On the last day of the third quarter, the financial markets continued to climb higher. By the end of the first week in October, stocks were defying the history cited here recently, slumping sharply in the Thursday and Friday sessions.

Bonds received blame for stock’s two-day slump, as longer-term Treasury yields rose above their previous 2018 peaks to their highest level in seven years, pressuring equities” valuations. Strong U.S. economic data underpinned expectations for future Federal Reserve interest-rate hikes.

Nonetheless, U.S. fundamentals remain good. While growth is likely to moderate somewhat through the end of the year, it is relatively high and should be supported by robust labor markets and stimulus from the tax cuts and February budget. Corporate earnings have also been strong and boosted by tax cuts. Finally, the United States may be better positioned for a downturn than other major economies: with the Federal Reserve hiking rates and rolling off its asset purchases during quantitative easing (QE), I believe it will have more flexibility than the European Central Bank (ECB) or Bank of Japan (BoJ) to add stimulus if necessary.

U.S. market performance in the third quarter reflected this optimistic economic outlook. U.S. equity markets outperformed other regions, bringing S&P 500 Index year-to-date returns to 10.6%. Similarly, the yield on the 10-year Treasury rose to 3.05%. Volatility as measured by the CBOE Volatility Index (VIX) and by daily high/low spreads for the S&P 500 Index declined from earlier in the year but remained above 2017 levels. Sector and factor indices experienced some rotation, but their returns reflected tech and growth outperformance on a year-to-date basis. (1)

While rising interest rates garnered most of the market coverage to start the fourth quarter, it wasn’t until the only story behind the early October swoon. Big bank, JPMorgan’s cross-asset strategy team called the Fed policy mere “ambient noise” compared with what it viewed as the biggest factors: Italy, oil and China.

Italy’s populist governing coalition must submit its draft 2019 budget to the European Commission (EC) by October 15th. On September 27th, the coalition agreed to a budget deficit of 2.4% for the next three years, reversing plans by the previous government to achieve a balanced budget in 2020. While the details have yet to be released, on the surface the plan seems likely to lead to: confrontation with the EC, new concerns about Italy’s medium-term debt sustainability, and possibly credit rating downgrades. Second, the United Kingdom likely needs to conclude a withdrawal agreement with the European Union (EU) before the end of the year to leave enough time for approval. The risk of a “hard Brexit” or even a Brexit with no agreement by 30 March 2019 is rising, with significant consequences for markets and the UK economy.

Oil prices continue to move up like bond yields. With Brent crude hitting a 2018 high above $86.00 a barrel. JPMorgan sees the price of the international benchmark heading toward $90.00, with Russia and OPEC not making up for supply shortfalls. “The U.S. probably could not have chosen a worse time to sanction Iran” with the oil market already in deficit by 500,000 to a million barrels a day, the banks strategist’s concluded. (2)

China has maintained rapid growth since the global financial crisis in part through rising leverage, particularly in the corporate sector, where debt is now 164% of GDP. Reducing debt and financial system risk has become a priority in Xi Jinping’s second term. However, several economic indicators have recently suggested that slowing credit growth has reduced economic activity. In response, Chinese policymakers have begun to ease credit access and prices (Exhibit 4). We are watching for further monetary easing and fiscal stimulus, as authorities seek to calibrate policy to both rebalance the economy and maintain rapid growth, a challenge made even more difficult by trade conflict with the United States. (3)

Exhibit 4: Chinese Authorities Are Easing Policy

Three-Month SHIBOR

As of September 28th, 2018,
End-of-week values
Source: Haver Analytics, People’s Bank of China

Fed Chairman Jerome Powell declared in an interview aired in early October on PBS that interest rates remain “accommodative”, but that policy is headed toward “neutral” and possibly beyond. “but we’re a long way from neutral at this point, probably”, he concluded. It appears the Treasury market is absorbing that realization. In my opinion that’s a negative for stock valuations in the short-term and, at a minimum, a headwind for the U.S., economy. There’s also some skepticism over higher oil prices.

As for tailwinds, overall, I remain optimistic about U.S. economic fundamentals. The broadening of household income growth to middle- and low-income households that began around 2014 has continued. Robust labor markets signal that it should be sustained, as do signs that wage growth is beginning to grind higher after stalling in 2017. Fiscal stimulus from February budget and tax cuts are adding to momentum, with the latter also boosting corporate earnings.

However, I am concerned that Fed tightening against a backdrop of slowing stimulus and increasing U.S. protectionism could derail economic growth and sentiment over the medium term. The impact of protectionism is playing out with China bilateral tariffs and can be more meaningful for markets than for the economy and are difficult to assess at an individual company level. This mixed outlook makes careful risk assessment of stocks and security selection particularly important in my view.

Q/3 Earnings kick-off on Friday, October 12th with three banks reporting: JPMorgan, Wells Fargo and Citi scheduled. I always say that during this decade long bull cycle, corporate earnings can provide a real catalyst for the market marching higher or disappointment sending the market lower.

According to FACTSET, as of October 5th, the S&P 500 is expected to report earnings growth of 19.2% for the third quarter. What is the likelihood the index will report actual earnings increase of 19.2% for the quarter? Based on the average change in earnings growth due to companies reporting positive earnings surprises, it is likely the index will report earnings growth above 20% for Q3, but below the 25% growth reported in the previous two quarters (Q2 2018 and Q1 2018).
Industry analysts in aggregate predict the S&P 500 will see a 10.5% increase in price over the next twelve months. This percentage is based on the difference between the bottom-up target price and the closing price for the index as of October 4th. The bottom-up target price is calculated by aggregating the median target price estimates (based on company-level estimates submitted by industry analysts) for all the companies in the index. On October 4th, the bottom-up target price for the S&P 500 was 3205.51, which was 10.5% above the closing price of 2901.61. (5)

I am a Strategist, a Financial Planner, not an Analyst, though I follow them all closely. I take a holistic approach. With what I am seeing, I believe the equities market continues its bull run. Fixed income and the real estate sector will be challenged in this rising interest rate inflationary environment. Alternatives such as hedge funds, commodities and private equity deserve an investor’s consideration as an allocation for hedging volatility and for non-correlation asset classes compared with fixed income and stocks in their portfolios. When you want to be defensive, Cash is your friend.

Mark Martiak is a New York based Investment Advisor Representative for Premier Wealth Advisors LLC. Mark is a regular Contributor for VEGAS LEGAL MAGAZINE who has appeared on CNBC’s CLOSING BELL, YAHOO! FINANCE MIDDAY MARKET MOVERS, FOX BUSINESS NETWORK and has been quoted in THE WALL STREET JOURNAL.

Securities offered through: First Allied Securities, Inc. A Registered Broker/Dealer. Member: FINRA /SIPC. Advisory Services offered through: Premier Wealth Advisors, LLC. (PWA) & First Allied Advisory Services, Inc. (FAAS). Both Registered Investment Advisers. PWA is not affiliated with First Allied Securities, Inc or FAAS.

Such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data is taken from sources generally believed to be reliable, but no guarantee is given to its accuracy. Indexes are unmanaged, and investors are not able to invest directly into any index. Past performance is no guarantee of future results.

Sources:
1. LAZARD ASSET MANAGEMENT OUTLOOK ON THE UNITED STATES 2018 October 5
2. BARRON’S: October 5th, 2018 Rising Yields Could Batter Stocks
3. LAZARD ASSET MANAGEMENT OUTLOOK ON THE UNITED STATES 2018 October 5,2018
4. Exhibit 4: As of September 28th, 2018, End-of-week values
Source: Haver Analytics, People’s Bank of China
5. Earnings Insight, October 5th, 2018 by John Butters, Senior Earnings Analyst at FACTSET