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September 26, 2014 9:41 am

US markets face volatile fourth quarter

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An autumnal chill awaits US financial markets in the coming weeks, judging by recent turbulence across equities and government bonds.

On the surface, an S&P 500 just shy of record territory and a 10-year Treasury yielding roughly 2.5 per cent suggests a good deal of complacency among both equity and bond investors.

The divergence between high equity valuations and low-risk premium of the bond market faces a series of tests during October, however, starting with the latest monthly read of employment, the formal completion of quantitative easing by the Federal Reserve and quarterly corporate earnings.

Evidence of unease ahead of the third quarter ending next Tuesday has registered across markets, with the S&P dropping 1.6 per cent alone on Thursday, and the CBOE’s Vix, a measure of implied volatility, rising sharply to approach the peak seen in early August.

“Seasonal patterns strongly favour more volatility over the next five weeks,” says Nicholas Colas, chief market strategist at ConvergEx, noting how most industry sectors in the S&P 500 have experienced higher implied volatility over the past month.

As investors adjust their portfolios with three months left in the financial year, they must choose whether chasing market returns or turning defensive will be the appropriate strategy. That choice rests on the performance of the US economy.

“The issue remains whether the US economy can grow and meet the valuations suggested by risk assets,” says Tad Rivelle, chief investment officer at TCW. “It’s impossible for investors to have it both ways, the views of rates and risky markets are not reconciled. The suppression of interest rates, risk premiums and volatility will not end well.”

The quarterly performance of US equities has seen a near 4 per cent surge during August bracketed by a drop of 1.5 per cent during July and a decline of 1.9 per cent for September, after the S&P 500 closed at a record high of 2,011.35 earlier in the month.

The strengthening dollar and sliding commodity prices have hit energy and industrials shares hard over the current quarter. Utilities have also lagged behind, hit by the upward drift in market interest rates, led by short-dated Treasury yields rising to peaks last seen during May 2011.

Bright spots have been healthcare, technology and financials, all handily outperforming the broader market’s modest gain since the start of July.

Investors are not getting a lot of income and as the US economy is growing they will chase the better-performing sectors of the equity market

- James Sarni, Payden & Rygel

Vadim Zlotnikov, chief market strategist at AllianceBernstein, says investors continue to question how long the current economic cycle will last and what that entails for various sectors.

“There is a remarkable lack of clarity about where we are in the business cycle, in part because it has been so long due to the Fed’s liquidity efforts, he says.

As the Fed ends QE3 next month, some investors are looking for leadership from industrials and technology, while others believe financials, energy and consumer discretionary sectors are more appealing. Mirroring the downbeat message from the bond market, defensive groups such as utilities and consumer staples are favoured by some.

“The biggest problem I see right now is the difficulty in judging valuations,” says Ralph Segall, chief investment officer at Segall Bryant & Hamill. “You can’t really say markets are cheap or expensive due to the distortions from central bank policies.”

He says the outlook for equities will be determined by the next move in bond yields, with major tests of valuations and profit estimates looming.

In the event that the low 10-year yield stands validated by benign or falling inflation, then US companies will face a tough time trying to boost their profits. Higher interest rates will test equity valuations, however, with a stronger dollar hitting the earnings of US multinationals.

The S&P trades about 15.6 times estimated earnings for the next 12 months, above the 10-year average of 14.1 times according to FactSet. S&P 500 profits are forecast to increase 11.5 per cent during 2015, a figure that looks vulnerable as the dollar strengthens.

“A stronger dollar represents a tightening of financial conditions,” says Mr Rivelle.

With markets showing signs of preparing for a bumpier ride next month, any slide in valuations for risk assets during October could well provide investors with a buying opportunity.

James Sarni, managing principal at Payden & Rygel, says the end of QE is largely priced into markets and investors are focused on the need for returns given the absolute low level of yields.

“Investors are not getting a lot of income and as the US economy is growing they will chase the better-performing sectors of the equity market,” he says.

He adds that while a stronger dollar can hurt multinational S&P 500 earnings, “investors want dollar-based assets and in that regard, are prepared to overlook lower foreign earnings”.

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