Investment Overview: 3rd Quarter 2024

The economy

For now, the U.S. economy appears to be on a path for the elusive “soft landing,” with economic growth continuing to generally surprise to the upside. Importantly, consumer spending advanced 2.8%, which highlighted the continued resiliency of the U.S. consumer who accounts for over two-thirds of GDP. Markets responded favorably during the third quarter, with broad-based gains in both equity and fixed income markets, with the S&P 500 Index ending the quarter at a fresh all-time high. However, despite these favorable headlines, there are some more worrisome data points beneath the surface.

The labor market, while still healthy by historical standards, has been trending in a negative direction. The unemployment rate reached 4.3% in July, the highest since October 2021. The rise from recent lows in the mid-3% range triggered the warning sign that often signals a recession, when the unemployment rate rises by 0.5% relative to its low from the past 12 months. Still, with unemployment currently at 4.2% and weekly jobless claims numbers at relatively healthy levels, the verdict is still out on the overall health of the labor market.

Inflation has declined to more tolerable levels, at least according to the Federal Reserve. Headline CPI inflation rose 2.5% over the past 12 months, its lowest level of increase on a trailing annual basis since February 2021. The Fed’s preferred measure of tracking inflation, called the core PCE price index, rose at an annual rate of 2.7% in its most recent reading. This level is still above targeted inflation levels but is also trending in the right direction and has given the Federal Reserve enough confidence to begin cutting rates.

September’s Federal Reserve meeting was the first “live” meeting in some time, where an action was expected but the magnitude of the rate cut was not a forgone conclusion. With the aforementioned issues of the labor market trending unfavorably and the inflation backdrop trending to more favorable levels, the Fed enacted a 50 basis point rate cut, which was a larger reduction than many market watchers had expected. Along with the September cut, the Federal Reserve has indicated that further rate cuts are on the horizon, which may spur an increase in spending and fixed investment.

In contrast to the still-positive state of the consumer, the manufacturing side of the economy continues to reside in contractionary territory. In fact, economic activity in the manufacturing sector has contracted in 22 of the past 23 months. Similarly, the Conference Board’s Leading Economic Index declined again in August, its sixth consecutive monthly decline. The Conference Board noted unfavorable new orders are a persistent headwind, as these readings suggest a difficult path for economic growth ahead.

Across the globe, geopolitical tensions are high and continue to escalate, posing a continuous and elevating risk profile. These conflicts may adversely affect trade, influence consumer behavior, and impact commodity prices. Economically, major countries continue to wrestle with slow growth, and several central banks are easing monetary policy, so far with limited progress to show for it. Near the end of the quarter, China implemented a large stimulus program designed to reignite growth in the world’s second-largest economy.

While a soft landing for the U.S. economy would certainly be a favorable development and is the current base case, elevated risks abound both at home and abroad.  First, on the economic front, we are most concerned that any further weakening in the jobs market could push the U.S. economy into a recession, which is a non-consensus view at this time. Secondly, election season is upon us, and we are likely at the precipice of a hotly contested election for control of the White House and Congress. While it appears for now that some form of a divided government is the most likely outcome, which would likely limit the scope of any new policy initiatives, the markets will likely treat any additional uncertainty over the next few months with even higher volatility.

Fixed income

Interest rates decreased substantially over the third quarter on the back of the Fed’s 50-basis-point target rate reduction on September 18. The 10-year Treasury Bond finished the quarter at 3.78%, down from 4.40% at the end of the second quarter. As such, bond market performance was spectacular given that bond prices move inversely to interest rates. The Bloomberg U.S. Aggregate Index was up 5.2% for the quarter, while the Fed Funds target range now stands at 4.75%-5.00%.

Interestingly, the yield curve is now positively sloped with the 2-year Treasury bond currently yielding 3.68%, ending a 26-month inversion (the longest on record) where shorter-term rates were higher than longer-term rates. Historically, inverted curves have been reasonable indicators of an impending economic recession. However, persistent economic growth and a healthy employment backdrop suggest a recession isn’t likely to materialize any time soon.

The Fed’s September rate cut (the first since March 2020) was widely anticipated, albeit many were surprised that the cut wasn’t a more modest 25 basis points. Further rate cuts are expected, with the most likely scenario calling for a 25-50 basis-point reduction at the conclusion of the Fed’s November 6-7 policy meeting. Fed Chair Jerome Powell indicated at quarter end that the economy is in solid shape and “we intend to use our tools to keep it there.”

The Fed’s dual mandate appears to be shifting from battling inflation to supporting employment and averting an economic slowdown. Diminishing inflation gives the Fed more leeway to cut aggressively. The core personal consumption expenditures price index, which excludes food and energy, rose by 0.1% in August from July, down from monthly gains of 0.2% in both June and July.

Moving into 2025, policymakers expect continued cutting throughout the year. Currently, the median forecast among committee members suggests a target rate close to 3.5% at the end of 2025. However, a hot September jobs report, upward revisions to July and August employment data, and higher oil prices in the face of geopolitical uncertainty may cause the Fed to slow their rate cutting campaign in the months ahead.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Investors witnessed strong equity markets both domestically and overseas during the third quarter. The S&P 500 Index increased almost 6%, following a second-quarter rise of over 4%. The index is up a staggering 36% dating back to the start of the fourth quarter of 2023 and has posted 42 record highs so far in 2024.

The third quarter was unique from the standpoint that value-oriented stocks outperformed their growth counterparts as the artificial intelligence or AI rally stalled. The Fed rate decrease likely fueled the rotation with the S&P 500 Value Index finishing the quarter up 9.05% compared to the S&P 500 Growth Index lagging behind but still increasing a respectable 3.70%. Despite value’s nascent emergence, growth stocks continue to dominate as AI stocks have largely fueled market returns since late 2022.  

Internationally, Chinese stocks have gone from market laggard to one of the best-performing markets this year in a matter of days, with the last full week of September marking their best week in almost 16 years. Chinese shares have rallied over 30% in the past two weeks as Beijing rolled out coordinated efforts to stabilize its economy through interest-rate cuts, fiscal stimulus measures, and bank recapitalization initiatives.

Overall, U.S. large-cap growth stocks continue to carry above average multiples. According to BlackRock, the sizable outperformance of large-cap technology stocks in recent years has resulted in value-orientated holdings representing their smallest weight in the S&P 500 in the last 25 years.

Consequently, we are finding compelling value in select domestic equities and while limiting outsized growth exposure. Smaller-capitalization stocks have also piqued our interest. Companies in the small-cap Russell 2000 Index are trading at 15.8 times their projected earnings over the next 12 months, below their 10-year average multiple of 16.4, according to FTSE Russell. In comparison, the S&P 500 trades at a multiple of 21.5.

As we head into the fourth quarter, stock-market volatility is likely to persist, if not intensify. Election frenzy, Fed rate decisions, and Middle East turmoil are all likely to present challenges and opportunities over the next several quarters and well into 2025.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

Third-quarter sector returns reflected investor preferences toward rate-sensitive stocks in the wake of the Fed’s first rate decrease since 2020 and a rotation away from big tech names that largely dominated over the last few years.

Investors bid up shares of companies that pay higher-than-average dividends, most notability in the Utilities (up 19.4%) and Real Estate (up 17.2%) sectors. The Utilities sector also performed well during the second quarter as these stocks have become the newest way to play AI and its immense power requirements.

The Energy sector (down 2.3%) was the only sector to lose value this quarter. While global energy demand remains relatively stable, oil prices have moderated in recent months, with record U.S. oil production helping to stabilize global prices. Also, OPEC+ hinted that it might begin easing production cuts over the next few weeks. Of course, oil prices and Energy sector returns are likely to be quite volatile in the months ahead given fears of a broadening Middle East conflict.

As we move into the fourth quarter of 2024, sector performance could be heavily influenced by an election season pitting Vice President Kamala Harris against former President Donald Trump. While it remains probable that a divided government is the outcome, higher trading volatility is almost an inevitability as markets digest prospects of shifting policy changes.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).