Q3 2024 Market Perspective

In September, the Federal Reserve (Fed) lowered its key interest rate by 50 basis points, nearly nine months after first signaling this policy change. Prior to this cut the Fed had increased interest rates 11 times between 2022 and 2023, while attempting to slow down rampant inflation. Fed chairman Jerome Powell stated that the shift in monetary policy was necessary to recalibrate interest rates towards more normalized levels and it was not a response to deteriorating economic conditions. With inflation steadily decreasing throughout the year, a greater focus is now on the strength of the job market and maintaining healthy levels of economic activity.

Broadly speaking, most major asset classes posted strong third quarter results, despite the ongoing political and global unrest. The S&P 500 total return index has appreciated more than 22% this year, including a 6% gain in the quarter.[1] In our previous note, we discussed the importance of rebalancing portfolios and maintaining diversification, with certain segments of the market (such as mega-cap growth stocks) significantly outperforming most asset classes during the first six months of the year. One positive sign during the third quarter was broader market participation, with large-cap value stocks, smaller market capitalization stocks and international stocks all outperforming.

A rate cut cycle is underway and we believe the U.S. economy is trending towards a soft economic landing. This is the “goldilocks” scenario investors have been cautiously hoping for, and the market gains over the past 12 plus months reflect this sentiment. However, it is important to note that there will be a lag in the time it takes for interest rate changes to affect the economy, and therefore it is still very early to declare victory for the Fed. We expect investors will be paying close attention to economic readings on growth, inflation and unemployment throughout the remainder of the year and into 2025. Changes in economic conditions and corporate earnings are catalysts that could lead to increased market volatility.

In this note we will take a deeper look into past interest rate cut cycles and discuss potential implications for the economy, the markets and portfolios. We reiterate that while it is important to understand the possible range of outcomes, it is prudent to have a plan and create a custom investment strategy that has been optimized to achieve your measure of success under varying circumstances.

Source: Q3 2024 Total Return as of 09/30/2024, Bloomberg

• The U.S. stock market experienced broader market participation in Q3, specifically with value stocks and small-cap stocks closing the gap on U.S. large caps. As a barometer of overall improvement in market breadth, the top 10 largest weighted stocks in the S&P 500 index have accounted for 50% the index’s gains through the first three quarters of the year, down from roughly 67% at the end of the second quarter. [2]
• Stock valuations and earnings expectations remain historically rich, with the forward P/E ratio of the S&P 500 index at 21.4x.[3] The second quarter turned out to be one of the best earnings growth quarters in recent history, which helped to soften valuation concerns. However, maintaining elevated valuations will likely be highly dependent on Q3 earnings continuing the trend of year-over-year earnings growth for the index.
• Bond markets performed well in the quarter as the market priced in an expected rate cut in September. The treasury yield curve continued to steepen as investors adjusted their expectations surrounding the number and magnitude of future rate cuts. We believe the opportunity still exists to extend portfolio duration and increase yield within fixed income portfolios. With cash yields expected to fall during this rate cut cycle, we expect investors will continue swapping out money market investments for new high-quality bonds.

WHAT TO EXPECT WHEN THE FED IS CUTTING RATES

While there is no playbook for exactly how the U.S. economy will respond to declining interest rates, there are historical precedents that have been set during the several rate-cut cycles experienced since the Great Depression. In many instances, rates were cut just prior to or during an economic recession, yet in a few instances, cuts occurred without the presence of a recession. When looking at the previous rate cut cycles, important variables to consider include the length of the cycle, the degree of rate cuts, and the underlying strength of the economy. When referencing the previous cuts, we are citing recently released studies.[5],[6],[7]

Review of Previous Rate Cut Cycles and How it Compares to Today:

Length of Cut Cycle:

• Previous cuts: Over the last 40 years, policy loosening cycles concluded within a year from the time of the first rate cut.[4]
• We expect the Fed will be patient with its rate cuts this cycle. Fed projections currently estimate the fed funds target rate will be 3.4% in 2025 and 2.9% in 2026, indicating this cycle may take longer than usual.[10]

Market Reaction:

• Previous cuts: Since inception of the Fed, markets have historically reacted favorably in the year following the first cut. There were exceptions though, and two examples of negative market returns were in 2001 and 2007. See chart below.[5]
• The S&P 500 index was up 22% through September, which is in-line with what history would have suggested in a soft-landing, or no-landing, scenario.

Economic Strength:

• Previous cuts: GDP growth has averaged 2% during Fed cut cycles.[6] Additionally, over the last 40 years, when there was no recession, unemployment dropped 0.2% within a year following the first rate cut.[4]
• It is important to understand why the Fed is cutting rates this cycle. In many historical instances the Fed needed to stimulate the economy to end or prevent a recession from occurring (i.e. stop rising unemployment and/or contracting GDP). However, today the Fed is cutting rates to recalibrate to more normalized levels and its main goal is not to accelerate growth, which could reignite inflation. The Fed’s current median projection for real GDP growth is 2% through 2026. The Fed projects the unemployment rate to be 4.4% in 2025 and 4.3% in 2026 (the September unemployment rate was 4.1%).[9],[10]

Degree of Rate Cuts:

• Previous cuts: The average soft-landing cutting cycle over the past 53 years has seen approximately 200bps of easing, however more recently it has averaged only 75 basis points.[7]
• The Fed currently expects roughly 150 basis points of additional cuts by the end of 2025. This degree of rate cuts would be above the historical average of rate cuts that have coincided with a soft-landing over the past 40 years. This will continue to be a moving target as the Fed assesses incoming data, while managing towards its dual mandate of price stability and maximum employment.
  

Source: Charles Schwab, Bloomberg, and the Federal Reserve as of 08/16/2024

Current Economic Conditions: While we are mindful that an accelerating economy may reignite inflation (a variable that must be monitored), there is optimism that the U.S. economy will avoid a recession. The recent 50 basis point cut to interest rates should be another tailwind to an economy that is already benefiting from stable consumer spending, corporate spending on Artificial Intelligence and public spending on national defense and infrastructure. Current data on jobless claims and GDP all point towards an economy that seems poised for further growth.

The Core Personal Consumption Expenditures (PCE) price index, the Fed’s preferred gauge to measure underlying inflation, was up 2.7% YOY in August after rising only 0.1% during the month.[8] The Fed cited this reading on inflation as a positive indication that inflation has slowed in the economy. With a rate cut cycle now underway, investors (along with the Fed) will maintain a close eye on inflation.

SUMMARY

Both equity and fixed income performed well during the third quarter. Equity indices remain at or near all-time highs, and while fixed income yields have come down slightly, they remain near decade-high levels. Supporting this momentum is a consensus that the U.S. economy will avoid a recession and with the Fed now engaged in a rate cut cycle, the economy is perceived to have additional wind at its back.

The Fed will be closely monitoring employment data (such as the unemployment rate and jobless claims) and will likely base the trajectory of future rate cuts on the strength of the labor market. Furthermore, while the Fed believes that it has made tremendous progress in achieving price stability, if we experience a significant trend reversal in inflation, we should expect market volatility to increase due to the economic uncertainty that would likely follow. As we look out to the remainder of the year, we must also be mindful of potential short-term market impacts from the upcoming presidential election as well as the ongoing conflicts abroad (though there has been little impact to the markets thus far).

We have the benefit of speaking with our diverse client base regularly, and of listening to their points of optimism and reasons for concern as it relates to current market conditions and personal situations. This perspective reinforces to us the core tenets of our investment philosophy. Specifically, we know the portfolio factors we can control, such as market risk, costs and taxes. We understand that market timing is unpredictable and will often be a detriment to the long-term success of an investment strategy. Lastly, we understand that each one of our clients has their own measurement of success and through thoughtful conversations and planning we can customize appropriate investment strategies, designed to meet these individual needs throughout the ups and downs of a market cycle.

It is through these conversations that we ensure your plan remains on track, and we look forward to connecting with you again soon.

APPENDIX

Chart A: 2024 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2024 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni index; 09/30/24

1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index 2 – Source: Bloomberg PORT Analytics: S&P 500 portfolio contribution to return 1H/YTD 2024
3 – Source: FactSet Earnings Insight October 4, 2024
4 – Source: https://www.treasurefi.com/blog/a-short-macro-guide-to-the-federal-reserve-interest-rate-cut-cycle
5 – Source: https://www.schwab.com/learn/story/what-past-fed-rate-cycles-can-tell-us
6 – Source: Fidelity Institutional Commentary: What Fed cuts have meant historically for the economy and the market – Denise Chisholm, Director of Quantitative Market Strategy
7 – Source: https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/tmt/rate-cut-breakdown-what-you-need-to-know-now
8 – Source: https://tradingeconomics.com/united-states/core-pce-price-index-annual-change
9 – Source: https://tradingeconomics.com/united-states/unemployment-rate
10 – Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240918.pdf

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