Q4 market outlook: Six trends to watch

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

Last quarter saw stocks globally continue to rise. The relatively accommodative monetary policy environment and improved global growth were strong drivers. However, as we head into the fourth quarter, I think it’s important that we recognize the potential for greater disruption – in terms of both geopolitics and monetary policy – which can cause greater volatility in capital markets.

Below are six things to look for in the fourth quarter:

1. European uncertainty

After last week’s elections, a weakened Angela Merkel remains in power in Germany, but is forced to form a coalition government with unlikely partners – the liberal Green Party and the pro-business Free Democratic Party (FDP). These delicate negotiations will likely take weeks and will be probably result in an uneasy alliance at best, given the two minority parties’ very disparate platforms. This arguably weakens Chancellor Merkel’s hand as she begins her fourth term as Germany’s leader. However, amidst this disruption, there is the potential for more focus on economic growth if the FDP can take over the Finance Ministry.

In the U.K., the next several weeks and months will likely be crucial in determining whether the country pursues a “hard Brexit” or a “soft Brexit.” In her speech in Florence more than a week ago, Prime Minister Theresa May – long a proponent of a “hard Brexit” – suggested a softer course. She proposed that after the official Brexit in March 2019, there should be a lengthy period in which the U.K. maintains a very similar relationship to the one it currently has with the European Union (EU). Now it is being reported that Prime Minister May is leaning toward Chancellor Philip Hammond’s version of a “soft Brexit” relationship with the EU, which would entail strong alignment in terms of regulations in order to benefit from a close trading partnership. However, there will likely be other cabinet members who attempt to pull her in a different direction as negotiations unfold. I expect this to result in more volatility for the U.K. stock market as investors follow the developments of the negotiations, as well as continued economic policy uncertainty for U.K. businesses, which could stymie their spending.

In addition, there is an ongoing crisis in Spain, marked by violence and disruption this weekend as Catalonia voted to secede, in what was deemed by Spain to be an unconstitutional referendum. We will want to follow all the uncertainty and disruption as it unfolds in Europe in coming weeks.

2. U.S. tax reform debate

“The Big Six” Republicans who were tasked with crafting tax reform legislation announced their plan last week, and the Trump “reflation trade” is back on, as evinced by the stock market’s rally over the past few days. The tax reform plan is, as promised, very broad and encompasses all three areas discussed on the campaign trail: corporate taxation, household taxation and the repatriation tax. The good news for markets is that the proposed plan lowers the corporate tax rate to 20% – which should significantly improve corporate profitability going forward. The bad news is that this plan also has some very controversial elements that will make it difficult to garner enough Congressional support, particularly: 1) elimination of the estate tax, which would not help the middle class, but would add significantly to the federal deficit; 2) elimination of the state and local tax deduction, which would disproportionately impact residents of states with higher property taxes and/or income taxes – and not only high-income residents, but middle- and lower-income residents as well.

The Committee for a Responsible Federal Budget has projected that this tax package in its entirety will add $2.2 trillion to the federal deficit in the next decade, although President Donald Trump’s administration has countered that this tax cut will trigger so much economic growth, it will pay for itself. I expect that negotiations about the tax package will play out in Congress over the ensuing weeks, as the administration barters with different factions in order to arrive at a package that passes. Given that some fiscal conservatives in the Republican party will be unlikely to support the bill, we could see the administration pivot to a more middle class-friendly tax bill to win over enough Democrats to pass the bill. But that could ultimately mean that the bill will look quite different – with perhaps an increase in the highest income tax bracket. The only element of the bill that I believe is untouchable is its centerpiece – the corporate tax rate. This is the component that I believe is most critical for the stock market because it directly impacts corporate earnings. I expect more volatility for the U.S. stock market going forward as stocks react to the ups and downs of the negotiation progress.

3. Leadership uncertainty at the Federal Reserve

President Trump has begun focusing on his selection of the next Fed chair, and it’s looking less likely to be Janet Yellen. He has already begun meeting with candidates and plans to announce his nomination in the next several months. As I have mentioned in past commentaries, there is a significant amount of uncertainty about future Fed leadership, given that there are four open seats on the Fed, including the Fed chair and the Fed vice chair. However, the market hasn’t really reflected this uncertainty – at least not yet. That might change now that we are closing in on an actual nominee – especially if that nominee is non-traditional (i.e., from the business world as opposed to academia or the Fed). The Fed chair nomination will likely garner much attention from Congress, given the growing recognition of the incredible power of the role. I expect this uncertainty will be reflected at least somewhat in markets in the fourth quarter. We need to recognize the possibility that new Fed leadership might make changes to the balance sheet normalization plan or might not have the same data-dependent approach to rate hikes.

4. Leadership developments in China

The 19th Congress of the Chinese Communist Party will be held later in October. The Congress occurs every five years and is a critical event for the government and economy of China. Therefore, this will be very important to follow for two main reasons.

First, this Congress – which occurs in the middle of the Chinese president’s 10-year term – is typically a leadership transition event where we see the emergence of a new leader who is likely to take over once the incumbent’s leadership ends in five years. However, we could see President Xi Jinping signal his plans to remain in power beyond 2022. While unusual, this would not come as a surprise given that President Xi has been consolidating power – and many Chinese are suggesting that this is a unique time in which the country needs to retain its strong leader. After all, China has arguably been threatened like never before by the specter of protectionism coming from U.S. President Trump. And, tensions with regard to North Korea and its nuclear ambitions have necessitated involvement by China and its firm hand.

Second, we are likely to get an assessment from the Congress on the progress of the “Chinese Dream,” which is the government’s initiative to create a “moderately prosperous society” despite the enormous geographical, educational and economic differences of its populace. This assessment should provide some insight into what we can expect from the third plenum, which will meet in the fall of 2018 and usually results in an economic and political agenda for the following years. For example, the last third plenum, in the fall of 2013, produced a broad agenda of economic and political reforms, including the anti-corruption crackdown. China is facing many challenges as its demographics change and as it transitions from an export-based economy to a consumption-based economy. Of course, what happens in China has an impact on the global economy, so we will follow the developments from this Congress and its following plenums closely.

5. Japanese uncertainty

Japanese Prime Minister Shinzo Abe recently called for snap elections later this fall. His intention appears to be to win a mandate for dealing with North Korea with a stronger hand. He also would like to win support for a massive stimulus package, including spending on education as opposed to paying down the national debt, which is nearing a crisis level.

However, it seems Prime Minister Abe may be making a mistake similar to that of U.K. Prime Minister May last spring when she called for snap elections in order to strengthen her hand in negotiations with the EU – only to have that hand weakened by tepid support at the polls. That’s because Prime Minister Abe is facing stiff competition from a political outsider. While PM Abe will likely be re-elected, it could occur with less support, weakening his hand going forward. He has very difficult tasks ahead as he attempts to stimulate the economy, navigate high debt levels and deal with a significant national security threat in the form of North Korea. We will want to follow the economy closely to see whether it will stumble – after exceeding expectations recently – in the face of a possible weakening of PM Abe’s power.

6. Central banks’ delicate balancing act

In general, I expect key central banks to continue their very delicate calibrations as they attempt to support growth while beginning to normalize monetary policy. The U.S. is at the forefront of this effort but is not alone. Canada has begun the same process with two successive rate hikes and the potential for more – which may threaten economic growth, especially in the face of a government proposal to raise taxes on small-business owners. And the Bank of England appears poised to begin normalization soon – no doubt having the most difficult balancing act of all: controlling relatively high inflation while supporting economic growth in the face of great uncertainty about the future vis-a-vis Brexit.

Key takeaways

There are a few points I would like to stress:

  • First of all, there is no guarantee we will see the tax reform plan come to fruition in its current form – keep in mind, we could actually see tax rates rise for high-income households. But more importantly, we will remain in a relatively low rate world – especially if we add upwards of $2 trillion to the national deficit with this tax plan.
  • I believe it is important to derive income from a diversified group of sources. That includes dividend-paying stocks, which have continued to benefit from favorable tax treatment.
  • While there is excitement about the U.S. stock market because of this sweeping tax reform plan, I believe international stocks – many of which offer lower relative valuations and have benefited from growth catalysts – should not be overlooked in the renewed enthusiasm over U.S. equities.

In summary, because I expect markets will be buffeted by geopolitical and monetary policy events going forward, I expect significant currency movements and a continued rotation of outperformance among sectors and market capitalizations. An actively managed, dynamic, multi-asset strategy may make sense in this environment. Finally, we can’t forget that risk is increasing, although the monetary policy and global growth environment creates a continued upward bias for stocks. Investors may want to consider an investing approach that focuses on capital appreciation but with an eye toward protection. That includes broad diversification – which may include adequate exposure to alternatives such as long-short and market neutral strategies that may help cushion portfolios in times of market stress.

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This post was originally published at Invesco Canada Blog

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