Equities spent most of September consolidating gains made early in the month after rebounding from August’s lows. Shares experienced a sharp rally in the final week of the month, fueled by a bounce in energy prices, which in turn drove battered energy and materials sectors to their highest levels since early August. While these sectors represent only a small portion of the overall stock market, they had been straining broader market performance. With those shares joining the broader rally, the major indexes experienced solid gains. The rebound in energy and materials also compensated for weakness in the healthcare sector, which was burdened by a pullback in the biotechnology and pharmaceutical sectors.
Healthcare stocks have been weak since the market sold off in August, though biotechnology and pharmaceutical stocks had been exceptionally strong in 2015. Momentum leaders often experience a sharp reversal once the pendulum reverses, and the dip in healthcare stocks quickly turned into an exodus by short-term traders. Amid the selling came a controversial 55,000 percent price hike by Turing Pharmaceuticals for its anti-parasitic compound Daraprim. Investors should not harbor any political concerns in regard to biotech; attacks on “predatory” pricing are fairly common and should have little, if any, long-term impact on the sector.
Turning to the broader economy, the Atlanta Federal Reserve’s GDP Now model is forecasting third-quarter GDP growth of 1.0 percent. The consensus forecast is still close to 2.5 percent. The Atlanta Fed model continuously updates to reflect the most recent data, but only three weeks remain before the first estimate of GDP growth. Estimates are likely to recede if data doesn’t improve, but the Atlanta Fed model can turn on a dime should even a solitary key data point exceed expectations.
The next month will see the bulk of the earnings season. FactSet Research reports analysts are predicting a 5.5 percent decline in S&P 500 earnings for the past quarter. Their consensus forecast fell during the third quarter; at the start of the quarter, analysts were predicting an earnings decline of 1.0 percent. The potential drop may be attributed to a stronger U.S. dollar and weaker energy prices. As in the second quarter, energy is responsible for nearly all of the anticipated drop in earnings, with analysts forecasting an earnings decline of 64 percent for the sector. Materials are expected to report an earnings decline of 18.5 percent from last year, while analysts believe the industrial sector will report a 5.7 percent drop.
Pulling S&P 500 earnings higher are telecom, consumer discretionary, healthcare, financials and, very likely, technology. Telecom is forecast to report an earnings increase of 18.4 percent, and healthcare, 6.3 percent, while technology is expected to see earnings fall 0.1 percent from last year. Technology, however, is likely to report greater-than-expected earnings. In nearly every quarter over the past few years, we’ve seen analysts drastically underestimate earnings. FactSet reports that since 2011, 72 percent of companies beat all of their quarterly estimates.
Fed officials decided against a September rate hike due to concerns over slowing growth in China, but they remain confident about domestic growth. Statements made by Fed officials have been inconsistent, with one official even opposing his peers by calling for negative interest rates. Public comments indicate that a December hike is still possible, but the market gives it barely better than one-third odds. As of October 10, the futures market suggested a 47 percent chance of a January rate hike, rising to 59 percent in March.
The biggest risk to the market remains the slowing Chinese economy. The impact on commodity sectors is enormous, because China is responsible for the majority of demand for resources such as copper and iron ore. Even if the broader Chinese economy grows, the slowdown in heavy industries is devastating for resource producers and exporting countries such as Brazil, Australia and Canada. Additionally, Australia and Canada are coping with housing bubbles partially fueled by Chinese demand, which could result in a double whammy.
Commodity producers and emerging markets are skating close to a major crisis due to high levels of debt. Many firms that are solvent today will go bankrupt if commodity prices sink to new lows. Emerging market currencies that have taken a beating could experience even more selling if their economies slump into recession due to a slowdown in Chinese demand. A tilt toward U.S. assets, which benefit from a stronger U.S. dollar, as well as prudent fixed income allocations will pay off handsomely if buying opportunities present themselves. Meanwhile, growth in sectors such as healthcare will deliver solid returns domestically. If emerging markets avoid a negative outcome and stabilize in the fourth quarter, a December rate hike would become a much stronger possibility, and with that, the financial sector would return to outperformance.