The US economy has been able to defy expectations amid tight monetary policy, geopolitical concerns, and a normalizing of the labor market. Equity markets have followed, delivering another strong year of returns (22.1%) so far after last year’s advance of 26.3%. Returns had been concentrated, but a noticeable broadening of stock market contributors has provided another spark in the third quarter. There are five themes to watch as 2024 concludes and 2025 begins:
• Stock market volatility
• Continued broadening of returns
• US economic normalization
• Shift in monetary policy regime
• Balancing risks in fixed income
NAVIGATING VOLATILITY
US large-company equity markets had another strong quarter, with the S&P 500 index rising 5.9%, reaching an all-time high on 12 occasions in the third quarter, underscoring the intensity of the rally from the beginning of the year. Year-to-date, the stock market reached
an all-time high on 45 occasions. Putting this number into perspective, the stock market reached an all-time high almost 20% of the time during the quarter. These strong return numbers occurred despite increased levels of volatility. The stock market experienced a drawdown of 8.5% in July through August and another drawdown of 4.3% to begin September. During the drawdown in early August, the VIX index (a measurement of stock
market volatility) spiked to a level of 38.6, the highest level since October 2020.
Volatility Reacts to Economic Normalization
GLOBAL EQUITY MARKETS ROTATE
After outperforming its smaller company peers in the first half of the year, the S&P 500 index’s lead narrowed in the third quarter. The Russell mid-cap index advanced 9.2% and the Russell 2000 index rose 9.3%, both exceeding the S&P 500 index by more than 3%. A few reasons can explain this performance divergence. First, the relative valuation of small- and medium-sized companies has widened for most of the year. Investors are trying to reconcile whether the current valuation of large sized companies can be supported by future growth rates. This came to the forefront amidst the economy’s drift towards normalization with rising concern of further slowing. Second, the earnings expectation for small- and medium-sized companies is improving relative to larger companies. Looking out several quarters, earnings growth is expected to match or exceed larger companies. Third, an improving interest rate environment (lower short-term rates) supports profitability for smaller companies, due to their reliance on bank lending that typically resets faster to rate conditions.
Small-cap Earnings Catching Up to Large-caps
The equity rotation didn’t only occur from a company size perspective. There was a noticeable shift in the style within the larger company asset class, in particular value and growth. The S&P growth index advanced 3.7% in the third quarter, trailing the S&P 500 value index by 5.4%. For many of the same reasons that sparked the rotation into small- and medium-sized companies, value stocks benefited from the change in the macro-environment, too. Although larger companies, in most cases, don’t immediately benefit operationally from lower interest rates, value stocks have attributes that are favored when long-term interest rates drop. Equities with higher-than-market dividend yields, usually found in the value category, are naturally a substitute for bonds. For example, REITs and Utilities outperformed the market in the 3rd quarter given their dividend yields of 3.6% and 2.8%, respectively. The defensive components of the stock market are relatively inexpensive to the rest of the stock market.
Internationally, emerging markets exhibited stronger performance during the quarter, with the MSCI emerging markets index returning 8.8%, beating the MSCI International Developed index by 1.4%. One of the main catalysts for emerging markets was the largest country holding, China, committing to economic growth policy once again. While this is positive for the near-term, international stocks are influenced by the global growth trajectory, unlike the US equity market’s influence by secular growth attributes of technology/artificial intelligence. Sustained global growth is necessary for international stocks to lead global equity markets.
U.S. ECONOMY NORMALIZES
Rising volatility was perpetrated over concern of a sharp slowdown in the US economy. However, the slowdown has been nothing more than a return to normal after a positive outlier in growth from 2020-2024. The labor market is a perfect representation of this dynamic. The most-followed indicator of jobs, nonfarm payrolls, has exhibited a notable decline in the pace of jobs added. Beginning in March 2024, the three-month moving average of nonfarm payroll growth totaled 270,000. Although that has fallen to a three-month moving average of 117,000 jobs added in August. Putting these numbers into context, the year-over-year pace of jobs is currently at 1.5%, slightly below the average of 1.7%. More evidence of the labor market returning to normalized levels can be found analyzing the job openings and the quits rate. The supply of available jobs in the market topped out at a level of 12 million jobs in 2022, falling to just above 8 million job openings in 2024. This level remains above previous cycle peaks. The labor market’s confidence in finding a new job, viewed through the lens of the quits rate, remains at elevated levels, only falling slightly below the last cycle’s peak. Furthermore, the unemployment rate rising from 3.5% to a high of 4.3% in the 3rd quarter of 2024 has triggered angst. However, there is a reasonable explanation. The labor force is expanding faster than hiring. According to Goldman Sachs Research, 150 -180k jobs added per month is needed to stabilize the unemployment rate, which is more than double than the pre-pandemic level. Labor supply growth is expected to slow as the recovery in labor force participation is over and immigration is dropping.
Employment Growth Moderating
3-month average for payrolls falling since the end of Q1 2024
Inflation continues to show signs of normalizing, too. The year-over-year growth to the headline consumer price index (CPI), a proxy for inflation, continues to trend closer to the Federal Reserve’s preferred rate of 2%. Inflation totaled 2.5% in August, down from a high of 3.5% earlier this year. Shelter costs remain one of the largest contributors to inflation, followed by Restaurants, Hotels, and Transportation.
Despite the improving trend in inflation, consumer confidence remains depressed because wage growth has yet to overcome the extraordinary levels of price increases. However, wage growth remains above average, so real purchasing power with the catalyst of declining price growth should support the most important component of the economy, the consumer. Consumption growth should continue to improve on elevated wages adjusted for inflation.
Contributors to Headline CPI Inflation
FEDERAL RESERVE PIVOTS TO RATE CUTS
Given expected normalization of inflation, the Federal Reserve was compelled to get ahead of any softening of the labor market and support the economy with a 0.50% rate cut, somewhat unexpected by the market. Federal Reserve Chair Jay Powell noted the trend in employment as being notable to the Federal Open Market Committee. As a result, the market is pricing in three, 0.25% rate cuts through the end of 2024 and four to five more 0.25% rate cuts by the end of 2025. This aggressive path underscores the market expectation that rate cuts will be necessary to support the economy. As a result, longer maturity bond yields followed and dropped about 1.1 % in 5 months. The 10-year Treasury yield declined from a level of 4.7% in April 2024 to nearly 3.6% in September, reflecting the change in economic expectations. Looking forward, the path of least resistance is a trend higher in rates, unless there’s a deterioration in the economy that pushes investors to the safety of bonds. With inflation stabilizing, bonds should provide comfort to investors seeking relative safety from equities.
Fed Feds Rate Expectation: Market & FOMC
FINDING SHELTER FROM HIGH YIELD
While the economic outlook remains constructive, that shouldn’t preclude investors from identifying asset classes that are not compensating enough for risk. One asset class, high yield, fits this narrative. At the end of September, the Bloomberg US Corporate High Yield Option Adjusted Spread totaled 2.95%. Plainly speaking, investors are only receiving about 3% in extra yield relative to comparable maturity Treasury bonds. That might seem like a lot on the surface, considering that high yield bonds have at least double the risk of investment grade, the compensation for high yield bonds relative to higher grade bonds is near the lower end. Going back 20 years, the extra compensation of yield is below the average level of 4.9%. It’s prudent to reallocate risk, but not lose sight of high yield bonds being a considerable diversifier of return and risk over time.
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