Quarterly Perspectives

October 1, 2024

U.S. stock indices finished the third quarter at record highs driven by growing corporate profits, slowing inflation and the anticipation of a reduction in the federal funds rate, which came to fruition in September. Fixed income returns were positive as yields declined across the maturity spectrum, reflecting moderating consumer prices and slower job creation. Global growth varied by region, but the U.S. economy remained firmly in expansion. The outlook at this stage of the economic cycle will depend on the pace of monetary easing and labor market conditions.

Economic Backdrop

Despite one of the fastest monetary tightening campaigns in history, in which the federal funds rate increased by more than five percentage points in sixteen months, the U.S. economy remained resilient through the end of the third quarter. In September, the Federal Reserve officially reversed course by reducing the upper end of its target range from 5.50% to 5.00%, reflecting its attentiveness to both sides of its dual mandate of stable prices and full employment. Inflation continued to cool, with the consumer price index reaching 2.5% in August, down from 3.4% at the beginning of the year. The Fed expressed confidence that their 2% inflation objective will be met and acknowledged that overly restrictive policy risks weakening the labor market. 

The unemployment rate increased to 4.1% from 3.4% last year, but joblessness is low relative to history and many other measures of consumer health are still strong. There are no signs yet of widespread layoffs as evidenced by muted unemployment claims. Although credit card balances and delinquencies are elevated, the default rate of mortgages, a significantly larger percentage of total household borrowing, remains very low. Consumer net worth has increased nearly 12% over the prior year fueled by real estate and financial asset values. Wage growth continues to exceed the rate of inflation, supporting household spending. With personal consumption accounting for nearly 70% of the U.S. economy, the outlook is likely to depend on the health of the job market. Additionally, the upcoming U.S. presidential election may have implications for taxes, global trade and international relations. Overseas, growth remained sluggish in the Eurozone and the U.K, where central banks have

U.S. Unemployment Rate - Past Forty Years

unemployment rate

*Shaded areas represent recessions

Source: Bloomberg

been easing policy since the summer. Though business activity remained fickle in Japan, its central bank, in contrast to many others, recently tightened policy as inflation hovered above its target. The narrowing of policy rates between the U.S. and Japan triggered significant foreign currency and stock market volatility in August as investors who had borrowed yen to invest in higher yielding assets were forced to unwind those positions. China’s industrial and consumer sector continued to retrench. In response, the government announced major new stimulus measures in September, but excessive debt and a shrinking workforce will serve as long-term challenges for the country. In aggregate, global growth has been persistent but there is potential for economic headwinds to mount.

The Fed Pivot

Periods of interest rate cuts by the Fed often heighten debate on the economy. Constructively, monetary easing stimulates consumption by reducing borrowing costs for corporations and individuals. Housing, for instance, is likely to be an initial beneficiary as affordability improves. Declining interest rates also boost prospects for stocks and bonds by increasing the present value of their future cash flows. The recent performance of equities can be partly attributed to investors factoring in a policy shift in advance of the event. A more cautious interpretation of Fed rate reductions is that they are often initiated in response to signs of a slowing economy. Given its long and variable lags, monetary policy may not deliver its intended stimulative impact for some time.  

Patterns emerge when analyzing the six cycles of Fed rate reductions over the past forty years. Four of those cycles were accompanied by recessions, each of which was preceded by an inverted yield curve. The two soft landings were orchestrated by Fed Chairs Volcker and Greenspan in 1985 and 1995, respectively. Key to their success was preemptive action to tighten policy ahead of accelerating inflation and ease policy before unemployment rose. In neither case did the yield curve invert nor layoffs surge.

Federal Funds Target Rate - Past Forty Years

fdtr chart last 40 years

Four of the last six easing cycles were accompanied by recession, each of which were preceded by inverted yield curves. Fed Chairs Volcker and Greenspan orchestrated soft landings in 1985 and 1995, respectively. 

*Shaded areas represent recessions

Source: Bloomberg

Market performance of the last six cycles varied widely. All four recessionary easing cycles included significant equity market drawdowns, but only during the dot-com collapse of 2000 and the Great Financial Crisis of 2008 did equity returns remain negative more than a year after the initial rate cut. Furthermore, stocks delivered above average returns in the twenty-four months following the other four Fed pivots, including the recessions of 1990 and 2020. Fixed income returns have demonstrated more consistency through easing cycles with decisively strong returns before and after the first rate cut. Long-term bonds generally outperform shorter-term issues during easing cycles as their duration benefits disproportionately from falling interest rates. History demonstrates that monetary easing cycles can be associated with volatility in the equity markets though stocks typically recover their losses before long while fixed income investments act as a ballast to portfolios. These periods of transition argue for adhering to a long-term investment philosophy with an asset allocation strategy tailored to one’s tolerance for risk.

Fixed Income

Fixed income returns were strong in the third quarter. In client bond portfolios, we gradually extended the maturity range over the last several quarters to lock in attractive yields with the expectation that moderating inflation would drive interest rates lower. In the three-month period, tempered consumer prices and job growth pushed yields on ten-year U.S. Treasury notes down from 4.4% to 3.8%. Interest rates on two-year U.S. Treasury notes fell even further and are now below the level of long-term issues. The yield curve is in the process of normalizing after a historic two-year period of short-term rates exceeding those of longer maturities. Yield curve inversions often precede recessions, which typically commence only after the curve has steepened into positive territory. With Fed policy still restrictive, several more rate cuts are forecasted over the coming quarters. Money market funds, which offered attractive returns of over 5% for much of the last two years, are likely to see their yields wither as the Fed’s easing cycle advances.

2-Year / 10-Year U.S. Treasury Yield Spread

2_10 spread

The yield curve has steepened into positive territory. As shown above, this development usually occurs late in the business cycle.

*Shaded areas represent recessions

Source: Bloomberg

Equities

Global equity markets rose during the third quarter and have registered solid gains for the year-to-date. The S&P 500 Index recorded a 5.9% return for the three-month period and has gained 22.1% so far in 2024, outpacing most international markets. Notably, the advance in stocks during the third quarter was driven by a broad range of industries. Sectors such as utilities, industrials and financials were among the strongest performing while technology, the largest component of the index, made only modest progress. 

The valuation of the S&P 500 Index, heavily influenced by large technology companies, remains at the high end of its historic range, reflecting strong fundamentals, lower interest rates and the expectation of an acceleration in corporate profits into next year. U.S. companies are adapting to higher costs by harnessing efficiencies which has driven profitability to historically high levels. With Fed policy in transition and the U.S. economy expected to decelerate, a pullback in stocks from all-time highs would not be surprising. Additionally, international tensions have the potential to pressure stock prices. In client portfolios we continue to trim exposure to specific areas of the market where expectations appear lofty and reallocate proceeds into stocks we judge more attractively valued. With potential for the global economy to slow, we are focused on managing sector diversification with an emphasis on businesses that can generate growth and profitability over the course of the economic cycle.

S&P 500 Index - Past Five Years

spx last 5 years

The S&P 500 Index closed the third quarter at an all-time high.

Source: Bloomberg