What to watch as the fourth quarter starts.

Paced by strong performance in large-cap technology stocks, equities generally moved higher. This led to strong gains for the Nasdaq Composite and the S&P 500. With Treasury yields continuing to move higher, interest rate–sensitive equity sectors came under pressure. Fixed income markets were also weaker across the board.

BEYOND THE HEADLINES:

What to watch as the fourth quarter starts.

The arrival of fall also marks the end of the third quarter. Although stocks and bonds have experienced volatility throughout the quarter, equities have generally finished September on a strong note.

Volatility isn’t likely to dissipate as the year ends, however. Many concerns that have weighed on investors will continue to do so. But fundamentals also remain strong, and they have helped markets climb the wall of worry over the past two years.

As we enter the fourth quarter, some major issues to watch include midterm elections, interest rates, the Federal Reserve (Fed), and third-quarter earnings reports.

Election Uncertainty Is Nothing New
Headlines about the upcoming elections are everywhere. History indicates that markets will worry about the political outcome and what it means for future policy. This year is no different. Investors are weighing how different election outcomes could affect future policy, including whether Democrats secure a blue wave or Republicans successfully limit their losses.

We are in one of the most volatile parts of an election cycle. Markets typically underperform during midterm years, often from summer through October, compared with other years. That is the peak level of election uncertainty.

But history also provides insight into what ultimately matters. After the election, uncertainty typically dissipates, stocks rally, and the following year is often a good one for investors. The power-sharing arrangement in Washington has very little effect on returns. Over the long term, returns don’t show a significant difference based on which party controls the White House, Senate, or House of Representatives.

Fundamentals are far more important than politics when it comes to long-term investment returns.

Bond Yields Are Surging; How Much Will the Fed Do?
For the first time since July 2007, the 10-year Treasury yield reached 5.2 percent. Although much of the move higher in yields over the past month has been driven by inflation expectations, last week’s move appeared to reflect stronger economic growth.

While strong economic growth and accelerating inflation have different implications for investors, both could support additional interest rate increases. Chair Kevin Warsh has commented that the Fed should take signals from the bond market when evaluating monetary policy.

Markets currently expect the Fed to raise interest rates four more times over the next 12 months. If bond investors continue to push yields higher, that could increase pressure on the Fed to tighten policy further and may create additional headwinds for equity markets.

Will Corporate America Continue to Carry the Day?
Despite the many headwinds companies have faced over the past couple of years, their ability to deliver strong earnings has not slowed. Analysts currently expect third-quarter earnings to increase more than 29 percent. That would mark three consecutive quarters with earnings growth exceeding 25 percent.

Over the past seven quarters, companies have delivered earnings that have exceeded expectations. As those expectations increase, however, the bar rises—and the possibility for disappointment increases. Nonetheless, it’s encouraging that all 11 sectors are expected to show year-over-year growth.