Third Quarter Volatility

By Ketu Desai

September, historically the worst performing month of the year, was a positive month for equities, despite certain events during the month that could have easily caused a significant negative move.

Most notably, the market was resilient after a 10 percent tariff on $200 billion of Chinese imports was put in place. China's retaliatory response was less severe than expected, and the staggered structure of the latest US tariffs, with a 25 percent rate coming into place in 2019, allows time for adjustment and opportunity for negotiation.

China has also taken steps to stimulate their economy to mitigate the impact of the tariffs. Premier Li Keqiang said that there is no intention to devalue the yuan directly, which further alleviated market concern. The US dollar weakened on the news, and investors rotated into industrials, materials, and certain commodities. Bellwether cyclical names such as Caterpillar and Boeing staged a rally, while the market sold certain rate-sensitive sectors such as utilities, home-builders, and REITs.

Rate sensitive sectors were particularly hurt as the Fed raised rates during the month and the 10-year hit its highs of the year. Even with the yield curve steepening slightly, and rates moving back above 3 percent, financials continued to underperform. Financials have been particularly weak this year, despite a strong economy, earnings, and favorable market conditions, names such as Citi, Goldman Sachs, Morgan Stanley, and Wells Fargo, are down more than 10 percent since their January highs.

Financials are trading at a discount to the market at 13.4x forward earnings; many are trading at book value, and have RSIs that indicate they are oversold. They begin to report earnings in early October, and with tempered expectations, could be the sector that further supports the S&P.

The Fed will likely raise rates one more time this year in December, and is expected to raise rates three times in 2019. Despite rising rates, leveraged credit markets remain strong. Perhaps a good data point of the health of the credit markets is a deal Blackstone brought to the market in its LBO of Refinitiv. This deal is the second largest debt package for a buyout post-crisis, and the fifth largest in history. The deal is highly levered at 7x EBITDA, and has covenants and protections that are reminiscent of pre-crisis deals.

The state of the leveraged credit markets is an indicator of the liquidity in the marketplace, the strength of the economy, and perhaps investor complacency.

Historically, an important warning sign can come from the credit markets, as conditions become tighter, and spreads start to widen. While high-yield spreads may not be attractive at below 330 bps, we are not yet seeing conditions that are adverse for equities.

Looking forward, the markets will have a close eye on third quarter economic data and earnings reports. The Atlanta Fed is forecasting third quarter growth at 3.6 percent, which would be an upside surprise relative to sell-side consensus. While companies have spent record numbers on buybacks, capital expenditures are up 19 percent this year, on pace to set a 25-year high, according to Goldman Sachs. A cap ex boom leading to productivity could mean that a higher than trend level of growth is more sustainable.

In terms of earnings, Factset expects earnings growth to continue to be strong at 19.3 percent and 7.6 percent revenue growth. The fourth quarter is usually strong for the market, especially as fund managers have cash balances at the highest level in 18 months and need to chase performance.

The fourth and final quarter of 2018 promises to be quite eventful.


Ketu Desai is the Principal of i-squared Wealth Management Inc. (, an investment management firm based in New Jersey.