A strong stock market raised the risk of policy mistakes by both the Federal Reserve and President Donald Trump. A bear market could do the opposite by removing the sense of complacency about the economy.
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The Fed Grapples With Bear Market
The Fed probably made a mistake by hiking its key rate last week. Yet a single quarter-point rate hike likely won't kill the economy, and the end of the bull market has probably averted a more serious mistake in monetary policy.
Fed Chair Powell said in September that it would take a "significant correction and lasting correction" to have an impact on Fed policy. We've cleared the "significant" hurdle, and "lasting" isn't far off.
This Fed wasn't afraid of a bear market, but it doesn't want to see a sustained bear market. Now financial markets are pricing in roughly equal odds of a rate cut and a rate hike by early 2020.
New Trump appointments will help create a more dovish Fed bench in 2019. Barring a strong rebound for the stock market, the Fed could announce a plan to begin winding down quantitative tightening as soon as Jan. 30.
Bear Market Saps Trump's Trade War
The bear market in stocks will make Trump even more determined to avoid an escalation of a trade war that could disrupt the global economy and keep the Dow Jones from getting off the mat.
JPMorgan analysts wrote in September that the strength of the economy and stock market may "embolden the president on all geopolitical fronts" and create risk of "a major miscalculation."
Trump tariffs of 10% on $200 billion worth of Chinese imports took effect Sept. 24, within three days of the S&P 500 hitting a record. At the time, a number of Wall Street firms were predicting that Trump tariffs would likely escalate to 25% on the full half-trillion in imports from China in 2019. But stock market weakness in October and November helped set the table for a constructive meeting between Trump and Chinese President Xi Jinping.
For now, fear seems to be running high on Wall Street that the cease-fire in the U.S.-China trade war could end on March 1, the deadline for a deal to avoid an escalation of tariffs. Yet the arrest of Huawei CFO Meng Wanzhou, rather than a deal breaker, reveals why China can't afford a technology cold war with the U.S. right now. It's still too dependent on American tech.
That gives Trump the leverage he needs to exact an acceptable deal from China. The risk that he'll demand too much, pushing the talks to the breaking point, is now lower.
Bear Market Weighs On Trump Political Fights
Trump appeared to have little to gain from a government shutdown, but provoked one anyway, demanding money to build a wall to appease his base.
The shutdown has contributed to a stock market swoon, and future political actions may be constrained by a sagging Dow Jones.
For example, Trump has apparently decided against firing Powell because the hit to Fed independence could jolt financial markets.
Still, Trump will have plenty of opportunities to pick market-rattling political fights. The Democrats won back the House, gaining the power to investigate Trump. Meanwhile, the Robert Mueller probe is moving toward a climax and getting closer to the White House. Where it goes is impossible to say.
Bottom line: The combination of a dovish Fed shift and fading trade-war fears could help stocks regain their footing and give the economy a good chance of avoiding recession this year or next. Yet Trump remains a wild card.
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