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• The Trump trade is on, with the S&P 500 hitting fresh highs this past wek.

• But in their exuberance, investors risk overlooking risks to the market.

• Trump's pro-business agenda may distract from headwinds such as inflation and high interest rates, strategists say.

Stocks are at records, and it's clear that the Trump trade is on in the first week of the president's second term in the White House.

But while investors rejoice at the thought of Donald Trump's pro-business agenda, the risk of complacency setting in when it comes to other key issues may be rising.

Trump's return to the White House sparked a big shift in the stock market. It's involved investors re-focusing on the flurry of executive orders and what the president is saying about future policy versus risks that are still present in the economy.

The result could be investors are caught off-guard as inflation and interest rates stay higher for longer, even as tariff threats — one of the main drivers of forecasts of higher inflation — appear to have softened.

Strategists speaking with Business Insider said that they wouldn't be surprised to see a 10% drawdown in stock prices in the coming months as the Trump-fueled rally snaps.

Investors already appear to be somewhat distracted. Bond yields crept up this week, with the 10-year Treasury yield rising from a daily low of 4.53% on Tuesday to as high as 4.65% on Friday morning, suggesting bond markets are repricing on the outlook for interest rates to remain elevated.

Trump said he would "demand" interest rates come down in an address to the World Economic Forum, though the 10-year yield continued to edge up after his comment.

The uptick in yields didn't stop the S&P 500 from hitting fresh all-time highs at the end of the week, even as other recent spikes in bond yields have been catalysts for painful sell-offs in the last few months.

Clark Geranan, the chief market strategist at CalBay Investments, thinks the rally is partly explained by markets being too distracted by Trump's flurry of legislative changes to pay attention to the inflation picture.

"As of now, we're expecting inflation to go up between now and the end of the year, and that's going to be Trump's main point of contention and a battle that he has to fight. So from my perspective, I do feel that a lot of the executive orders that have been put into place are a distraction from this larger inflation problem," Geranan said.

Investors also appear to be betting that Trump's pro-growth policies will outweigh the negative impact of higher inflation, according to Paul Stanley, chief investment officer of Granite Bay Wealth Management. Investors think it's likely that the president will slash taxes and dial back regulation during his second term, two developments Wall Street forecasters have said could boost stock prices.

"I think Trump's made it pretty clear that what to expect is less regulatory oversight and lower taxes and things that have made some people optimistic about the markets. So those other risks that have been out there with inflation are just kind of taken to the back burner right now," Stanley told BI.

But investors should ignore inflation at their own risk.

Economists have warned that some of Trump's policies—like his plan to levy steep tariffs on China, Mexico, and Canada—could stoke inflation and keep interest rates higher for longer. Trump's orders this week were softer than feared, which lifted stock prices. However, the threat of a damaging trade war is still present, and it remains to be seen what shape tariffs actually take.

Inflation, meanwhile, has accelerated in recent months, with consumer prices rising 2.9% year-over-year in December, the highest level since July.

Five-year inflation expectations have also risen, climbing to 2.4% in January, according to Cleveland Fed data.

Inflation could remain stuck at around 3% this year, Geranan predicted. He speculated that the Fed may only cut rates once or not at all in 2025, surprising some investors who are pricing in looser monetary policy.

"As a firm, we are hedging against that inflation pop," he said, adding that he wouldn't be surprised to see a sell-off happen sometime in the next six months, taking stock prices down as much as 10%.

"I think both retail and institutional investors right now have high spirits, animal spirits, and there could be a pullback. We haven't seen a market correction and it's been over a year."

Stanley also considers a 10% stock pullback to be a "strong" possibility.

"There's the likelihood of extreme volatility in one direction or another just based on where we sit," Stanley said. "So if there's any sort of hiccups in earnings for some of the mega-cap companies and things, then we certainly could have some sort of pullback."

Talk of a stock correction has gained traction on Wall Street after back-to-back years of gains of over 20% for the S&P 500.

Investors, though, are still broadly optimistic about stocks. According to the AAII's latest Investor Sentiment Survey, 43% of investors said they were bullish on the stock market over the next six months, up 18 percentage points from the prior week.

Read the original article on Business Insider