Q4 has gotten off to a rocky start. With the benefit of hindsight, we can now see that the downside volatility actually started on October 3, when the S&P 500 traded near its all-time high for the last time in October. As the month draws to a close, the S&P 500 is teetering on the edge of correction territory and would officially become a correction with a total decline of 10% or more. The Nasdaq is already there. [1]

Looking ahead, no one can say with certainty how long the S&P 500 will endure this selling pressure, or how deep the correction may go. But what we can say with confidence is that we believe the downside pressure is less a function of economic fundamentals breaking down and more a function of cyclical, normal bull market volatility. The likelihood of a recession in the next six months remains very low, in our view.

That being said, the volatility in the equity markets seems likely to continue, in my view, and there are three factors that could shape the ‘give and take’ equity markets experience in the final months of the year. Investors should see these three factors as potential negatives but also as potential positives, since any outcome that’s better than expected or not as bad as originally feared could give a boost to markets.

1) Midterm Elections and the Mueller Report – there are a few key statistics worth noting when it comes to midterm elections. The first is that historically, during the summer months leading up to midterms, the market has felt downward pressure (seems that history is somewhat repeating itself in 2018). But history also suggests that the twelve months following a midterm election have been strong for stocks, with an average gain of 31.2% in midterm years from 1962 – 2016. Even if power gets redistributed in Congress and Democrats gain control of the House and Senate, with Trump in the White House it is doubtful that any large-scale legislation would pass. And the markets like gridlock, in my view. [2]

The wild card this time around, however, could be the Mueller report, which is scheduled for release shortly after the election. To the extent that Mueller’s report results in some history-making legal and power struggle in the White House, the markets might arguably respond with volatility to the uncertainty.

2) The Federal Open Market Committee Meeting on December 19th – the Federal Reserve and particularly its chairman, Jerome Powell, have come under some recent criticism from the Trump Administration for raising interest rates too much and too quickly. I’ve argued before that I see the Federal Reserve’s moves as not only widely telegraphed and expected, but also consistent with what the economic data suggests. The Federal Reserve, in my view, should be ticking the interest rate up to a point at or beyond the neutral rate, to preserve economic growth, control inflation, and re-establish a tool in the toolbox to fight the next recession.

Regardless of the economic and fundamental rationale for interest rate increases, the market is not likely to be thrilled about another rate increase in December, particularly if the Fed in their minutes indicates a commitment to more hikes throughout 2019.

3) Bolder Actions Against China – the tension between the United States and China has continued to ratchet higher, to the point where some analysts are uttering the term “cold war” in opining about future relations. An October 4 speech by Vice President Mike Pence at the Hudson Institute in Washington certainly seemed to be an indication that the United States is digging in their heels and will not budge until the Chinese make concessions. The Wall St. Journal referred to the speech as the “broadest and deepest in its criticism of China” by the U.S. government in the past several decades.[3]

Bloomberg also reported that by early December, the U.S. is prepared to announce tariffs on all remaining Chinese imports if the talks between Xi Jinping and President Trump at next month’s G-20 meeting go nowhere, which is essentially the baseline expectation from where we sit today.[4] It’s a tenuous situation between the two largest economies in the world.

Bottom Line for Investors

I think there’s a good probability that the outcomes on all three factors above will not be as bad as the ‘worst-case scenario,’ which can actually be a positive for stocks. That being said, I chose these three factors because I’d argue they are the three that are least certain, and could really end up going in a direction that many don’t expect. They’ll be at the top of my radar in the next two months.

Disclosure

1 Google Finance, October 30, 2018. https://www.google.com/finance
2 Strategas Quarterly Review in Charts, October 1, 2018
3 The Wall Street Journal, October 19, 2018. https://www.wsj.com/articles/the-crisis-in-u-s-china-relations-1539963174
4 Bloomberg, October 29, 2018. https://www.bloomberg.com/news/articles/2018-10-29/u-s-said-to-plan-more-china-tariffs-if-trump-xi-meeting-fails

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