2013 Third Quarter Market Statistics (June 28, 2013 to September 30, 2013):
• Standard & Poor’s Stock Index: 1682 vs. 1569, up 7.2%
• Ten-year US Treasury Note yield: 2.62% vs. 2.48%, up 14 basis points
• Crude Oil: $102 per barrel vs. $96, up/down 6.3%
• Gold: $1328 per ounce vs. $1,232, up/down 7.8%
The stock market and Treasury yields advanced in the third quarter based on continued, yet modest, growth in the US economy, led by automobile manufacturing and housing. For the bulk of the quarter, the market was fixated on whether the Federal Reserve would begin to reduce, or “taper”, its purchase of $85 billion of Treasury bonds and mortgage backed securities per month. These purchases are often referred to as “quantitative easing” or QE for short. In the second quarter, the Federal Reserve suggested that it may begin reducing asset purchases as soon as its September meeting. Initially, this sent stocks lower and Treasury yields higher (bond prices lower). The Federal Reserve’s purchases were widely seen to be supporting stock and bond prices, so the withdrawal of asset purchases would conversely lead to lower prices. Over the course of the quarter, however, stocks were able to overcome investors’ concern over the tapering of Fed purchases, while Treasury bonds remained under pressure for fear of tapering leading to higher overnight interest rates sooner rather than later.
On September 18, the Federal Reserve shocked the market by not reducing the pace of its asset purchases. This initially sent stocks to a record high and sharply reduced bond yields. Stocks have since pulled back while bond yields have continued to drift lower. Having not reduced asset purchases after several months of suggesting otherwise, some feel that a lack of clear communication by the Federal Reserve introduces further uncertainty into the system, which is not a positive for asset values. We do not feel this is the case. The Federal Reserve’s initial guidance of a September tapering of asset purchases was in our view arbitrary and not based on economic fundamentals. While growth has continued at a modest pace, unemployment remains stubbornly high, and inflation is well under control. By choosing not to taper, the Federal Reserve has indicated that its policy will not be driven merely by the calendar but by economic data, which we see as a positive.
With the Fed focusing once again on economic fundamentals, the biggest risk to the market by far is political dysfunction in Washington. Federal Reserve Chairman Bernanke said himself that one of the reasons the Federal Reserve’s Open Market Committee chose not to reduce asset purchases was likely “fiscal drag” on the economy emanating from Washington. The dual threat of a government shutdown and a failure to raise the Federal debt ceiling is bad for the stock market, and there is no other way to say it. While many have said a short-lived government shutdown would do no harm to the economy and therefore not negatively impact stocks, we believe a shutdown would undermine confidence in the political system and be seen to increase the likelihood of a failure to raise the debt ceiling. Failure to raise the debt ceiling could have catastrophic consequences for financial markets as it would call into question the creditworthiness of the United States. To wit, in ten trading days prior to the last debt ceiling showdown in the summer of 2011, the stock market declined a whopping 17%. Given the devastating consequences of a failure to raise the debt ceiling, we are confident that the ceiling will ultimately be raised, but not before it is taken to the eleventh hour, which purportedly will be midnight on October 17. However, we expect dramatically increased market volatility leading up to an ultimate market and economy saving settlement.
The performance of the stock market in the fourth quarter is heavily dependent upon the outcome of the budget and debt ceiling crises in Washington. If the situation is dealt with in a timely manner, stocks will likely resume their upward trajectory, while if it is not, the consequences could be severe. As stated above, we feel the former is much more likely to the tune of a greater than 90% probability. That having been said, market volatility will be elevated prior to a settlement. After the budget and debt ceiling crises are put to bed, markets will return to the analyzing the intentions of the Federal Reserve and the forecast for corporate earnings, in the context of continued moderate economic growth that is supportive of stock prices. For the remainder of the quarter, we see the S&P 500 trading in a range of 1600 to 1800. It finished the third quarter at 1682.