The year-end stocks rally on the heels of the election of Donald Trump as US president was built on expectations of reduced regulations, big tax cuts and a large fiscal stimulus.
Now signs are emerging from the Trump camp that harsher trade policies that could jeopardize the honeymoon are likely in the offing, and investors would be well advised to give those prospects more weight when gauging how much further an already pricey market has to run.
By naming China hawk Peter Navarro as head of a newly formed White House National Trade Council, the incoming administration is signaling Trump's campaign promises to revisit trade deals and even impose a tax on all imports are very much alive.
Among the policies favoured by Navarro and Trump's pick for commerce secretary, Wilbur Ross, who has the president-elect's ear on a range of economic issues, is a so-called border adjustment tax that is also included in House Speaker Paul Ryan's "Better Way" tax-reform blueprint.
If implemented, economists at Deutsche Bank estimate the tax could send inflation far above the Federal Reserve's 2 per cent target and drive a 15 per cent surge in the dollar.
Analysts calculate that, all else being equal, a 5 per cent increase in the dollar translates into about a 3 per cent negative earnings revision for the S&P 500 .SPX and a half-point drag on gross domestic product growth.
The dollar index .DXY has already gained more than 5 per cent since the US election.
Harsher trade policies may not cause a full economic slowdown, "but I'd expect a localized recession in manufacturing and smaller gains in factory employment as well," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin.
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He said the border tax could trigger retaliation, pouring uncertainty into the market.
"Even if the drafters of the legislation have pure intentions, other countries could use this as a pretext for propping up or subsidizing their own favourite industries."
TOP ECONOMY RISK
Stocks have rallied broadly since Nov. 8, with the S&P 500 advancing by 5.7 per cent and the Dow Jones Industrial Average .DJI surging nearly 9 per cent to brush up against the 20,000 mark.
Some sectors, such as banks .SPXBK, have shot up nearly 25 per cent in the post-election run.
US equities have gotten substantially pricier from a valuation vantage as well.
The forward price-to-earnings ratio on the S&P 500 has risen by a full point since Election Day, from 16.6 to 17.6, Thomson Reuters data shows.
That makes stocks about 17 per cent more expensive, relative to their earnings potential, than their long-term average multiple of around 15.
Small caps have gotten pricier still. The forward multiple on the Russell 2000 has risen to 26 from 22 on Nov. 8, up 18 per cent, while the index price has climbed 14 per cent.
S&P 500 earnings are expected to rise 12.5 per cent next year, according to Thomson Reuters Proprietary Research estimates.
Anything that impedes companies from achieving that target, such as a bump from a trade spat or further dollar appreciation in anticipation of new trade barriers, would undermine equity valuations.
In the latest Reuters poll of US primary dealers, economists at Wall Street's top banks cited Trump's evolving trade policies over other factors, such as fiscal policy, a strong dollar and higher interest rates, as the greatest risk to the near-term economic outlook.
The idea of a tax on imports "should alarm people," according to Michael O'Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut.
"If we do have a trade war that's going to be a major negative" for stocks, he said, adding that the upward momentum in equities, alongside the lack of participation due to the upcoming holidays, have so far prevented a repricing but "we could cap the rally here, that could very well happen."
O'Rourke said technology, a sector that represents the globalisation trade, would be among the hardest hit by taxing imports.
Deutsche Bank's auto sector equities analyst estimated the border tax could slam other industries that rely on global supply chains, with the cost of a new car, for instance, jumping by as much as 10 per cent.