Despite some turbulence in July and August, the third quarter was positive for equities and bonds across the board. The S&P returned 5.9%, which was led mostly by value stocks, and the Bloomberg US Aggregate Bond Index returned 5.2% as the 10 Year Treasury Rate fell to 3.81%.
In what was likely the biggest headline of the quarter, the Federal Reserve ended its fourteen-month rate pause by lowering the Federal Funds Rate by 50 basis points to the 4.75-5.00% range. Fed officials also signaled a tentative target of 4.25-4.50% by the end of the year and 3.25-3.50% by the end of 2025. As shown below, markets are expecting a lower terminal rate, closer to the 3% level.
Typically. the start of a rate cut cycle is a red flag that recession risks are elevated, but in this case the Fed’s language is more consistent with a soft landing. Unless they see major economic cracks that they are not communicating with the public, they appear to believe that the economy has cooled enough to warrant looser policy and that inflation has been sufficiently tamed. Although we tend to agree with the soft landing story, we are still somewhat apprehensive of the inflation victory given the rapidly developing stories of conflicts in the Middle East and East Coast port strikes.
Shortly before the Fed’s rate cuts, the yield curve ended its longest 2-10 Year Rate inversion in history, which ended up lasting over two years. We expect this curve normalization to continue as the Fed keeps pushing down the front end of the curve and the long end remains relatively stable. However, given global trends that could prove to be inflationary for years to come, such as deglobalization and demographic shifts, we might be entering an era where bond yields will be structurally higher through upcoming cycles. These higher yields will not help our government’s debt servicing costs, which has already risen dramatically to nearly match the level of our defense budget despite only a 4.2% unemployment rate. The good new is that we still have some time to address our outsized deficit issue before the bill comes due in a major way.
The Presidential election next month continues to be extremely tight, and it likely will be too close to call for the rest of the race. This tightness increases the odds of a contested election, which could lead to an uptick in volatility. The stock market has historically done well after elections under both parties, but the results could have major implications on the direction of foreign policy and trade, taxes, and regulation. For example, a red victory would likely accelerate the pace of deglobalization, extend Trump’s tax cuts more broadly, and deregulate banks and healthcare, while a blue victory would increase taxes for high earners and increase spending on infrastructure and clean energy.
The Harris campaign should benefit from the extent to which the economy remains resilient over the next two months, and our base case is still a continuation of the soft landing. The only sectors of real weakness recently have been manufacturing and housing, which might be bottoming with the onset of lower rates, and the labor market should stay firm through the election despite a small uptick in unemployment. There are some notable risks stemming from the wars abroad, the East Coast port strikes, and Japan hiking rates, but factors like rate cuts and Saudi Arabia likely increasing oil production should help mitigate the potential downside.
Along with economic resilience, Americans have benefitted from a strong stock market this year. Returns in the first half of the year were driven almost entirely by mega cap technology and communications stocks, but the market started to broaden over the summer. Although tech names like Nvidia and Microsoft tend to dominate the headlines, sectors like utilities, financials, and industrials have all outperformed technology through the first three quarters. Small cap and international stocks have also picked up steam in the third quarter.
Investment Allocation
Although market performance has broadened, we still believe that concentration risks are elevated and large cap growth valuations are too lofty. The forward P/E ratio of the eight largest companies is around 28.8, compared to about 18.6 for the remaining S&P 500 stocks (see chart below). As such, we continue to favor high quality names further down the cap spectrum, with an emphasis on dividend growers. We are cautious of taking on too much beta from small caps because of their economic sensitivity, but we think there are some strong small and mid-size companies trading at attractive multiples.
In the same vein, the valuations of international stocks are quite attractive, and we would add more exposure if there were less geopolitical risk. This is a space where we believe active managers can benefit from picking specific countries and stocks that can withstand these risks.
We also strongly believe in the benefit of active management for fixed income, and the current rate environment should provide ample opportunities to find value beyond the short-term treasuries we have been favoring for years. We are still underweight duration and overweight quality versus the benchmark, but we are carefully monitoring opportunities to extend duration and yield as the curve normalizes.
It’s hard to bet against stocks or bonds in this environment, but their increasing positive correlation continues to make the case for adding satellite positions to uncorrelated alternative classes to portfolios, such as gold or managed futures.
Third Quarter 2024
Despite some turbulence in July and August, the third quarter was positive for equities and bonds across the board. The S&P returned 5.9%, which was led mostly by value stocks, and the Bloomberg US Aggregate Bond Index returned 5.2% as the 10 Year Treasury Rate fell to 3.81%.
In what was likely the biggest headline of the quarter, the Federal Reserve ended its fourteen-month rate pause by lowering the Federal Funds Rate by 50 basis points to the 4.75-5.00% range. Fed officials also signaled a tentative target of 4.25-4.50% by the end of the year and 3.25-3.50% by the end of 2025. As shown below, markets are expecting a lower terminal rate, closer to the 3% level.
Typically. the start of a rate cut cycle is a red flag that recession risks are elevated, but in this case the Fed’s language is more consistent with a soft landing. Unless they see major economic cracks that they are not communicating with the public, they appear to believe that the economy has cooled enough to warrant looser policy and that inflation has been sufficiently tamed. Although we tend to agree with the soft landing story, we are still somewhat apprehensive of the inflation victory given the rapidly developing stories of conflicts in the Middle East and East Coast port strikes.
Shortly before the Fed’s rate cuts, the yield curve ended its longest 2-10 Year Rate inversion in history, which ended up lasting over two years. We expect this curve normalization to continue as the Fed keeps pushing down the front end of the curve and the long end remains relatively stable. However, given global trends that could prove to be inflationary for years to come, such as deglobalization and demographic shifts, we might be entering an era where bond yields will be structurally higher through upcoming cycles. These higher yields will not help our government’s debt servicing costs, which has already risen dramatically to nearly match the level of our defense budget despite only a 4.2% unemployment rate. The good new is that we still have some time to address our outsized deficit issue before the bill comes due in a major way.
The Presidential election next month continues to be extremely tight, and it likely will be too close to call for the rest of the race. This tightness increases the odds of a contested election, which could lead to an uptick in volatility. The stock market has historically done well after elections under both parties, but the results could have major implications on the direction of foreign policy and trade, taxes, and regulation. For example, a red victory would likely accelerate the pace of deglobalization, extend Trump’s tax cuts more broadly, and deregulate banks and healthcare, while a blue victory would increase taxes for high earners and increase spending on infrastructure and clean energy.
The Harris campaign should benefit from the extent to which the economy remains resilient over the next two months, and our base case is still a continuation of the soft landing. The only sectors of real weakness recently have been manufacturing and housing, which might be bottoming with the onset of lower rates, and the labor market should stay firm through the election despite a small uptick in unemployment. There are some notable risks stemming from the wars abroad, the East Coast port strikes, and Japan hiking rates, but factors like rate cuts and Saudi Arabia likely increasing oil production should help mitigate the potential downside.
Along with economic resilience, Americans have benefitted from a strong stock market this year. Returns in the first half of the year were driven almost entirely by mega cap technology and communications stocks, but the market started to broaden over the summer. Although tech names like Nvidia and Microsoft tend to dominate the headlines, sectors like utilities, financials, and industrials have all outperformed technology through the first three quarters. Small cap and international stocks have also picked up steam in the third quarter.
Investment Allocation
Although market performance has broadened, we still believe that concentration risks are elevated and large cap growth valuations are too lofty. The forward P/E ratio of the eight largest companies is around 28.8, compared to about 18.6 for the remaining S&P 500 stocks (see chart below). As such, we continue to favor high quality names further down the cap spectrum, with an emphasis on dividend growers. We are cautious of taking on too much beta from small caps because of their economic sensitivity, but we think there are some strong small and mid-size companies trading at attractive multiples.
In the same vein, the valuations of international stocks are quite attractive, and we would add more exposure if there were less geopolitical risk. This is a space where we believe active managers can benefit from picking specific countries and stocks that can withstand these risks.
We also strongly believe in the benefit of active management for fixed income, and the current rate environment should provide ample opportunities to find value beyond the short-term treasuries we have been favoring for years. We are still underweight duration and overweight quality versus the benchmark, but we are carefully monitoring opportunities to extend duration and yield as the curve normalizes.
It’s hard to bet against stocks or bonds in this environment, but their increasing positive correlation continues to make the case for adding satellite positions to uncorrelated alternative classes to portfolios, such as gold or managed futures.
Stonebridge Financial Group
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