2024 Q3 Thoughts

Market Recap

It was far from a quiet summer for the financial markets, which 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 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 (Russell 1000 Value) gained 9.4% and outperformed large-cap growth’s (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 (up 9.6%) easily outperformed the cap-weighted S&P 500 during the quarter. 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.

Outside of the U.S., developed international stocks (MSCI EAFE) gained 7.3%, finishing ahead of domestic stocks in the three-month period. Emerging markets stocks (MSCI EM Index) were relatively quiet for most of the quarter but rose sharply in the last week of the period after China announced its 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 (MSCI China Index) 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 5.0% and credit performed well in the quarter as high-yield bonds (ICE BofA Merrill Lynch High Yield Index) were up 5.5% 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.

Investment Outlook and Portfolio Positioning

The Fed’s half-point rate cut in September came after one of the most rapid series of hikes in history that were an effort to combat the highest level of inflation since the early 1980s. Fed Chairman 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.

The question now is the pace of cuts going forward. Expectations of individual Fed members (the Fed’s so-called “dot plot”) suggests the Fed collectively expects another 150 basis points of cuts by the end of 2025, and more modest cuts in 2026.

Comparing the Fed’s outlook for the fed funds rate to what the market is pricing in, if we look to the end of 2025, the Fed is expecting the fed funds rate to be between 3.00% and 3.50%. The bond market, however, is currently pricing in a fed funds rate of 2.7% at year-end 2025/early 2026. This difference 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.

If the Fed’s short-term rate estimates become reality over the next couple years, we don’t believe there will be a significant benefit to owning intermediate- to long-term duration such as core bonds and 10-year Treasury notes. In fact, if the Fed is wrong, and fed funds move lower than currently expected, say by 50-75 basis points, we still think duration will have a relatively limited long-term benefit. Given this range of outcomes, we think we can generate better returns over time by owning shorter-term, higher-yielding investments that are not included in the core bond benchmark.

Stocks have posted one of the strongest year-to-date returns through September since the 1990s, with the majority of S&P 500 return due to expanding valuations. 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, earnings growth will need to do the heavy lifting in order for investors to realize similarly strong returns 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.

With the U.S. presidential election less than a month away, we reiterate our long-held view that portfolio positioning should be guided by an analysis of longer-term risks and rewards, not election outcomes. 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 significance of the election, but to point out that the gears of the economy are not overhauled based on an election outcome.

Closing Thoughts

We remain cautiously optimistic about the current investment landscape. While there are promising signs in the economy, we are also acutely aware of the potential risks that could impact market stability. 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 staying disciplined and opportunistic, we aim to navigate the complexities of the market and position our investments for long-term success.

As always, The Gardner Group appreciates your trust.