There is still a month to go before 2016 draws to a close, yet I think it's fair to say that we can call this the Year of the Unexpected. From the world of sports to the world of politics, we saw some big surprises. Track fans were surprised when Wayde van Niekerk of South Africa shattered the 17-year old world record in the 400 meters at the Olympic Games. Baseball fans were surprised when the Chicago Cubs won the World Series. But as great as these surprises were, they had no impact on the markets.
Then there's the world of politics. In particular, Brexit and Donald Trump's victory were huge surprises to many people and they certainly rocked the markets. However, I think what was even more surprising was how quickly the markets bounced back after these unexpected political outcomes.
Well, with just one month left in the year, I began to wonder what other surprises might be in store that could really shake up the markets. I see two potentially big ones on the horizon. The first is the Italian referendum to be held on December 4. Italians will either vote "Yes" in favor of making major reforms that will streamline the government, or they will vote "No" to reject these reforms. Prime Minister Matteo Renzi has promised to resign if the No vote wins. So far, that doesn't seem too worrisome. However, the problem is that Renzi's resignation increases the odds that a populist party called the Five Star Movement will eventually take control of the government. Members of this party favor holding a referendum on Italy's membership in the European Union, much like the one held in Britain. And if Italians vote to exit just as the Brits did, this could mean the collapse of the entire European Union. Just to be clear, a victory for No on December 4 does not guarantee Italy's exit from the European Union, but it does increase the odds of an exit. How would U.S. equity markets react to a No victory in Italy? I suspect we would see something similar to what happened with Brexit and Donald Trump's election: a strong sell-off followed by a rebound.
The second potential surprise would be much bigger. On December 14 Janet Yellen and the Federal Reserve will announce what they plan to do with interest rates. The overwhelming expectation is for a 25 basis point hike in the Fed's target range for the Fed funds rate. This expectation is so strongly baked in that the CME Group's FedWatch Tool (which calculates the probability of a rate hike based on the behavior of futures prices) is currently predicting that there is virtually no chance that the Fed won't raise this key interest rate. I'm not suggesting the Fed won't hike. In fact, I believe the Fed should have raised rates six months ago. I'm simply pointing out that it would be a huge surprise and a shock if the Fed decided to stand pat just as it has at every meeting so far this year. How would the equity markets react if the Fed doesn't hike? Contrary to what we've seen in the past and to what many investors believe, this time I suspect we would see a strong sell-off. I say this because failing to raise rates when the expectation is so high would make investors wonder what the Fed is really thinking. Does it believe that the economy is still much too fragile? Or is it telling us that it lacks confidence in the new Trump administration?
A sell-off in reaction to a No vote in Italy would most likely be a buying opportunity. But a sell-off in reaction to Fed failing to raise interest rates could be quite prolonged. If the Fed doesn't hike on December 14, I might just lock in some profits for the year and turn my focus to holiday shopping.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.