2024 Quarter 3 Commentary

“We’re not saying ‘Mission Accomplished’ or anything like that. I have to say, though, we’re encouraged by the progress we have made.”

-Federal Reserve Chairman Jerome Powell on announcing a half percentage rate cut

The Federal Reserve has begun the long-anticipated rate cutting cycle, with a half percent reduction in the Federal Funds Rate on September 18th. There seem to be two schools of thought as to the magnitude of the Fed’s rate cut. One possible reason for the Fed’s 50 basis point cut to the Fed Funds Rate is that it is concerned about a potentially slowing economy. Some investors are conjecturing that, because the Fed cut by 50 bps rather than 25 bps, that means that the Fed is indeed worried about this scenario and is trying to avoid the hard landing (recession.) However, another reason might be that the Fed’s more aggressive rate cut is a signal that it believes it has tamed inflation and therefore can move quickly to reduce the restrictive rate environment. In other words, the Fed believes it can stick the soft landing. The quote above gives some insight into the Fed’s mentality, and it would appear to lend some credence to the latter line of thinking.

The conventional narrative about the state of the economy has been that it is weakening. Certainly, expectations for future economic growth are not as strong as they had been in the past. The accompanying chart shows actual quarterly growth in Gross Domestic Product for the U.S. in purple and economists’ future growth estimates in gray. Clearly, expectations are for continued growth, but at more moderate rates than seen previously. This is a normal expectation given that, for over a year, the Fed had maintained the Fed Funds Rate at 5.5%. Keeping the rate that high was meant to dampen inflation, with the understanding that there would be an accompanying dampening of the economy as a whole.

Adding to the expectation of a weaking economy is a slowing labor market. Back in April 2023, the U.S. unemployment rate was 3.4%, which was a multi-decade low. Today, the latest unemployment rate is 4.2% for the month of August. This is still very low among historical standards, but the upward movement has caused concern among investors. The fear is that, if left unchecked, the unemployment rate can begin to move upward at an increasing rate. This in turn can lead to a deteriorating spiral in which workers begin to lose their jobs, which leads to cutbacks in consumer spending, which leads to companies cutting costs, and so forth, until the economy is in recession. That concern or worry has led to higher market volatility since the beginning of July. However, the data is not entirely clear as to whether we are seeing a slowdown which could potentially lead to this spiral or if we are simply seeing a “soft patch” in economic information.

Consider the latest unemployment information. The rate of unemployed is increasing, but it is not entirely due to layoffs. Rather, it appears that employers are hiring less aggressively, which means that anyone who does find him or herself out of a job is having a harder time finding new employment. Weekly jobless claims are relatively muted (at a four month low on September 26th) while the number of people willing to work – the labor pool- has grown. This does not appear to describe a recessionary signal in the labor market. In addition, other data seems to be showing signs of improvement. For example, the Chicago Fed’s National Activity Index (CFNAI) improved from -0.42 in July to 0.12 in August. The CFNAI measures 85 monthly indicators of growth in national economic activity. Positive values are associated with above-average growth.

In addition to the CFNAI, the Atlanta Fed’s GDPNow, which is an estimate of the current quarter’s GDP growth, seems to be showing improvement above consensus estimates. While the expectations for third quarter GDP growth are close to 2%, the GDPNow estimate implies some upside beyond what most economists expect for this quarter’s economic performance. At this point, it is difficult to determine which is true: is the economy continuing to soften, or is it emerging from a “soft patch”?

On the global front, the Organization for Economic Co-operation and Development (OECD) released its forward estimates for the global economy on September 25th. Based on moderating inflation and easing monetary policy in most central banks, the OECD is estimating that global economic growth will improve from 2023’s mark of 3.1% to 3.2% for 2024 and 2025. While they note that the U.S. is slowing down somewhat from its higher than expected growth in 2023, growth is still projected for the next couple of years.

Along with declining inflation, economists at the OECD also cite “robust trade growth.” Risks still persist, such as the Ukraine war and conflicts in the Middle East. From a U.S. investor’s vantage point, international stocks have underperformed the U.S. stock market for a number of years, which has led to stocks outside the U.S. to be priced more cheaply than their U.S. counterparts on a price to forward earnings basis. Improved economic growth, combined with a stock market that is numerically cheaper than the U.S., could begin to attract more investor interest.

While uncertainty over forward economic progress has led to higher market volatility since the beginning of July, the approaching election also has added to uncertainty. The graphic to the right illustrates this point rather clearly. It shows how the Volatility Index (VIX) increases from six months prior to the election, peaking within days before election day over past presidential elections from 1992 through 2016. (Note: the 2020 election was excluded due to Covid.) After the election has happened, volatility slowly begins to fade over time. Intuitively, this makes sense. The uncertainty over future possible changes to regulations and other policies could lead to higher volatility. After the election, simply knowing which party has won the White House means that the uncertainty of the election result has faded, and along with that knowledge comes lower levels of market volatility. And while past performance is no guarantee of future results, it does not appear to be out of the question to assume that volatility could still increase as we approach November 5th.

While increasing volatility may lead to downturns in the market, that hasn’t stopped equities from capturing significant gains since MBI’s previous quarterly market update, pushing returns higher since the beginning of the year. The most significant risk- adjusted gains have come from value stocks, which have benefited from increasing volatility as well as sliding interest rates. Because value stocks tend to pay higher dividends and are typically more mature companies, anticipated future cash flows can stabilize portfolio movements. In addition, they aren’t quite as rattled by interest rate changes in the way that short term bonds may be, given that they fluctuate closely with the Federal Reserve’s target rate. For the readers’ reference, sectors like financial services, materials, and consumer staples all tend to align closely with the value categorization.

This performance has led the S&P to recent highs, with small and mid cap equities not far behind. Most surprisingly, the ‘magnificent seven,’ as seven of the largest domestic stocks have come to be known as, have underperformed in the recent quarter, while other large cap stocks have made significant progress. This is encouraging given the megacap stocks’ large run ups in recent years; more breadth to performance across the board may indicate a more healthy bull market than one driven by AI-mania (or dot com mania, or housing mania, for that matter).

These gains are despite significant events that we could consider contributors to market instability in the past several weeks and months. As previously mentioned, presidential elections can increase volatility in the months leading up to it, even if it does subside after the fact. However, we don’t discount rising tensions in the Middle East, with tensions between Iran and Israel growing, as another contributor, as well as the recent threat of a strike from the Longshoreman Union. In particular, the latter could have a significant impact on imports, driving up prices in an environment still feeling the sting of recent inflationary punches.

Alternatively, the fixed income market thrives on volatility and interest rate decreases, and we have seen yields already begin to dip below their highs as prices continue to climb. Short maturity fixed income prices tend to correlate tightly with Federal Reserve policy, and as such yields have dropped accordingly. Meanwhile, long term rates have also dropped, but remain more volatile on a day-to-day basis. These prices can be driven by factors beyond the Federal Reserve policy that make short term movements unpredictable. For example, interest rate expectations in two years had played into rising yields over the past few weeks when investors priced in the possibility that decreasing rates could lead to higher inflation. That isn’t to say that the downward pressure is not pushing down these rates as well, but not to the extent to which we see it with short term securities.

Internationally, Chinese stocks have finally begun to turn around after a three-year slide on the back of a stimulus package and more lax homebuying requirements from Beijing and the CCP. The CSI 300 index, which tracks Chinese companies, rose 9.1% on September 30th, taking Chinese stocks to YTD highs, and the market has only grown since then as hedge funds and institutional investors continue to pour into the market. Investors that had previously held concerns about the country’s governance and business environment were encouraged by policy meant to seemingly encourage stock prices and diminish fears of authoritarian overreach.

Meanwhile, Japanese equities continued to perform poorly after a scare over monetary policy in July to August when the Bank of Japan hiked rates in a surprising move in July and scaled back some of its bond purchasing. The turbulence, made worse by some speculators caught in the middle of carry trades, compounded, not only affecting Japanese securities but global stocks as well. While many countries’ markets have since recovered, the Nikkei 225 and Tokyo stock exchange have continued to lag and underscoring the significance of clear, consistent communication when issuing monetary policy.

While big (and contrasting) moves in both markets have elicited a wide range of Bloomberg and Wall Street journal coverage, surprisingly these two Asian countries amount to a smaller percentage of the total stock market than at first glance. In particular, both countries combined account for approximately only 8% of the global market make up of stocks when using a total stock index as proxy for a global index. While significant, other countries like India, France, and Germany also account for large amounts of total portfolio population by country with less coverage overall.

France and Germany, as well as other EU countries, may also be headed toward additional stimulus if the European Central Bank decides to cut rates in line with recent Federal Reserve actions. The expectations stem from a combination of factors, including the first sub-2% inflation readings in more than three years as well as business sentiment deterioration. Despite these headwinds, the European stock market has continued to post gains year to date, increasing 9.06% as of this writing, despite lagging significantly behind American stocks.

As we move towards the end of 2024, we at MBI will maintain a watchful eye on any economic developments and corporate earnings which could shape the direction of the equity markets. Going forward, we believe that diversification across different equity classes is important, particularly given the potential for increased breadth in equity markets as described above in this letter. Given the downward trajectory of interest rates, we will look to extend fixed income portfolio duration/maturities to take advantage of lower rates. In addition, given the potential for higher levels of market volatility, we will remain watchful for any opportunities to harvest capital losses if they become available.

Thank you and stay safe and healthy!