For investors, the days ahead promise to be anything other than a leisurely return from summer vacation. The two issues that have been the primary source of recent market volatility will come into immediate focus.
The first is what to do about Syria. The Obama Administration seems convinced that the Assad regime has crossed the so-called red line of chemical weapons use, requiring some kind of military response from the U.S. and its allies. Preparations escalated quickly, until the British Parliament voted not to support Prime Minister Cameron’s decision to participate in that response. The president himself has now decided to seek the support of Congress before moving forward.
However, Congress is on recess until Sept. 9, and the leaders of both houses have indicated they do not intend to recall the membership back to Washington early — which means that for investors, the uncertainty surrounding the U.S. response will hang over markets for a while longer than appeared likely last week.
It is also unclear what will happen after a Congressional vote takes place. The administration has said it believes strongly that it does not need congressional approval to proceed. Does that mean it is prepared to initiate a strike even in light of a possible no vote? That seems problematic. If the administration is not prepared to strike regardless of the vote’s outcome, then it risks a serious blow to its credibility in light of its red line stance.
For investors, whatever action the U.S. takes is less of a concern than what happens next. Does it trigger a response from other actors in the region? Do Assad supporters, including Iran and Lebanon, become more overtly involved? What about Russia, which has blocked any resolution condemning the Assad regime by the UN Security Council? Will Israel be drawn into the conflict?
These are questions that so far cannot be answered. But the potential for a more widespread conflict in the region is certainly there, with implications for energy markets, safe haven investment classes and general market volatility.
In the week after Aug. 21, when the chemical attacks are alleged to have occurred, the price of Brent crude oil climbed $6.80 a barrel to $116.61, and the price of gold rose from $1370.60 an ounce to $1419.00. Both receded somewhat over the final two trading days of last week as the pace of response preparations slowed. The VIX index of implied volatility on the S&P 500 ended the week at its highest level since late June. Since Aug. 21, the S&P 500 itself is down a more modest 0.6%.
Fed Tapering Timeline Still Unclear
It is impossible to separate concern over Syria from the other major issue influencing recent market behavior, namely the presumed approach of Fed tapering. While many expect the Fed to announce a reduction in its bond-buying program at its upcoming meeting on Sept. 17 and 18, the daily ebb and flow of economic data seems to alternately raise or lower the odds of a September commencement.
Since hitting a recent peak of 2.93% on Aug. 22, the yield on the ten-year Treasury note has fallen to 2.78%. During that time there has been some evidence of a slowdown in the pace of activity in the housing market, as rising mortgage rates have seemingly begun to bite. According to Freddie Mac, after starting the year at a rate of 3.34%, the average rate on a thirty-year conforming mortgage was 4.51% last week, down slightly from its high for the year of 4.58% the week prior. New home sales fell 13.4% in July from June, and pending home sales fell 1.3%. In contrast, existing home sales were stronger than expected and both housing starts and building permits held firm. And second quarter GDP proved to be stronger than initially thought.
With consumer spending, income growth and durable goods orders also soft in July, it seems a tossup as to whether the Fed will act in September, or wait for additional data. A big influence on that decision will come this Friday with the release of the August employment report. However, if the consensus is correct that the economy generated 180,000 new non-farm jobs, the result will be as ambiguous as the rest of the data has been lately, leaving investors uncertain as to the future course of Fed action.
The Return of the Debt Ceiling Debate
Slightly further out on the horizon is the issue of the debt ceiling. Last week, in a letter to Congress, Treasury Secretary Lew said the U.S. would hit its debt limitation sometime in mid-October, and urged lawmakers to raise the debt ceiling as early as possible to avert the possibility of the U.S. defaulting on its obligations. For his part, House Speaker Boehner last week promised “a whale of a fight” over the debt ceiling, insisting on cuts and entitlement reforms in excess of any increase in debt authorization. If you liked the first two installments of this trilogy in 2011 and 2012, which gave us a ratings downgrade, the fiscal cliff and the sequester, you are no doubt looking forward to this one.
So far, after peaking at 1709 on Aug. 2, the S&P 500 has fallen a still rather modest 4.5%, and remains 14.5% higher for the year. During the pullback, the two best performing sectors have been materials, -1.4%, and technology, -2.5%. These happen to be two of the three worst performers for the year-to-date, albeit with positive returns of 7.7 and 8.8% respectively. The other laggard on the year is the utilities sector with a positive return of 6.8%, which also happens to be the second worst performer since Aug. 2 at -5.7%, trailing only the decline in financials at -6.6%.
Interestingly, since the decline in U.S. equities began, emerging market equities, as measured by the MSCI EM index, have outperformed, falling just 2.7% in dollar terms and just 1.0% in local currency terms. This comes despite a 12% decline for the year in dollars and -5% in local terms, and a much discussed capital flight in anticipation of a change in Fed policy.
Stock valuations compared to earnings are arguably reasonable. This is especially so given prevailing low inflation. But forward earnings estimates are aggressive given the current pace of economic activity. Unless there is a sustained pick-up of economic growth above 2.5%, earnings estimates will come under pressure. And beyond earnings, valuations using sales, book value and GDP are all above their long-term averages.
Much has to go right, it seems, for stocks to move meaningfully higher from here to the end of the year. That is certainly possible, but there is a lot to overcome for that to happen.
So, welcome back from vacation. With all that is going on, it may be only a matter of days before that vacation feels like it was a long time ago.
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The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.
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