Third Quarter Market Update: The Highly Anticipated Fed Pivot
THIRD QUARTER EQUITY MARKETS
U.S. Markets
U.S. equities had a strong third quarter across large, mid, and small-cap equities despite several stretches of market volatility along the way. Domestic large cap equities, as measured by the S&P 500, continued their movement upward as year-to-date gains ended the quarter up 22.1% for the year. For the trailing 12 months, the index is up a surprisingly strong 36.4%!
S&P 500 leadership rotated in the third quarter away from the “magnificent 7” and broadened across sectors, signifying relative strength across U.S. large-cap equities. The chart below illustrates the strength in equities across various sectors with double-digit year-to-date gains for all economic sectors except energy.
As of quarter end, the top 10 stocks of the S&P 500 represented 35.8% of the market cap weighting of the S&P 500 compared to 37.0% at the end of the second quarter.1
As a result of the Fed’s change in tone from hawkish to doveish, U.S. mid and small-cap stocks outperformed the S&P 500 for the first time in 18 months with both asset classes gaining over 9% in the quarter!
The beginning of Q3 saw some volatility across U.S equity markets due to softness in the U.S. jobs market. The prospect of recession rattled the markets initially, but the Fed signaling and eventually executing a September rate cut, sent the markets soaring towards all-time highs. Indeed, the S&P 500 has racked up 46 new “all-time highs” during the year.
EARNINGS GROWTH FOCUS
At the time of publication, third quarter earnings season has begun, and the early read shows financial firms posting solid results. A few firms (AMSL Holdings and Louis Vuitton - LVMH) have noted revenue softness due to slower Chinese demand. The next few weeks will provide us with a better glimpse of the earnings power of most of the publicly traded firms. Stay tuned.
Looking at a broader timeline, one of the highest areas of earnings growth stems from the capital spending of artificial intelligence (AI) players on chips and infrastructure. As the table below shows, current and expected growth in capex of the AI hyperscalers is quite large. This spending also has a trickle-down effect on other sectors like industrial and utility companies as AI firms need to build plants, infrastructure and source the energy needed for this new technology. The graphic below estimates the capital spending needs of the major AI players.
VALUATIONS ARE STRETCHED BUT NOT BACK TO HISTORICAL HIGHS
The valuation of the S&P 500 on forward earnings stands at 21.5 times (price to forward earnings ratio). This valuation is only slightly higher than the 21.0x multiple at the end of the second quarter, signaling that the S&P 500’s 6% return in the quarter was not just a function of multiple expansion, but also due to solid corporate earnings increases.
This valuation multiple is still expensive from a historical standpoint, and we note that over the last 30 years, according to J.P. Morgan, the S&P 500 multiple has an average P/E ratio of 16.7x. Despite the market reaching new fresh highs multiple times during the quarter, the valuations have not reached historic highs of over 25x during the 2000 dot.com era, as the table below illustrates.
It is still worth noting that from a historical standpoint, valuations are extended. A reversion to the mean could occur via price declines bringing the price part of the P/E ratio more inline or with increased earnings (the E part). Just because valuations are high does not mean they cannot stay that way for a period of time, while the earnings catch up to the valuation.
International Equities
The third quarter saw positive returns across international equities. With tailwinds of the U.S. Fed and ECB cutting interest rates, the MSCI EAFE saw an increase of 6.5% throughout the quarter. It was not without some volatility, however, as the Bank of Japan increased its short-term interest rates sending shockwaves throughout markets as the Japanese Central Bank acted to increase the strength of the Yen against the U.S dollar.
Our decision to underweight international equities has been a relative benefit to client portfolios over the past few years as U.S. equities have continued to outperform their European counterparts. We have been below our baseline historical weight since 2020.
THIRD QUARTER BOND MARKETS
The biggest change in the fixed income market during the quarter was the yield curve shift to an upwardly sloping (normal curve) from an inverted curve. For over two years, we have experienced an inverted yield curve where the shorter maturity bonds, like two-year treasuries, were yielding a higher interest rate than longer-dated bonds, like a 10-year treasury. Usually, inversion is a sign of an impending recession and something we have discussed before in these quarterly reviews. After 26 months of inversion, there is no recession and Sandy Cove Advisors does not see one in the near future.
With the Fed interest rate cut (in short-term Fed funds rate), the shorter end of the curve fell more than the longer end. For the quarter, the two-year treasury fell 112 basis points in the quarter to 3.64% while the 10-year treasury fell 62 basis points finishing the quarter at 3.74%.
Municipal Bond Market
Municipal bonds posted solid gains in the quarter, as news of the Fed’s easing cycle started in earnest in September with a 50 basis point rate cut. Yields fell (and prices rose) for municipals despite a strong supply of bonds coming to the market in the quarter. Demand remains strong for this asset class and fund flows through the year totaled $25 billion, according to Baird Advisors.
As with the Treasury curve, the municipal bond curve also un-inverted in September with the Fed rate cut.
THE FED EASED
At the Federal Reserve meeting in September, the U.S. central bank lowered the fed funds rate by 50 basis points, cutting interest rates for the first time since March of 2020. This highly anticipated move came as the U.S. inflation rate fell closer to the Fed’s goal of 2.0% and hot labor markets began to moderate. Many economists expected a 25 bp rate hike in September given the Fed’s slow moving, data dependent actions over the last year.
JOB GROWTH – STRONG BUT SLOWING
Some viewed the the Fed’s aggressive 50 basis point cut as an admission that monetary policy has been too tight and high borrowing costs were hurting U.S. companies and consumers. The Fed acknowledged that the labor markets may be softening, but not enough to tip the U.S. economy into a recession.
U.S GDP growth estimates remained in the 2% range, signaling that while job markets may be softening, it still remained strong enough to keep the U.S. economy growing. Cracks in the labor market began in July as the U.S. added less jobs than expected and the unemployment rate ticked up to 4.3%. This continued with the August jobs report as the U.S economy added 142,000 jobs for the month, but to exacerbate the situation, job growth for the prior two months was again revised downward spooking global markets.
Just when the U.S. job market became a market concern, the Fed lowered short-term interest rates by 50 basis points and the September jobs number came in as a “blow out”number as the U.S economy added 254,000 jobs versus 150,000 expected. The combination of lower rates, a doveish fed, and a strong U.S. consumer created a strong tail wind for the U.S economy heading into the 4th quarter.
INFLATION CONTINUED TO RECEED IN 3Q
The August personal consumption expenditure (PCE) report showed price growth of 2.5% year-over-year and only up 0.2% from the prior month. After an uptick in the first quarter of the year, inflation moved lower toward the Fed’s 2.0% target.
Another inflation measure, the September Consumer Price Index (CPI), was up 2.4% year-over-year and core CPI (ex. food/energy) came in at 3.3%. The annual CPI inflation rate was the lowest since February 2021 and the graph below shows the path from the heights of 9.0% inflation in June 2022 to 2.4% today.
ECONOMIC DATA:
- PPI – September producer prices were flat. Goods fell -0.2% and services were up 0.2%
- ISM Manufacturing – the manufacturing index in September was flat compared with the August reading. It remained at 47.2 for the second month in a row.
- ISM Service – this index stayed in expansion territory (over 50) with a reading of 54.9% in September. This was the highest reading since Feb 2023.
- Retail Sales – fell -0.32% in September from August but increased by 0.55% compared to last September.
- Consumer Confidence – fell to 98.7, down from 105.6 in August. The biggest one month decline since August 2021
- U.S. Leading Economic Indicators – the Conference Board LEI fell in August by -0.2% to a reading of 100.2.
- Housing Starts – jumped 9.6% from July to August to an annual rate of 1.35M homes.
- GDP –U.S. GDP grew 3.0% in Q2 2024. Q3 estimates for GDP growth stand at 1.8%
ELECTIONS AND FOURTH QUARTER
We are in the midst of corporate earnings season where we will get information on earnings and growth, two key components to keep the bull market rally going. In addition, we are three weeks away from the U.S. elections where we will get clarity on the make-up of Congress and who will take over the White House.
While the earning cycle seems to be going well thus far, we are concerned that the markets may get more volatile as the elections approach. And given the tight races in the House and more than a few toss-up states, it may be a number of days (and potential recounts) before we know the election results. This could affect the bull market.
Lastly, any uncertainty surrounding geopolitical tensions could send stocks from their all-time highs. While we are still constructive on both equity and bond markets, we recognize that equities have already delivered stellar performance year-to-date.
Footnotes:
1 FactSet, Standard & Poor’s, J.P. Morgan Guide to the Markets – U.S. Data are as of September 30, 2024. The top 10 S&P 500 companies are based on the 10 largest index constituents at the beginning of each month.