Congress Could Play Havoc With Stocks

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What's it going to be? Raising taxes on individuals making over $200,000? Punishing China unless its currency rises? Imposing higher tax rates on private-equity funds and hedge funds? What move by Congress is the one that could send financial markets tumbling? So far, the stock market has been amazingly resilient to those threats as well as to the recent surge in interest rates. But recall Black Monday, Oct. 19, 1987, and the ensuing stock market crash. In its analysis of those events, the Federal Reserve highlights the following:

"Two events Wednesday morning [Oct. 14, 1987] have been pointed to as precipitating a decline in the stock market that continued for the rest of the week. First, news organizations reported that the Ways and Means Committee of the U.S. House of Representatives had filed legislation to eliminate tax benefits associated with financing mergers. . . . Stocks' values were reassessed as investors reduced the odds that certain companies would be takeover targets. Second, the Commerce Department's announcement of the trade deficit for August was notably above expectations. On this news, the dollar declined, and expectations that the Federal Reserve would tighten policy increased. . . . Interest rates rose, putting further downward pressure on equity prices."

What happens in Washington matters greatly to Wall Street. And it's not just the Fed and rates. Legislation proposed in Congress, even if it never passes, can create plenty of "headline risk" and cause a knee-jerk reaction by investors. The best bet for headline risk is still any of the various trade bills attempting to nudge China into letting the yuan float higher. Indeed, Morgan Stanley economist Stephen Roach, in his farewell note before taking over the firm's Asia operations, made a point of focusing on the issue of trade and globalization:

"The problem with globalization is that we have done a lousy job in understanding and explaining it. And by 'we' I mean my fellow economists, policy makers, politicians, business leaders, and other pundits. Far from the nirvana promised by the imagery of a 'flat world' and the ecstasy of the 'win-win' mantra, the road to globalization has led to saving and current-account imbalances, income disparities, and trade tensions—all having the potential to spark a very destabilizing backlash. The threat of just such a backlash remains a clear risk in today's environment."