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The interest rate pendulum finally swung the other way.  The Federal Reserve finally lowered interest rates at its September meeting.  The was the first cut since 2020 – the Fed said the larger-than-expected 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.  The Fed has a dual mandate: to keep inflation low and to support full employment.  Since the last meeting, inflation has fallen faster than the Fed had anticipated, while the unemployment rate has risen more than expected.  The economy has remained resilient thanks to strong consumer spending, lower inflation, and healthy corporate earnings.

The stock market reacted favorably to the rate cuts and resilient economy as it reached new highs with the S&P 500 gaining 5.9% in the third quarter, pushing its year-to-date return to 22.1%.  The bigger news was there was a rotation out of large-cap growth tech stocks and into a broader range of sectors and styles.  The Nasdaq lagged other benchmarks in the quarter.  Large cap value (Russell 1000 Value) gained 9.4% and outperformed large cap growth (Russell 1000 Growth) 3.2% gain, and small-caps (Russell 2000) rose 9.3% outpacing large-caps (Russell 1000) 6.1% gain.  The equal-weighted S&P 500 index rose 9.6% easily outdistancing the S&P 500 during the quarter.  We finally got the broad-based rally in U.S. stocks that investors have been waiting for this year.

Internationally, developed international stocks (MSCI EAFE) gained 7.3%, finishing ahead of domestic stocks in the quarter.  Emerging markets stocks (MSCI EM Index) were quiet for most of the quarter but rose sharply in the last week of the period after China announced their boldest stimulus in years.  Emerging market stocks finished the quarter up 8.7% thanks to a 23.5% gain from China during 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 5% and credit performed well as high yield bonds were up 5.5% in the quarter.

Overall, domestic economic and corporate fundamentals remained healthy in the quarter, although stretched 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 Outlook

The big news in the quarter was that the Federal Reserve lowered the target for the federal funds rate by .50% or 50 basis points, to a range of 4.75% to 5%.  The cut came after one of the most rapid series of hikes in history to combat the highest level of inflation since the early 1980s.  Outside of the pandemic, 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 a 25 basis point – 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.  Powell further indicated that two more cuts (likely 25 basis points each) are likely in the November and December meetings.  He also said that he does not see a recession on the horizon.  On the final day of the quarter, Powell reiterated his view saying that the economy is in solid shape with a healthy labor market and inflation is heading toward the Fed’s 2% target.

Since the Fed’s July meeting, inflation declined faster than the Fed had anticipated, while the unemployment rate has risen more than expected.  When it comes to inflation, our view has been that inflation has been under control and that it would be trending lower in the second half of the year.  (See chart below.)  Powell is now saying the recent decline in inflation has given the Fed the confidence to lower rates.  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.  The FOMC participants see a growing risk to the unemployment rate and more balance risks to inflation.  By moving their focus to the labor market, the hope is to safeguard a soft landing for the economy. 

The question now is the pace of cuts going forward.  According to the Fed’s so-called “dot plot,” which indicates where various members of the Federal Reserve expect the fed funds rate to be over the next few years, the Fed expects another 150 basis points of cuts by the end of the of 2025, and more modest cuts in 2026.  The farther the outlook, the wider the range of estimates.  Powell emphasized that the Fed remains data dependent, meaning that any future policy decisions will be based on economic data, and he was reluctant to commit to any level of cuts saying decisions will be taken meeting by meeting.

Looking longer-term, the Fed’s long run estimate of the fed funds rate, or the terminal rate, moved up slightly from the previous meeting from 2.8% to 2.9%.  This is up from 2.5% from the year-ago figure, which implies that the economy will continue to grow at a strong pace.

As for the labor market, the current employment picture remains in decent shape.  However, there are signs of slowing, and extrapolating recent trends 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. The unemployment rate has steadily increased since its low in 2023.  Further job losses would be worrisome for the Fed since consumption drives the economy, which is why investors are so focused on the labor market.  For now, the labor market is slowing, not breaking, but it needs to be closely monitored.

Overall, our view is that the economic data remains generally healthy. Real GDP for the second quarter was 3% and the estimate for the third quarter (Atlanta Fed) is currently 2.5%.  Meanwhile, inflation continues to moderate, corporate earnings remain strong, corporate defaults remain low, consumers (and the government) continue to spend, and interest rates are trending lower.  Lower rates should lead to lower mortgage rates, and it’s possible we could see a rebound in the housing market, which could 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 a game changer, shifting the market away from large cap technology stocks and short-term cash investments.  We think market returns will broaden out beyond the Magnificent 7 which may no longer be the only game in town.  Markets will remain volatile and data dependent and 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 longer term risk 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, however, is not supported by the historical data and we provide some evidence below that stocks have historically trended higher regardless of the political party of the president.

We think 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.  Headlines will influence short term market fluctuations, but longer-term fundamentals are what drive market performance.  The U.S. economy is consumer-driven which is not going to change overnight, and neither are the economic fundamentals. As a result, we don’t think an investment strategy should change either.

The lack of consistency in the impact of past elections on investments results runs deeper than just the overall stock market level.  Analysis by Richard Bernstein Advisors goes deeper and demonstrates the variability of returns at both the asset class and industry sector levels under past administrations (See chart below).

It’s important to note that the election and post-election year results shown in these charts reflect the average result historically, and the sample size is relatively small.  There are many reasons the market could respond differently in any given election.  But the broad point is that instead of betting on election results, we remain true to our longer-term investment discipline.  We are focused on fundamentals and our investment approach is built on confidence that over time securities prices will reflect these fundamentals. (See chart.)

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 close at 3.77% in early September.  The last time the yield curve was normally sloped – when short term bond yield is below the long-term yield – was in July 2022.  Historically, an inverted yield curve has been a warning sign of an impending recession.  That does not seem to be the case this time.  We are pleased that the Fed initiated a shift in policy.  We had been saying that the 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. 

The Fed’s recent shift puts us at a turning point in the fixed income markets.  The Fed’s recent cut and shift to a more accommodative stance will start a new chapter for fixed income.  As the central bank lowers 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.

One concern in today’s market is tight credit spreads.  The biggest reason that spreads are narrow today is good economic news.  Persistent economic growth has made the odds of a recession less likely.  Furthermore, strong fundamentals have played a role, as companies have responsibly improved balance sheets, locking in lower rates during the pandemic.  As a result, corporate defaults have been in the low-single digits, below their historical average.  While spreads are tight, the absolute yield on both investment grade and high yield bonds are attractive when compared to a few years ago.  Investment grade bonds are currently yielding 4.76% and high yield bonds are yielding 6.37%.  We favor core bonds, high quality credit issues, floating rate bonds and long-term municipal bonds.

Equities

When the Fed starts cutting interest rates, equities historically have reacted favorably.   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, returns started to broaden out in the third quarter.  Small-cap stocks, value stocks, and international stocks finally outpaced the S&P 500 during the quarter.

With valuations now near historic highs (see chart below), earnings growth will need to do the heavy lifting for investors to realize the same pace of returns (double-digit) as they have in recent years.  Such an outcome will be harder to come given historically high profit margins and valuations for large cap stocks.  We think mid cap, small cap and international stocks will do the heavy lifting going forward.  We think it’s quite possible that areas of the equity market which have lagged and have lower valuations – small cap companies, value stocks and international stocks – could benefit from an ongoing expansion and have a broadening out of the market rally now that the Fed has started cutting rates.

Alternative Strategies

Alternatives can provide significant long-term portfolio benefits and non-correlated returns to traditional stock and bond holdings and improve risk-adjusted returns of balanced portfolios.  Given the current rise in public equity markets, we think they offer attractive risk/reward characteristics when compared to public equities.

We favor private real estate investment allocations to multi-family, industrial and self-storage and selected grocery anchored centers. We expect equity like long term returns from these investments with built in inflation protection and tax efficient income generation.  We also favor private equity and credit opportunities and recently added a position in commodities.  We will continue to add alternatives to our diversified balanced portfolios.

Closing Thoughts

We remain cautiously optimistic about the current investment landscape. We expect more volatility given the headline risks related to Fed policy adjustments and the presidential races.  While there are promising signs of growth and resilience in the economy, we are also 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.  By staying disciplined and opportunistic, we aim to navigate the complexities of the market and position our investment for long term success.

We sincerely thank you for your confidence and trust in us. Please do not hesitate to reach out to us if you have any questions or wish to discuss how all this relates to your specific financial situation in more depth.