The head winds for stocks are expected to strengthen in September, as a series of major events could make for much stormier markets.
September is historically the worst month for stocks, but this year, the calendar is a minefield for markets. From the Federal Reserve’s midmonth meeting to German elections, Japanese tax changes and U.S. budget debates, there’s a long list of potential catalysts for pain. Add to that the selloff in emerging markets and rising military tensions with Syria.
There is also the question of whether the economy will really accelerate, or whether there are cracks showing up in the housing recovery. July’s durable goods, down 7.3 percent, also showed a worrisome trend Monday. Much of the stock market’s gains this year were based on the view of a second half rebound, and now tracking GDP for this quarter fell to just under 2 percent on the outlook for core capital goods shipments, according to Barclays.
The Dow, on average, has been down about 1 percent in September, and so far this month, it’s down about 3 percent, its worst monthly performance in more than a year. Depending how September plays out, rates could also be a problem for stocks, with some strategists expecting to see the 10-year Treasury yield touch 3 percent or even higher before the month is over. That in turn could push mortgage rates even higher.
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“In August, the spring has been coiling, and in September the spring explodes,” said Marc Chandler, chief currency strategist at Brown Brothers Harriman. “What people are kind of doing is taking positions to prepare for next month.”
The first big hurdle for markets is the August employment report, on Sept. 6, a report that could dictate the Fed’s decision on whether it will announce a reduction in quantitative easing. Economists are divided on when the Fed will start to pare down QE—its $85-billion-a-month bond purchases—but some believe it will be September.
“People are reluctant to take big positions right now. They’re more likely to lighten more risk,” Chandler said. “Take your summer vacation because after Labor Day, it ends very quickly.”
But September will also bring clarity to an issue of major concern to the markets for the past several months, and that is when exactly the Fed will begin slowing its bond purchases, something it has said it hopes to do by year end. The Fed meets Sept. 17-18, so volatility is expected to increase around that event.
“The main source of uncertainty since May has been, ‘Is the Fed going to taper?’ ” said Binky Chadha, Deutsche Bank chief global strategist and head of asset allocation. “Uncertainty should be resolved. We think they’re going to do it. You’re going to see some uncertainty leaving.”
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September markets also have history against them, with the Dow down 60 percent of the time since 1950. “September is usually not a good month for equities, so there are the seasonal issues. Given the volatility in the first half, net net, September is not going to be great, but October, November and December should be good,” he said.
Bond yields have been moving higher ahead of the Fed’s September meeting, and just as there is disagreement in the market about when the Fed will taper, there’s a range of opinions on how much it will reduce its bond purchases. Fed officials have said they would like to begin cutting back on purchases before year end and complete bond buying by the middle of next year.
“I suspect that we’re going to grind a little bit lower from these levels into the September employment report,” said Ian Lyngen, senior Treasury strategist at CRT Capital. “All the anecdotes suggest we’ll get an ‘at trend’ or ‘slightly better-than-trend’ employment report. Then we’ll commence the process of pricing in a tapering down, and that will push 10-year yields back to or above 3 percent. That’s predicated on the fact that nonfarm payrolls are strong enough and no one can predict that number.” The 10-year yield was at 2.79 on Monday.
Lyngen expects to see the Fed cut back $5 billion of its $40 billion in monthly mortgage purchases, and $10 billion from its Treasury purchases. Others expect the Fed to pare back as little as $10 billion in total and as much as $25 billion in the first move to cut back.
“We do think they are going to start tapering,” said Bruce Kasman, chief economist at J.P. Morgan. “This is going to be a slow process. There’s still an open question of whether they do it symmetrically, pulling down Treasury and MBS (mortgage-backed securities) equally. We think it could be only Treasurys.” Kasman expects the Fed to cut out $15 billion to $25 billion in Treasury purchases in the first round.
Kasman said the Fed will also be looking at its 2016 forecast at the September meeting, an event that in itself could bring some volatility to rates. “We think we’ll see them forecasting an economy that’s close to full employment at the end of 2016,” he said.
The market, however, is not forecasting normalized short-term rates by then—which would be more likely 4.25 to 4.5 percent, if the economy is at full employment, said Chadha. “The market pricing of the Fed funds rate is like 75 or 100 basis points by March 2016, and that would be basically off by 350 basis points. That is a huge challenge. That’s one of the reasons I believe there will be this volatility,” he said.
Fed Chairman Ben Bernanke holds a briefing after the September Fed meeting, his second-to-last post-FOMC briefing before his expected retirement at year end. The market focus on his replacement has already added volatility. Traders say an appointment of former Treasury Secretary Larry Summers would mean higher rates and be a minus for stocks since he is seen as less dovish than Fed insider Vice Chairwoman Janet Yellen.
“It’s one of the most ferocious fights I’ve seen in my career. I think people at the Fed adore Janet Yellen and they have great respect for her intellect, and they’re rooting for her, but Barack Obama has been through the wars with Larry Summers and he’s comfortable with Larry Summers,” said Greg Valliere, chief political strategist at Potomac Research. “I think there will be a calculation at the White House soon that a confirmation hearing on Larry Summers would be a train wreck.”
The White House is already gearing up for a battle with House Republicans on the budget this fall. “Yellen would sail through. Does the White House want another big fight by nominating Summers and angering Democrats? I think the prospect of a really ugly conformation fight could tip the balance in favor of Yellen,” he said.
Kasman said that September is just the beginning of an active several months, since it is likely the showdown in Congress, comes not with a budget resolution to fund the government by the end of September but with a debt ceiling debate in November.
“The odds favor an increase in the debt ceiling, but it could take a crisis mentality for that to happen,” said Valliere. “I just think we’ll come right to the precipice. There will be a lot of anxiety but at the end of the day, they’ll raise the debt ceiling. The bottom line is even more fiscal restraint is coming before the end of the year. It’s a headwind for the economy but not a huge one. It will keep growth a little lower than it would have been.”
Valliere said Republicans do not want to get blamed for shutting down the government, so he expects to see a budget compromise in September that keeps the government funded until December. This past week, House Speaker John Boehner, a Republican from Ohio, said he plans to avoid a government shutdown at the end of September by passing a short-term budget bill that maintains the automatic sequester budget cuts.
“Right now I’ve talked to an awful lot of smart people, and they can’t figure out how this is going to play out in December. There’s a chance the debt ceiling doesn’t need to be taken on until later because Treasury receipts look great,” Valliere said. It’s likely there will be a continuation of the sequester, or automatic spending cuts, in the amount of $100 billion for next year, he added.
“The hard-core conservatives in the House will insist upon new concessions in order for their votes to boost the debt ceiling. That could mean at least another year of sequester,” he said. “The idea they are going to defund Obamacare—I think the markets will look past that and look past the shutdown threat. The registration period starts October 1 and I think that it will be funded.”
There will also be uncertainty surrounding the beginning of registration for coverage under Obamacare, or the Affordable Care Act. House Republicans have been unsuccessfully proposing bills to kill it.
Around the globe
The German election Sept. 22 has been getting a lot of focus in the foreign exchange market even though a coalition backing Chancellor Angela Merkel is expected to win. “It’s not about what’s happening in the German election,” said Chandler. “What’s key is that the election has led to pent up problems they don’t want to address until after the German election”—Greece being one of them.
Greece’s bailout became an issue for Merkel this past week, when her predecessor Gerhard Schroeder said at a rally of his opposition Social Democrats that the governing coalition tried to hide the fact that another Greek bailout is necessary and that “Germany will have to pay for a Europe not as steady on its legs as we are.”
“People believe that when the German election is over, the German government can turn its attention to Europe in a more free way,” Kasman said. “People are pointing to the election as a pivot point for European policy going forward.”
Investors are also watching Japan, where Prime Minister Shinzo Abe has promised to decide in September on whether to raise the consumption tax by 3 points to 8 percent, which could slow the economy. The increase would be the first of two that would take it to 10 percent by 2015, and the question is what other structural changes Abe’s government would propose.
“I think the consumption tax is going to go,” said Kasman. “We’re hopeful but not confident that we see a corporate tax cut that hopefully softens the blow by about a half.”
Investors are also watching China to see if it is making a turn, after signs of improvement in manufacturing data.
“We see some signs that things are stabilizing and some signs that policymakers are doing things to stop growth from falling further,” said Kasman. But China is still a wild card, he said.