Third Quarter-Market Recap
It was far from a quiet summer for the financial markets. Markets have been volatile as investors parsed through economic data attempting to gauge whether the economy will slow and how much the Federal Reserve would need to lower interest rates to prevent a recession. Toward the end of the quarter, the Fed opted for a bold start to its shift in policy, reducing rates by a half percentage point. This was the first cut since 2020, and Fed Chair Jerome Powell said the larger-than-average cut was intended to show the Fed’s commitment to “maintaining our economy’s strength” in the face of a slowdown in the labor market. Year to date, the economy has proven resilient thanks to strong consumer spending, lower inflation, and healthy corporate earnings.
Despite the volatility, the stock market reached new highs, with the S&P 500 gaining 5.9% in the third quarter, pushing its year-to-date return to 22.1%. Notably, there was a rotation out of large-cap growth tech stocks and into a broader range of sectors and styles. The Nasdaq, which led the market higher in the first half of the year, gained 2.8% but lagged other benchmarks in the quarter. Large-cap value gained 9.4% and outperformed large-cap growth’s 3.2% gain, and small-caps rose 9.3%, outpacing large-caps’ 6.1% gain. At the sector level, traditional defensive sectors were by far the big winners, with utilities, real estate, and consumer staples gaining 19.4%, 17.2%, and 9.0%, respectively.
Internationally, developed international stocks gained 7.3%, finishing ahead of domestic stocks in the three-month period. Emerging markets stocks were relatively quiet for most of the quarter but rose sharply in the last week of the period after China announced their boldest stimulus in years in an attempt to boost their ailing economy. Emerging-markets stock finished the quarter up 8.7%, thanks to a 23.5% gain for China during the month of September.
Within the bond markets, returns were positive across most fixed-income segments. The benchmark 10-year Treasury yield declined from 4.36% to 3.81% amid lower inflation and recession concerns. In this environment, the Bloomberg U.S. Aggregate Bond Index gained 4.2% and credit performed well in the quarter as high-yield bonds were up 5.3% in the quarter.
Overall, domestic economic and corporate fundamentals remained relatively healthy in the quarter, although rich valuations remain a risk. Looking ahead, the expectation is that the Fed will continue to cut rates this year and next in an effort to guide the economy to a soft landing and avoid a recession.
Macroeconomic and Investment Outlook
At its mid-September meeting, the Federal Reserve lowered the target for the federal funds rate by 0.50%, or 50 basis points, to a range of 4.75% to 5.0%. The cut came after one of the most rapid series of hikes in history in an effort to combat the highest level of inflation since the early 1980s. Outside of the emergency pandemic reduction, the last time the Fed cut by 50 basis points was in 2008 during the global financial crisis. (See chart below, gray vertical bars represent a recession.)
Powell said this larger-than-usual half-percentage-point reduction—rather than 25 basis points—demonstrates the Fed’s commitment to its dual mandate of maintaining a strong job market while keeping inflation in check; balancing these two goals helps ensure a healthy economy. Powell emphasized that the recent cut was a “recalibration” of policy, bringing it in line with the current conditions and ensuring the Fed does not “get behind the curve” in normalizing rates. This comment was aimed at investors who believe the Fed has been too slow to start reducing rates, thereby increasing the odds of a recession. Powell further indicated that two more cuts (likely 25 basis points each) are likely in the upcoming November and December meetings. He ended the press conference by saying that he does not see a recession on the horizon. On the final day of the quarter, Powell reiterated his view by saying that the economy is in solid shape with a healthy labor market and inflation is heading towards the Fed’s 2% target.
Since the Fed’s July meeting, inflation has declined faster than the Fed had anticipated, while the unemployment rate has risen more than expected. With inflation less of a concern, the Fed’s focus has shifted to its full-employment mandate, and over the past few months, the job market has slowed. Powell stated that the “balance of risks” has shifted, and now, supporting the job market is the focus, saying, “the committee is strongly committed to supporting maximum employment.” By moving their focus to the labor market, the hope is to safeguard a soft landing for the economy.
Regarding the labor market, the current employment picture remains in decent shape. However, there are signs of slowing and extrapolating recent trends that can start to paint a recessionary picture. The question is whether recent trends are a return to normalization or if the deterioration will continue. Since the pandemic, the labor markets have been in flux. Post-pandemic, there was a significant worker shortage, and the ratio of job openings to unemployed job seekers was 2 to 1, meaning jobs were plentiful for employment seekers. This imbalance has since corrected, and the ratio is now closer to 1 to 1.
Part of the right-sizing of the labor markets has occurred thanks to an influx of foreign-born workers over the last couple of years. This eased pressure in the labor markets and helped bring down the wage pressures companies were experiencing in the aftermath of the pandemic. The increase in the labor supply has also been a driver behind the recent increase in the unemployment rate (i.e., more workers looking for the same number of jobs), which points to the increase in unemployment as “artificial,” according to some market participants. BCA Research points to some truth in this—calculating that roughly 40% of the increase in unemployment since its low in 2023 has been due to new entrants into the labor force. Increasing the labor force is a long-term driver of potential growth for the overall economy—something that has been a drag on growth in many developed Western economies. However, BCA also points out that half of the increase in the unemployment rate is due to job loss. Further job losses would be worrisome for the Fed since consumption drives the economy, which is why investors are so keenly focused on the labor market. For now, the labor market is slowing, not breaking, but it needs to be closely monitored.
Comparing the Fed’s outlook for the fed funds rate to what the market is pricing in, we can see in the chart below that through the end of 2024, the market is in line with the Fed. Each dot represents one of the 19 Fed representatives’ outlooks for the fed funds rate. But if we look to the end of 2025, the Fed is expecting the fed funds rate to be between 3.00% and 3.50%. Importantly, this scenario assumes the Fed manages to guide the economy to a soft landing. Any change in the economic outlook will influence this range higher or lower. The bond market, however, is currently pricing in a fed funds rate of 2.7% at year-end 2025/early 2026; see the green dashed line. This difference between what the bond market is pricing in, and the Fed expectations, is the market pricing in the possibility of a recession. In other words, the market is saying the Fed will need to lower rates more than their current soft-landing scenario.
Overall, our view is that the economic data currently remains generally healthy. For example, real GDP for the second quarter was 3.0%, and the estimate for the third quarter (according to the Atlanta Fed) is currently 2.5%. Meanwhile, inflation continues to moderate, corporate earnings remain relatively strong, corporate defaults remain low, consumers (and the government) continue to spend, and interest rates are heading lower albeit at a questionable pace. Lower rates should lead to lower mortgage rates, and it’s possible we could see a rebound in the housing market, which would be inflationary.
In summary, our near-term view is that a soft landing is the most likely outcome for the U.S. economy. Current conditions should be positive for both bonds and stocks, although we expect the pace of gains to slow. Fixed-income returns will be driven by income, not price appreciation, and equities will need earnings growth to justify premium valuations. We also believe that the Fed’s decision to start cutting rates will likely be somewhat of a game changer, shifting the market away from large-cap technology stocks and short-term cash-like investments. We believe the “Magnificent 7” and the strategy of “T-bill and chill” will no longer be the only games in town. We also think the market is projecting in too many rate cuts, and it’s likely that the longer-term bond yields will reset higher over time, creating a source of volatility; we are willing to give up some potential near-term returns in exchange for high longer-term returns. And, of course, we expect the market to continue parsing through economic data, which should result in pockets of volatility. The upcoming election will also likely be a contributor to volatility. We plan to stay vigilant and seek attractive risk-reward opportunities.
Presidential Election
With the U.S. presidential election one month away, we want to reiterate our long-held view that portfolio positioning should be guided by an analysis of longer-term risks and rewards, not election outcomes. We recognize that it’s natural for investors on both sides of the aisle—especially in today’s polarized environment—to believe that an election outcome could have a big impact on the financial markets. This intuition, however, is not supported by the historical data, and stocks have historically trended higher regardless of the political party of the President.
We think, ultimately, the market is driven by economic fundamentals, such as the fed funds rates, corporate earnings, valuations, fiscal imbalances, interest rates, inflation expectations, among other factors. Undoubtedly, headlines will influence short-term market fluctuations but longer-term, fundamentals are what drive market performance. Our intention is not to minimize the gravity of the election, but to point out that the gears of the economy are not overhauled based on an election outcome. For example, the U.S. economy is consumer-driven and that’s not going to change. We maintain the view that the fundamentals of the economy don’t change overnight, and we don’t think an investment strategy should either.
Meanwhile, Presidential election or not, in the shorter term we are prepared for the inevitable periods of market volatility and shorter-term downside risk. This is where risk tolerance becomes important and is the reason we manage portfolios to suit varying levels of discomfort with volatility and shorter-term loss. Regardless of where an investor falls between conservative and aggressive, it is critical to remember that volatility and temporary losses are a normal part of owning stocks and other higher-expected-return “risk assets.” With partisanship and news flow in overdrive in these final weeks, there will be many distractions. Our objective as always will be to ignore these and focus instead on dispassionate long-term analysis of our investment environment.
Fixed Income
In September, the longest inverted yield curve on record finally ended. The two-year Treasury yield closed at 3.76%, and the 10-year bond closed at 3.77% early in September. The last time the yield curve was normally sloped—when the short-term bond yield was below the long-term yield—was in July 2022. Historically, an inverted curve has been a warning sign of an impending recession. Typically, the curve un-inverts around the beginning of a recession as investors anticipate rapid Fed rate cuts amid a slowing economy.
An inverted curve is no guarantee of a recession. Interestingly, many recession indicators that have good track records of predicting recession have not worked this cycle, or at least not yet. We have written in prior commentaries about Fed policy being extremely accommodative while the curve was inverted, which signaled to us that a recession was not imminent. More recently, we have been saying that policy was on the verge of becoming too restrictive. Our belief was that the Fed should at least reduce rates in proportion to declines in inflation to prevent policy from choking the economy. So, we are pleased that the Fed initiated a shift in policy.
As mentioned above, we believe the Fed’s recent shift puts us at a turning point in the fixed-income market. The Fed’s recent cut and shift to a more accommodative stance will start a new chapter for fixed income. As central banks lower rates, yields move lower, and reinvestment risk comes into play for short-term instruments and investors will increasingly start to look for higher returns elsewhere. This, too, will result in generally lower yields across the fixed-income market.
In our portfolios, we continue to have a significant underweight to core bonds relative to a traditional bond benchmark. But we still hold some core bond allocations as ballast in the event of a deflationary recession or traditional “flight-to-safety” market shock. Our strong preference, however, remains for flexible, shorter-duration and credit-oriented fixed-income allocations, which we think will generate better yields over time. Importantly, we do feel that we are not “stretching” for yield, i.e., taking on excess risk to achieve attractive returns. Many of our exposures are investment-grade or are conservatively positioned within the high-yield space. As always, we are weighing a range of shorter-term risk scenarios against each asset’s medium- and longer-term return potential and portfolio diversification benefits assuming different macro environments (inflation/disinflation, growth/stagnation).
Equities
Through the first nine months of 2024, U.S. large-cap equities have delivered an impressive 22.1% return. While much of that year-to-date return can be attributed to the largest companies getting larger — i.e., market-beating returns concentrated among the largest weighted companies in the index — returns started to broaden out to other areas in the quarter. Small-cap stocks, value stocks, and international stocks finally outpaced the S&P 500 during the quarter.
This was one of the strongest year-to-date returns through September since the 1990s, once again proving that valuations are a poor marking timing tool. The majority of S&P 500 return year to date is due to expanding valuations. The trailing 12-month GAAP P/E ratio has gone from 24.8x to an estimated 28.2x (nearly 14% higher). This accounts for two-thirds of the market return. The remainder is due to earnings growth (about 5%) and dividend yield. While it is normal for short-term equity returns to be driven by valuation expansion or contraction, we believe that earnings growth is the more reliable driver of long-term returns.
With valuations now near historic highs (see chart below), earnings growth will need to do the heavy lifting in order for investors to realize the same pace of returns (double-digit) as they have in recent years. While it is not out of the realm of possibilities, such an outcome will be harder to come by given historically high profit margins and valuations.
Overseas, an announced stimulus package in China sent their equity markets higher in the second half of September. After slowing and disappointing economic data throughout the summer, Beijing signaled their support for the economy and financial markets. After falling more than 13% from mid-May through mid-September, Chinese stocks surged 28.7% in the final weeks of September.
So, what was announced in China, what impact might it have on the economy, and does it change our outlook for emerging-market equities? The short answer: the long-term impact on the economy is unlikely to change based on what was announced, however, given the nature of Chinese markets, investors should not rule out a cyclical, short-term rally.
Some of the stimulus measures announced include further cuts to borrowing rates (policy and mortgage rates), lower reserve requirement ratios at the banks, lower down payment requirements from home buyers, and support for the stock market. There were also reports that fiscal transfers to Chinese households could be on the table—something that pundits have been clamoring for, given the weak consumption trend. The government also signaled that further measures could be announced. However, as can sometimes happen in China, announced measures can often lack the necessary follow-through. It remains to be seen if these measures are fully implemented and if they provide enough support for the economy to recover, but at a minimum it should provide a floor in the near term.
Conclusion
We remain cautiously optimistic about the current investment landscape. While there are promising signs of growth and resilience in the economy, we are also acutely aware of the potential risks that could impact market stability and will remain vigilant in monitoring developments. Our focus will continue to be on identifying opportunities to improve long-term returns in line with the risk targets for the portfolios we manage. By being disciplined and opportunistic, we aim to navigate the complexities of the market and position our investments for long-term success.
As always, we appreciate your trust.
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