Summary
In our last commentary, we predicted that the news cycle would be inundated with election updates and analysis. Although, we did not expect events of this magnitude. In the last calendar quarter, President Joseph Biden withdrew from the 2024 race, Vice President Kamala Harris became the Democratic Party nominee, two assassination attempts were made on the Republican Party nominee and both parties, the media and the general public had to recalibrate to a new and very different campaign.
In the meantime, the economy continued to grow, but has reached an inflection point. Inflation has not yet reached the Federal Reserve’s target, though it appears to have softened to tolerable levels, whereas job creation in the labor market has slowed to the point where additional softening will likely result in job losses. As a result, the labor market has overtaken inflation as the prevailing concern at the Federal Reserve, prompting a recalibration of their priorities. In line with this shift, the Fed began its long-awaited rate-cutting cycle at its September meeting.
In the background of all this news, equity markets oscillated but ended the quarter on a high note with positive returns broadening to value and smaller company stocks. Bonds also rallied as yields fell amidst rising rate-cut expectations.
The Economy
The U.S. economy continued to slow in the quarter but has kept out of recession territory on the strength of a resilient consumer and a modest turn in the manufacturing sector. Concerns about an official recession remain as economic indicators continue to be mixed. Second quarter Real Gross Domestic Product (GDP) increased at an annual rate of 3%, driven by consumer spending, private inventory investment and business investment. The Philadelphia Fed’s factory index was up for the quarter. The labor market loosened slightly as new available jobs continued to shrink, including a significant 818,000 downward revision from March. Wage growth slowed and the unemployment rate crept above 4%. Some of this loosening can be attributed to a larger workforce, as the participation rate for prime-age workers rose (83.9%) and legal immigration continued to rebound. A drop in initial jobless claims shows that the economy is healthy enough to absorb most of these new workers. As consumers remain employed, they continue to spend. However, consumer debt balances continue to reach new highs, and the delinquency rate has risen to its highest level since 2012, raising concerns about consumers’ ongoing strength and increased reliance on additional growth from private investment and capital expenditures by businesses.
Price growth has slowed and is approaching the Fed’s target level. The Personal Consumption Expenditures index has remained below 3% for the last ten months and eased to 2.2% in the latest print.
As the risk of inflation has fallen and the risk to the labor market has increased, the Fed initiated a new rate-cutting cycle with a 50-basis point cut at its September meeting. While the size of the rate cut surprised many on Wall Street, it could be viewed as an effort to address concerns about time lags between policy decisions and their actual economic impact. With the Fed forecasting a potential policy change, the 10-year U.S. Treasury yield dropped below 4% during the quarter, and the 2- to 10-year U.S. Treasury spread moved slightly positive for the first time since July 2022.
Globally, central banks across Europe, including the European Central Bank, the Bank of England and the Swiss National Bank all cut rates slightly as their countries continue to struggle with growth. China’s central bank announced a blitz of measures, including rate cuts and lower reserve requirements, in an attempt to jump-start their economy. Conversely, the Bank of Japan increased rates again and saw an over 10% rally in the Japanese Yen.
Markets
Equities were broadly positive in the quarter, with returns spreading beyond U.S. large caps. While U.S. large caps were still strongly positive for the quarter, they were surpassed by smaller stocks and non-U.S. stocks. Within large caps, the Russell 1000 Growth index (3.2%) underperformed the Value index (9.4%) for the quarter, consistent with the trend of spreading performance to other market segments. International equities outperformed U.S. stocks with both developed and emerging markets returning more than 7%.
Earnings continue to be a tailwind for the market as third-quarter earnings growth is expected to be 4.6%. This would mark the fifth straight quarter of year-over-year earnings growth if achieved. However, expectations have been dialed back as numerous companies issued downward revisions to their estimates. The forward 12-month P/E ratio is 21.6, above the 5-year (19.5x) and 10-year (18.0x) averages.
Broad fixed-income indices rallied in the quarter with the Bloomberg U.S. Government/Credit Index returning more than 5%.
Looking Forward
The Fed rate-cutting cycle should help promote construction, especially for housing, which could relieve some of the largest components of inflation: rent and the cost of homeownership. Additional cuts would also provide relief to consumer debt service as interest on revolving debt remains at levels not seen in decades. However, dovish monetary policy and fiscal policy that includes tax cuts and spending increases may jeopardize these rate cuts by spurring demand and reversing the current disinflationary trend. If the U.S. elections in November result in a continued split government, fiscal policy changes may be limited and the 2017 tax cuts might expire as scheduled at the end of 2025. However, despite a gross federal debt that exceeded $35 trillion during the quarter, neither party has put forward much-needed debt and deficit reduction plans.
To date, U.S. consumers at the aggregate level have remained resilient based on labor market strength, the wealth effect and the expectation of lower interest rates. However, as household debt service has grown back to pre-pandemic levels, consumers may suffer from some level of austerity if the jobs market deteriorates further, or inflation experiences an unexpected dramatic increase.
Despite this uncertainty, the potential for further equity gains is possible. Clear results to the November elections, an ongoing slow restructuring of the labor market, a stable flow of Fed rate cuts in November and December, and continued progress in inflation data would be positive for risk markets. Furthermore, positive GDP growth is expected from continued consumer spending, easing financial conditions and a rebound in inventory investment. Forward guidance for earnings growth is projected to be 10% overall for 2024 and 15% growth for 2025.
In fixed income, we expect the yield curve to regain its normal structure slowly, ultimately removing the inversion that has been in place since July 2022. So, while longer-term yields may prove more attractive, fixed-income portfolio returns may still be dominated by yield rather than price movement for the rest of the year. Some portfolios may also see an increase in bonds called for the next few months.
As the last two years have been favorable to equity investors, realized capital gains could be more pronounced. We expect capital gains distributions from both equity and fixed-income mutual funds this. Tax optimization is part of our management of taxable portfolios, but additional financial planning could be considered.