Volatility is Here to Stay

U.S. equity markets endured their third consecutive week of losses as volatility climbed. The S&P 500 Index was down sharply enduring its largest weekly decline since May 2012. The sell-off can be blamed on a number of factors, with concerns over global growth coming in first on that list. Ongoing angst over the end of the Federal Reserve’s quantitative easing program and trepidation in advance of third-quarter earnings reports can also take their share of the blame.

Energy was the worst performing sector of the market, with oil prices falling more than 4% for the second straight week reflecting softer demand and abundant supply. Brent, the global benchmark, dipped to a four-year low around $88 per barrel while U.S. light sweet crude fell to $84 per barrel. The yield on the U.S. 10-year Treasury note slipped to 2.30% as weak data and stock volatility made “safe-haven” investments more attractive.

Wide-scale global economic weakness led to a sharp spike in stock market volatility year-to-date, as well this week. The Dow Jones Industrial Average rose, or fell, 200 or more points on three successive days. October is already the most volatile month for stocks since June 2013, with five daily up or down movements of 1% or more. The Chicago Board Options Exchange Volatility Index (VIX) jumped 24% to 18.76%, an eight-month high.  Although volume has started to increase, we think the volatility may be here to stay a while.

Volatility Index

Volatility Index (VIX)

U.S. Liquidity Is Fading, While Europe Needs More Support

Since the financial crisis, risk assets have benefited from the massive amount of liquidity that the Fed injected into the system. With that high liquidity phase now coming to an end in the U.S., stronger economic and earnings growth must serve as the driving forces if the bull market in risk assets is to continue.

The story outside of the U.S. is far different. Disappointing European economic data and the recent significant weakness in the major European stock markets are additional reminders that the European Central Bank (ECB) is well behind the curve in its easing programs. Unless, and until, the ECB proves it is serious about supporting economic growth, European equities are likely to struggle. The International Monetary Fund (IMF) lowered its global growth forecast for 2014 and 2015. Germany reported sharply lower industrial production and exports in August, feeding worries about another eurozone recession. China’s purchasing managers’ indices for services trended lower in September. However, Japan’s machinery orders rose.

Weekly Top Themes

  • U.S. growth has remained resilient.  Falling energy prices and lower interest rates have been supporting consumer confidence but sentiment does appear to be weakening.  The labor market continues to show signs of strength. In contrast, the data from Europe has been weak, with German industrial production plummeting by its largest annual decline since January 2009.  Should the eurozone fall into outright recession, we would become more concerned about U.S. growth.
  • Fed meeting minutes show caution on rates.  Fed officials are concerned about the risk of weak overseas growth and the impact of a stronger U.S. dollar on the domestic economy, according to minutes of the September policy meeting. Lower exports to Europe and Asia could curtail corporate profits, while the strong currency could lower the cost of imported goods and services to the U.S., which would keep inflation low.
  • Recent data confirms that U.S. employment is improving.   Last week, initial and continuous jobless claims both fell.  Initial applications for U.S. unemployment benefits fell by 1,000 to a seasonally adjusted 287,000 in the week ended October 4th, the fourth straight week that initial claims were below 300,000. The four-week moving average fell by 7,250 to 287,750, its lowest level since February 2006.
  • We expect more earnings disappointments this quarter than in the recent past. Weaker global growth and a stronger U.S. dollar could hurt earnings and revenues, especially for multinational companies.
  • The federal budget deficit shrank for the fifth consecutive year. Initial Congressional Budget Office estimates for fiscal year 2014, which ended on September 30th, show the deficit was only 2.8% of gross domestic product. Outlays rose by only 1%, revenues grew almost 9% and discretionary spending fell 3%.
  • We expect to see wage inflation begin in the first half of next year. Although inflation remains broadly contained, the declining unemployment rate suggests to us that some wage acceleration is due.

Does This Election Matter?

From an economic and markets perspective, we believe this election will matter, but it won’t be a game changer. The White House obviously won’t be changing hands, and the Republicans will certainly maintain the majority in the House of Representatives. If anything, most prognosticators predict the GOP will increase its numbers.

That leaves the Senate, which appears to be in play. A Republican takeover of the Senate would affect the balance in power in Washington and certainly change the legislation sent to President Obama. With that backdrop, we can take a look at two scenarios.

2014 mid-term election musical chairs

Scenario One: Democrats Retain the Senate

If the Democrats hold the Senate, we would continue with a divided Congress and a Democratic president. The next two years would look pretty similar to the last two from a legislation and policy perspective. As with most second-term presidents, President Obama has not been able to accomplish much over the last two years—particularly compared to the sweeping health care reform and massive stimulus package of his first term. At the same time, the 113th Congress has, by almost any measure, been extremely unproductive.
If the 114th Congress is similar in makeup, we expect political gridlock may continue to be the dominant theme in Washington, but we would still expect to see some developments that may affect the economy and financial markets. For one, if Democrats are successful in this election, they may push to reverse the sequester that still limits spending. More government spending would boost short-term economic growth, but would also have the longer-term effect of increasing the debt and deficit levels. Additionally, we would be more likely to see higher levels of infrastructure spending, which could boost the construction and heavy industry sectors.

Scenario Two: Republicans Take the Senate

If Republicans take control of the Senate, that would represent an opportunity for the GOP to show what they can do with control of both houses of Congress. In the run-up to the 2016 elections, we would expect Republicans to want to demonstrate to the American people that they can govern, and they may focus on a few issues they could quickly pass through Congress and get onto President Obama’s desk:

  • The long-debated expansion of the Keystone Pipeline would likely be high on the agenda. Legal challenges surround this project and it is unclear if the president would approve the construction. If it comes to pass, the additional phase of the Keystone Pipeline would likely be a boon to energy and infrastructure-related companies.
  • Changes to health care would almost certainly quickly pass through a Republican-controlled Congress. Specifically, Congress would likely repeal the medical device tax. This would also require the president’s cooperation, but President Obama may agree to the change since the tax has been so unpopular. Such a repeal would help the medical device industry.
    Faster adoption of liquefied natural gas exports from the U.S. (a positive for the energy sector) as well as increased defense spending would also be important agenda items.

Elections do matter for equity markets, but we believe they are less important than the state of the economy, the direction of corporate earnings, valuation levels and the fundamentals that determine a company’s stock price. That said, investors should understand some long-term historical trends that surround election cycles.4th Quarter S&P 500 HIstorical Returns

Equity markets have historically experienced a bounce in advance of and following mid-term elections. Since 1930, the S&P 500 Index performed significantly better on average in October, November and December than it did earlier in the year during mid-term election years. This effect also has tended to last into the following year. Since 1950, the S&P 500 Index experienced positive returns in every six-month period following the last 16 midterm elections, with an average gain of 16%. One reason for this trend may be that elections remove uncertainty, and if there is one thing investor’s love, it is clarity.

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