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Rough waters as the midterms approach

OCT. 15, 2018
  • Equity markets fell sharply, with the S&P 500 Index losing 4.1% last week. This was the worst week since February, and the 15th time since the financial crisis that the S&P has lost 4% in a week. The damage was widespread, with the Dow and NASDAQ losing 4%, and the Russell 2000 falling 5%. The S&P gained 1.4% on Friday, which was the first positive day in seven, ending a streak that saw the index lose 7%.
  • There was no obvious reason for the decline, which is unusual given the steepness of the decline. During the current cycle, we saw similar declines following the U.S. debt downgrade in 2001 and the China devaluation in 2015. This decline is analogous to the period earlier this year, where a combination of factors led to a decline, including rates, inflation, trade fears and global growth. Strangely, this decline came in a week when interest rates declined and inflation data came in benign. This could be an indication that the decline was a result in program-based selling, and was exacerbated by the fact that most companies are in a blackout period for buybacks given that we are in earning season.
  • Despite the flight to quality, foreign indexes outperformed domestic, with the emerging market index losing only 2%.
  • With the midterm election approaching, it is expected that volatility could remain elevated. The average daily change in the S&P is 45% higher the month before a midterm when compared with a normal month, as the market generally reacts to uncertainty. As the election approaches and the uncertainty fades, volatility dampens and performance improves through the end of the year. Also, the focus of investors will be on earnings season, which is likely to surprise to the upside.
  • Sectors: Growth and value stocks performed roughly in line during the downdraft, as the selling has been relatively indiscriminate. For the month, utilities and consumer staples have outperformed, while consumer discretionary, materials and technology have lagged. This could change however, as staples, real estate and utilities are expected to have the slowest earnings growth, while energy, financials and materials should lead.
  • Earnings Impact: Energy companies will see earnings growth of more than 100% compared with last year, as crude is up nearly 50%. High crude prices are a tailwind for energy companies, but is a headwind for most other sectors that use oil as a raw material. So far during earnings season, the three negative factors most commonly identified by managements are foreign exchange, raw materials and labor costs. Currently, the S&P is expected to grow earnings by 21% in the third quarter and 17% in the fourth quarter.
  • Safe Haven: Notable in the weakness in equities was the lack of a flight-to-quality. Generally, when we see sharp declines in equities, investors flock to bonds. That has not been the case in this period, with many bond ETFs experiencing record outflows as rates rise. According to Bloomberg, Wednesday was only the third time in this cycle that the S&P 500 fell by 3% while long bonds lost value. The correlation between stocks and bonds is at the lowest level since 2014 and the third-lowest since 2000. Other risk assets declined, including global stocks and oil prices.

What to Watch

  • Earnings season ramps substantially this week, which is likely to gain attention versus geopolitical issues. Commentary from managements will be critical, including the headwinds and tailwinds going forward. Economic data includes retail sales (weaker-than-expected this morning), industrial production and leading indicators. We get housing starts and existing home sales, which will be interesting given that mortgage rates have topped 5% for the first time since 2011. Finally, we get the minutes from the recent Fed meeting on Wednesday.


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