that materially weakens the labor market. So far, my base case is oil prices stay low, inflation while still elevated is manageable and the shutdown is unlikely to derail the economy. Until proven otherwise, the path of least resistance for stocks in Q4 is higher.

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