Eye on the Markets - 2017

Gauging the Fourth Quarter

By Ketu Desai

This year September, a historically volatile month for the markets, turned out to be strong. In this article, we will examine recent activity, discuss a significant policy change from the Federal Reserve, and look forward to market drivers for the fourth quarter.

During September within equity markets, rotation was a key theme. Investors rotated into factors/sectors that have underperformed thus far this year. Small caps outperformed large caps, value outperformed growth, underperforming sectors (such as energy) outperformed strong sectors (such as tech). The drivers behind these moves were continued global growth, a more hawkish Fed tone, and the prospect of tax reform/cut. These themes were also drivers of other asset classes. As Treasury yields rose, gold fell, and the dollar rallied. Oil rallied due to improving supply and demand dynamics and global growth.
One of the important events during the month was the Federal Reserve announcing that it will begin shrinking its $4.5 trillion balance sheet. The balance sheet has grown from approximately $900 billion pre-financial crisis, through the Federal Reserve's quantitative easing program. It is expected that the steady state level of the balance sheet will be around $2.5 - $3 trillion. As a reminder, to help recover from the crisis, the Federal Reserve initiated a quantitative easing program.

The program essentially allows the Federal Reserve to buy longer dated Treasuries, which in turn lowers longer-dated interest rates and pumps liquidity into the system. In particular, lower interest rates encourage economic activity from lower mortgage rates to lower rates for business owners to borrow to expand. From a financial markets perspective, as the Fed buys bonds, it pushes investors into other asset classes to achieve their desired rate of return.

While the plan has been well communicated and the monthly reduction is modest relative to the size of the bond market, it is unprecedented, and is a source of risk in the market. The growth of the balance sheet has been an important factor in the rally of most asset classes in recent years. As the Fed bought bonds, liquidity flowed to real estate, equities, and other asset classes.

One would think this change in Fed policy from providing liquidity to removing liquidity would have had a greater impact on risk assets. For the time being, the market appears to have comfort in a few factors. First, the Federal Reserve lowered its long-run level of the Fed Funds Rate to 2.75 percent from 3 percent. Second, the plan is well communicated and the market knows exactly what to expect in terms of size and timing. Third, from a global basis, central banks are still adding liquidity, as the ECB and BoJ will continue their programs.

For the near term, ECB and BoJ policy and the spread between rates in Europe and Japan with the US should provide support for longer-dated Treasuries. For shorter-term rates, the Fed did sound more hawkish, and it is expected that they will raise rates again in December, despite below 2 percent inflation numbers.

In October, the market will turn its attention to the tax reform/cut debate and earnings. For the third quarter, S&P earnings are expected to grow 4.2 percent and revenues 5 percent. A record number of companies have issued positive revenue guidance for the third quarter with particular strength in tech and healthcare. Two of the key drivers to earnings will be stronger numbers internationally and the weaker dollar. Companies have been making statements such as:

“From an FX perspective, that's a little bit of a different story. We had about $0.16 benefit from FX this quarter. And when we look at Q4, we have about a $0.12 FX benefit. So, some nice benefit coming from currency in Q3 and Q4." – Cooper Companies (August 31)

“The increase in our guidance is due to our confidence in the performance of our business in terms of volumes, especially in China. As Corning mentioned, we had a very good performance in Asia, better than we expected, and that is why we are – that's the principal reason we are increasing our guidance." – Air Products & Chemicals (August 1)

“And I think in general, even the performance in China, Tim has mentioned it. We think that the performance will continue to improve. So those are the drivers of our guidance range for the quarter." – Apple (August 1)

The fourth quarter in recent years has usually been a strong one, let's see if it holds this year.