With the third quarter ending, investors face a choice of sticking with winners or buying this year’s laggards in a final three months that will help shape their performance in a challenging year.
Among the major risks framing the fourth quarter are the US presidential election, a possible rate rise from the Federal Reserve, Opec’s gathering in late November along with corporate earnings and guidance from US and European companies that will arrive this month.
Here is how investors and strategists view the prospects for major asset classes in the quarter.
Equity markets’ performance swung during the third quarter and, most recently, saw them rebound from a bout of volatility in the middle of September. Leading the way among developed markets since the start of July has been Germany’s Dax, up 7.5 per cent, while Japan’s Topix has risen 7.8 per cent.
Powering the S&P 500’s current quarterly gain of 2.5 per cent has been technology shares, with a 12 per cent rally as the revenue and profits picture brightens for the sector. Opec’s production deal this week, has propelled energy shares into positive territory for the quarter.
Mislav Matejka at JPMorgan Cazenove says: ‘’At the sector level, cyclicals appear to have stalled since the start of the month, and we believe that they should be faded.”
Bank shares in the US, Europe and Japan had a winning quarter, but will remain at the front of investors’ anxieties as the fourth quarter starts. A global backdrop of negative and ultra-low interest rates remains a headwind for the sector, notably in Europe, with Deutsche Bank
shares at a multi-decade low. This week, Credit Suisse’s chief executive Tidjane Thiam warned European banks are in a “very fragile situation” and are “not really investable as a sector”.
Profits and guidance from corporate America are likely to prove critical to whether US equities can hang on to their gains.
Investors are keen to see stronger profits from US groups, with valuations having become “stretched”, says Peter Kenny, a senior market strategist at Global Markets Advisory Group. The S&P 500 was priced at 16.8-times forward 12-month earnings as the third quarter came to a close, according to FactSet data, compared with the average of 14.3-times over the past decade.
This year’s historic rally in bonds has made government debt a sweet spot for investors. Buying long-dated bonds has delivered double-digit gains, but notable investors, such as Jeffrey Gundlach of Doubline and Bill Gross, have voiced concern over frothy valuations.
Asset manager BlackRock warns that there is now a meagre safety cushion for holders of long-dated US government bonds. A 0.2 percentage point increase in Treasury yields “could wipe out a whole year’s worth of yield income”.
Moreover, Treasuries are becoming less attractive to non-US investors, as the increased cost of currency hedging wipes out the extra yield on offer. Foreign central banks have pared their holdings in recent months, and demand at auctions in coming weeks will be closely watched by traders.
The announcement by the Bank of Japan that it’s targeting a steeper yield curve, alongside the prospect of fiscal easing from governments, also cloud the outlook for fixed-income. ‘’We see a steeper yield curve ahead amid a gradual pivot toward fiscal expansion globally, although central banks still have the ability to limit any unwanted yield rises,” says BlackRock.
Others are more sanguine. Robert Michele, global head of fixed income at JPMorgan Asset Management, argues “it’s still a good time to be a bond investor”.
“Secular stagnation is inevitable and growth in much of the world is stabilising at below historical levels — not a bad backdrop for fixed income.”
Bonds issued by companies — especially highly-rated ones — have been the biggest winners from the evaporating yields in sovereign markets.
As a result, many measures of corporate indebtedness are worsening after a long borrowing binge since the financial crisis, and investors have recently ramped up bets against US corporate bonds. The rally in junk bonds looks particularly vulnerable, given the weak backdrop, but the eroding creditworthiness of big companies rated “investment-grade” is also causing some concern.
“There’s been an understandable increase in leverage in investment grades, as companies have taken advantage of their rock-bottom borrowing costs,” says Jesse Fogarty, senior portfolio manager at Insight Investment. “Money has been pouring in, so technically the market is in good shape, but we have the slow-moving tectonic plate of weakening fundamentals.”
Nonetheless, most fund managers are confident corporate bonds will continue to be a star performer. For many investors, highly-rated corporate debt is the only alternative, and every minor squall has quickly become a buying opportunity. “The demand is just overwhelming,” Mr Fogarty points out. “In every pullback we’ve seen interest come back in.”
G10 Foreign Exchange
There is plenty that points towards a stronger quarter for the dollar. Analysts at Barclays say they expect a stronger US currency over the quarter, “albeit at a slower pace, in the year to come. Slow but steady monetary policy normalisation along with its safe-haven status should support it.”
The caveat is, of course, the US election. The narrowing in opinion polls is forcing investors to pay more attention to the prospect of a victory for Republican nominee Donald Trump, an outcome that could potentially raise doubts over the future of leadership at the Federal Reserve.
For sterling, it’s all about the data and the picture it will paint of the UK economy post the Brexit vote. The picture that emerges will probably determine whether the pound will break this year’s low of $1.28 or stabilise above $1.30. November’s Autumn Statement from the UK chancellor also looms as a key driver of sentiment for UK assets and the pound.
Meanwhile, the euro has been in a period of stagnation for most of 2016, but the rest of the year is fraught with risk. Europe’s banking problems are threatening to develop into a crisis, the outcome of Italy’s constitutional referendum in early December may force the resignation of prime minister Matteo Renzi, Portugal’s investment-grade status is in peril and Spain’s attempts to form a government remain deadlocked. Even so, analysts expect the euro to hobble on to the end of the year broadly unchanged.
Emerging Market Assets and Currencies
With a few exceptions, emerging markets have regained their allure. EM currencies are among the best performers across FX this year, notably South Africa’s rand, Brazil’s real and Russia’s rouble. So how long can the run last?
Political risk may stalk these currencies, yet the low-rate environment in developed markets persuades investors to take the plunge anyway. This is unlikely to change anytime soon. “The Fed is most likely going into a one-month vacation,” says Luis Costa of Citigroup’s FX strategy team, expressing surprise at how little interest investors have shown towards the pronouncements of Fed members this week.
A European banking crisis could blow a large hole in the risk-on sentiment that has been driving the EM rally. The chances are, though, that EM assets will remain in vogue until investors sense a more fundamental realignment of rates in developed markets. That remains a distant prospect.
The scale of any production cut that ultimately emerges from Opec will dominate the outlook for the oil market. Brent crude closed out the second quarter just shy of $50 a barrel and is on course to end September little changed. Many are sceptical. The proposed cut in production to 32.5m-33m barrels is modest, while the details will not arrive until Opec’s meeting at the end of November.
Gold is at the forefront of investors’ minds. After a blistering first-half rally that saw gold peak at $1,375.5 a troy ounce in early July, gold has been stuck in a narrow trading range and fell to a low $1,302 in September. Stronger US consumer confidence and a recovery in the US dollar have sapped momentum.
For other metals, such as zinc, aluminium and nickel, the question for investors will be whether supply shortages that have boosted prices this year will last.
Aluminium prices, for example, have rallied 11 per cent this year, and zinc has surged 45 per cent. However China, which produces half of the world’s aluminium, is set to increase production as smelters restart operations. Consultants at CRU expect around 1.7m tonnes of capacity to come back online.
In zinc, Glencore, the giant commodity trader and miner, is weighing up when to bring back production it cut in the face of slumping prices last year. Traders say prices could be hit as soon as this happens. Zinc mines in China could also restart production.
“The pressure to cut supply further has evaporated with the commodity recovery,” say analysts at Macquarie. “For a healthier fundamental situation, further permanent capacity cuts are required across many markets.”
Reporting by Michael Mackenzie, Roger Blitz, Henry Sanderson, Michael Hunter and Robin Wigglesworth and Adam Samson.
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