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Turbulent Ascent Continues | Steve Henderly, CFA
Despite a bumpy journey, investors experienced attractive growth during the 3Q with the S&P 500 rising by 5.9% to reach a new all-time high. Client portfolios benefited strongly with both stocks and bonds enjoying price appreciation. This coincided with the Federal Reserve implementing its first rate cut after a year-long pause.
While it did not feel like it at times, mid and small-cap companies outperformed large-cap growth stocks (which include the “Magnificent 7”) during the 3rd quarter. Since mid-July, the technology sector, which was leading the market by a wide margin in 2024, showed signs of softening relative to the broader market, a trend that seems appropriate considering their lofty valuations. Bonds also produced attractive returns, even as they are often viewed as more stable and/or “boring” as investors adjusted to the idea that inflation is back in an acceptable range, allowing the Fed to focus more on the employment portion of its dual mandate.
As is common during election years, August and September were bumpy. Our recent commentary “Air Pockets” highlighted the abrupt declines stocks experienced in the early days of both months before rebounding to conclude in positive territory. Considering the astounding storyline of the US Presidential contest in 2024, the resilience of the market might feel amazing. Recent market barometers, including the market being positive since the end of July, are tilting toward an incumbent party win in November. Conversely, history suggests if stocks are negative over the 3 months leading up to the election, the challenging party usually prevailed (pattern held in 20 of last 24 elections).
As investors look beyond the U.S. election, what’s in store for 2025? With borrowing costs declining and a bit more clarity on what policy may look like, companies may once again focus on deploying cash to invest in new technologies, which would enhance both productivity and profitability. Simultaneously, China unleashed a broad stimulus strategy, including rate cuts and liquidity injections for banks to purchase stocks, which lifted their equity market from a 52-week low to a 52-week high in the span of one week. This surge is impacting other asset classes, including commodities and European equities. Additionally, this action is positive for global growth. U.S. government spending is expected to increase, no matter which candidate wins – this is stimulative in the short-run.
Stock market performance ranked stronger than average for the first 9 months of 2024. History indicates that experience produces a strong 4th quarter. Yet, finishing the year must sometimes pass through a spooky October. The good news is that if the market decides to consolidate – maybe because of geopolitical events or other economic news – it’s doing so from a position of internal strength. Over 80% of stocks in the S&P500 are trading above their 200-day moving average. That’s a strong, supportive longer-term trend.
Whiplash!
NFL fans are aware of a significant rule change implemented on kickoffs: The “Dynamic Kickoff” stipulates that the kicking team will line up on the receiving team’s 40-yard line and must not move until the ball is touched by the receiving team or hits the ground in what is now referred to as the “landing zone” or end zone. The purpose of the new rule is to restore the importance of kickoffs (kicks were increasingly hammered through the end zone and not returned) while also reducing the risk of serious injuries including concussions and whiplash. When players sprint the field at full speed, their blocking and tackling can be extremely violent to a receiving team player. Intense collisions can (and do) still happen, but less frequently.
Investors experienced whiplash of their own in 2024, especially relating to expectations for interest rates. Entering the year, the market anticipated six quarter-point rate cuts (1.5% total). But unfavorable inflation data in early spring brought “April Showers” causing many to question if additional rate hikes may be needed to further ease pricing pressure being felt by consumers and businesses. Following a few soft unemployment figures and renewed progress on inflation, market participants again shifted expectations during the summer for the Fed to cut interest rates. They delivered with a “double-sized” cut of -0.50% in September. The market now expects a total of 6 or 7 additional rate cuts prior to the end of 2025, implying short rates will settle around 3.25% to 3.50%. Thinking about whiplash… if/as employment remains strong, the Fed may be constrained on the number and size of future rate cuts.
With the Fed now cutting, it is natural to wonder “what’s next?”. Every rate-cutting cycle is different, and the economy’s response to interest rate changes is long and variable. Milton Friedman, speaking before Congress in 1959, likened changes in Fed policy to “a water tap that you turn on now and that then only starts to run six, nine, 12… months from now.”
The most natural implication to rate cuts is the effect on borrowing costs – cheaper and more attractive. Historically, sectors like real estate, automobiles, utilities, and capital-intensive industrials tend to do relatively better under lower rates. Yet history is mixed about how the overall stock market fares when the Fed begins cutting rates (see related chart on the bottom of pg 4). In the last 40 years, there are a number of examples where stocks declined following the first rate cut; those tended to align with an economy that was already deteriorating; the Fed’s decision to cut was reactionary with expectation of stimulating economic growth. A troubled economic backdrop is not obvious today. Unemployment is variable, drifting higher over the past 12-18 months, but showing recent resilience. It would be a stretch to suggest economic weakness is widespread. This cycle is a bit unique in that there isn’t a clear historical template for the current situation with the Fed cutting before monetary policy creates economic pain. The recent rate cut is the first since the mid-90s that occurred outside of a recession or financial panic.
As we consider the implications of this new rate-cutting cycle, we highlight the following:
- Individuals and businesses previously enjoyed 5% returns risk-free, but will now receive less. For wealthy consumers with low debt levels and low mortgage rates, the high 5% interest rates on “cash” provided a spending stimulus to the economy.
- Sectors like real estate are expected to benefit from lower rates, but mortgages seem unlikely to return to the ultra-low levels of 2020-21 anytime soon. 10-year Treasuries – the security on which mortgage rates are linked/priced – already declined since the spring anticipating the Fed’s cuts. Industrial companies requiring regular borrowing should benefit from lower interest expense. Recall, for much of the past two years, the yield curve was “inverted” and unkind to banking and finance businesses. Recent Fed cuts are shifting the yield curve; it is steepening and becoming more normal. This will improve the profitability of financial companies and encourage them to lend long.
- Lower rates make assets like bonds and stocks a more attractive asset class for returns moving forward; money market funds become relatively less appealing and some of the historic balance that accumulated in the last 24 months may begin to flow back into stocks and bonds. We suspect rates probably need to decline closer to 3% before savers feel more urgency to exit the stability of money market funds.
- Smaller-size companies, many with higher levels of debt, are at their cheapest valuation relative to large company stocks since the late-90s. Lower interest rates may benefit small-size companies more. Large companies, which amassed huge hoards of cash, will be earning less on their idle balances and be pressured by shareholders to begin deploying that money back into their businesses or return it to shareholders in the form of dividends.
In the short run (next 12-18 months), rate cuts appear to be supportive of the economy and investments in stocks, bonds, and real estate. It is difficult to get too cautious when economic readings appear stable, inflation appears better, and markets do not seem immediately concerned about current levels of debt. On average, bull markets last about 5 years and enjoy gains of around 178%. In contrast, the current bull market is just 24 months with a gain of 66%. It’s worth noting that the third year often shows softer performance compared to the first two years (table pg. 4).
Possible challenges next year could be brought on by a resurgence of inflation brought on by extended labor strikes, or geopolitical unrest which quicken de-globalization. These could be ingredients for “whiplash” and trigger a 2nd wave of higher inflation. Investors understand that the path to continued advancing returns and portfolio values is seldom smooth. But they are the bumps on which we climb.
Harvesting During a Drought | Jordan Ranly, MBA
As we turn the page from the summer of 2024 and enjoy more moderate temperatures, we reflect on a summer in which Ohio suffered one of the worst droughts in history. Local farmers were impacted and yields from carefully planted crops suffered. Hurricane Helene, while bringing unprecedented damage and destruction to the US Southeast, brought much needed rain and welcome reprieve from the drought in Ohio. Our thoughts and prayers continue for everyone impacted by this historic storm!
Steve appropriately described how investors may feel “whiplash” around the interest rate environment in 2024. After raising rates at a historically fast pace (reference chart), the Fed paused in August 2023 for over 12 months. The Fed pause ended last month with a double-sized rate cut of 0.50%. How quickly and how far will rates fall? How should savers manage cash in this environment?
While cash might “feel” safe and stable, the reality is that holding too much will lead to diminishing long-term returns. Over the past four cycles, bonds outperformed cash by 6% on average in the 12 months following the Fed’s last rate hike. In each case, the yield on the 10-year Treasury peaked before the Fed started cutting rates. Periods between the peak in yields and the first-rate cut were great for bonds, which averaged a 9.4% return. And yet, an often shared comment we hear: “I’ll wait for the Fed to start cutting rates before moving out of cash.” Remember, as interest rates fall, bond prices rise, allowing investors to benefit from both coupon payments as well as price appreciation. Moving money out of cash and into traditional bonds can be compared to harvesting a crop during a drought. Both scenarios require strategic decision-making, foresight, and a commitment to long-term growth despite immediate challenges.
While yields on cash are still attractive following last month’s – 0.50% Fed cut, waiting for Fed cuts to drive cash yields below traditional bonds leaves money on the table; we miss return opportunity. With the Fed now cutting rates, it is natural to wonder if it is too late to pivot from cash. But you should be aware that bonds delivered nearly double the annual return of cash over the last 40 years! Further, bonds and stocks are an investor’s only chance at beating their enemies of inflation and taxes over the long-term. Both can enjoy price appreciation in addition to their yield; something which cash cannot do.
Reallocating cash into a diversified investment portfolio will provide investors with better return opportunities over the long-term due to economic expansion. It is important to understand that short-term steps can lead to future prosperity. Risks in the short-term are inherent, but the potential for growth much like a well-timed harvest, can lead to bountiful rewards. If you’re sitting on levels of cash which exceed your anticipated needs over the next 12-18 months, history strongly supports the notion that it should be deployed into more productive assets: bonds (2-5 year bucket) and stocks (5+ year bucket). Just as farmers adapt to environmental challenges, savvy investors must navigate the complexities of financial markets to cultivate their wealth over time, ensuring resilience and prosperity in the face of uncertainty.