Ready for Lift-Off?

3Q 2014

It was a wild ride in the markets during the third quarter. The S&P 500 finished the quarter relatively flat, with a +1.1% total return, which was pretty respectable given the volatility caused by Fed fears and international headwinds. However, domestic mid-caps and small caps did not fare as well, at -1.7% and -7.4%, respectively.

Much of the third quarter’s volatility had to do with anxieties over Fed policy “normalization” (whereby the federal funds rate will start to “lift-off” from near-zero, toward some eventual level of 2%-4%, or higher). The concern of many is that the longer the Fed keeps interest rates near zero while the economy continues to improve, the greater the probability that we will find ourselves in a situation with too much liquidity in the system, ultimately causing us to fight stronger inflation down the road. Those critics argue that the economy is strong enough to stand on its own, and that the Fed should start raising rates (slowly, of course, but sooner rather than later) before they find themselves “behind the curve”.

The market accepts the idea that we are on the cusp of a major change in direction of Fed policy for the first time in more than eight years, but wrestles with every data point to try to estimate when that inflection point will occur (i.e. good data imply earlier rate hikes, bad data imply delayed rate hikes). And while the “lift-off” date is still to be determined, analysts believe Fed members are leaning toward mid-2015.

On the international front, markets were decidedly negative for the quarter and experienced additional volatility from a number of sources. Early in the quarter, investors dealt with systemic concerns over the Portuguese banking system and an Argentina default. Geopolitics played a role too, with escalating tensions between Ukraine and Russia, a conflict between Israel and Palestine, and the realization that the Islamic State terrorist organization would require coordinated international military efforts. Finally, while the US economy has been a relative bright spot in the world, investors are dealing with the possibilities of a double-dip recession and disinflation in European economies, and the potential for another downshift in Chinese growth and the ripple effects that may have on other emerging economies.

The biggest headlines in fixed income were those involving large swings in interest rates and the departure of the Bond King, Bill Gross, from his throne. The ten-year Treasury began the quarter at 2.52%, fell to 2.33%, then climbed back to 2.63% before ending the quarter virtually unchanged at 2.51%. That left the Barclays Aggregate Bond Index with only a +0.2% return in the quarter with most other fixed income sectors (e.g. high yield, emerging market debt, inflation-protected) negative.

As we make the final turn into the home stretch, we hope for an October with no tricks (but lots of treats), a November to be thankful for, and a hefty Santa Claus rally in the markets. However, we won’t be surprised with continued volatility given that markets usually react six months (give-or-take) prior to Fed actions. As always, discipline is more valuable in such times.