Altair Insight: New Territory (3Q24) – Quarterly Market Review
“And you may ask yourself: Well, how did I get here?” – Talking Heads (“Once in a Lifetime”)
Two momentous transitions, one newly under way and the other imminent, provide much for investors to ponder as 2024 winds down.
The two-year-old U.S. bull market has charged past all obstacles, including high interest rates and inflation. The lowering of rates by the Federal Reserve removes further barriers, although geopolitical instability is among the risks to the market and economy.
The Jerome Powell-led Federal Reserve recently kicked off a much-awaited era of easier money and lower interest rates. The central bank’s substantial, half-percentage-point cut in interest rates in September marked the first time it had trimmed borrowing costs since 2020, in the early days of the pandemic. While the pace, impact and full extent of cuts have yet to be determined, we anticipate positive ramifications for the economy into 2025 and beyond.
The other new era will begin to take shape on Election Day. Razor-thin polling margins separating not only Donald Trump and Kamala Harris in the presidential race but Republicans and Democrats in the House and Senate have complicated attempts to forecast which party will have the upper hand in Washington and in what alignment. We take a big-picture look below at some of the key issues at stake and the range of potential consequences, and will have much more to say in the weeks ahead.
Perhaps improbably, the one constant thread running through this year of uncertainty has been the bull market. We say improbably because most soothsayers did not foresee that the stock market would not only hold steady but have its best first nine months in an election year in the face of this year’s challenges. To recap: High inflation took longer than expected to subdue, causing recession fears to escalate. The Fed’s first rate cut came months later than the market thought it would. The tech stocks behind the market’s artificial intelligence rally in the first half cooled in the summer and fall. One of the two major presidential candidates withdrew from the race abruptly and the other was nearly assassinated.
Yet that is how we got here. The bull market passed the two-year mark in October, with a year-to-date 23% return for the S&P 500, with other asset classes showing similar resilience. The first three quarters were the strongest for the index since 1997, putting it on pace for a second consecutive year of 20%-plus gains for the first time in 26 years.
Despite all the challenges and unnerving news events, the continued healthy economic conditions made all the difference, as both the U.S. and global economies remained resilient.
We advise our clients to remain at target portfolio allocations in all three risk categories – higher, medium and lower. Within the higher-risk bucket, we are shifting our allocation from international real estate to exclusively U.S. REITs, thus increasing our exposure to what has been by far the top-performing asset class in the second half of 2024.
Please read on for a more detailed discussion of these issues:
1. The Federal Reserve’s gamble in delaying interest-rate cuts is on course to pay off.
The Fed’s decision to sit tight for 14 months before lowering interest rates from a two-decade high was a dangerous one. Powell channeled his inner Paul Volcker – the Fed chair who squeezed the U.S. economy into recession from 1980-82 by using steep rate hikes to crush double-digit inflation – and held firm while hoping the economy and markets would withstand this latest dose of monetary medicine.
So far, so good. Five weeks after the Fed finally initiated a rate-cut cycle with a half-percentage-point reduction, the economy is holding up well and we see no recession on the near-term horizon. The stock market, as mentioned, is having a banner year and global markets are largely following suit. (More on the economy and markets in subsequent sections.)
The Fed’s timing appears to be propitious for the stock market. In the last 50 years, S&P 500 returns have been well above average in rate-cut cycles that were begun in a healthy economic environment. Returns over the two years following the Fed’s first rate cut were 42.8% in 1984, 65.5% in 1995, and 46.5% in 2019. (A brief recession in 2020 did follow the 2019 cut but we attribute this to the pandemic.) The other six rate-cut cycles of the period occurred during weaker economies, in or soon before recessions, with two-year returns that were significantly lower and sometimes negative.
We view today’s conditions as particularly analogous to the mid-1990s, when the Fed normalized rates in a strong economy. Even after Chair Alan Greenspan cautioned of “irrational exuberance” in the stock market at the end of 1996, it went on a long upward run until 2000. In other words, even if this robust rally somehow reflects irrational exuberance, it could take a long time to play out. The economy’s durability has bought the Fed time. “This committee is not in a rush to cut rates quickly,” Powell said recently, referring to the decision-making Federal Open Market Committee. The FOMC’s own projections nonetheless make clear that a series of further cuts is expected that will lower short-term lending rates substantially and ease economic pressures that have been building. Taking their cues from public comments by Fed officials, market traders expect the central bank to lower the federal funds rate from the current 4.75% to 3.5% by next June and 3.25% by September. The FOMC’s own “dot plot” projections show they expect to reduce it to 3.25%-3.5% in 2025. Those cuts should further fuel the economy and markets.
Declaring victory in the Fed’s inflation crackdown might be premature, given price data fluctuations and the looming threat of an oil price shock or supply-chain issues resulting from war in the Middle East. We continue to believe that the remaining path back to a stable 2.0% target rate will be bumpy, potentially causing the Fed to temporarily pause its rate cuts. However, that should not derail the overall trajectory. 2% has already more or less been reached by some measures. The latest annualized readings showed 2.4% for the Consumer Price Index, 2.2% for the PCE price index and 1.8% for the producer price index. Based on history, we think inflation is unlikely to worsen because of the cuts. In the Fed’s past nine rate-cutting cycles, inflation was mostly flat or down over the six, 12, and 24 months after the first cut.
Perhaps a “Mission Accomplished” banner can be printed up soon.
2. Economic growth has not faltered in the U.S. despite high rates.
Steady U.S. progress toward a soft landing – fast-approaching if not already achieved – continues to drive the world economy forward. Areas of sluggishness persist in the post-pandemic environment. Economists generally are more optimistic than when the year began, however, as are we. One notable example: The 38-nation Organization for Economic Cooperation and Development (OECD) recently raised its forecast for global growth to 3.2% in both 2024 and 2025, upgraded from 2.7% and 3.0%, respectively, entering this year. That would represent only a slight uptick from 2023 expansion of 3.1% but belie widespread expectations of a slowdown. “There is a disconnect between how the economy is perceived and how the economy is doing,” OECD chief economist Alvaro Pereira said of the upgrade.
In the whack-a-mole world of the economy, different weak spots continue to take turns popping up and demanding attention. Now that the Fed and other central banks have helped knock inflation down to size, our growth-related concerns include U.S. manufacturing, a still-stagnant housing market, small-business uncertainty at an all-time high, and problems with the largest economies in both Asia – China’s recovery from the pandemic is fragile – and Europe – Germany’s economy is contracting for a second straight year. Falling interest rates should help allay some of those concerns.
Overall, the positives outweigh the negatives. The strength of the U.S. service economy has more than offset manufacturing weakness, powering GDP expansion projected by the Atlanta Federal Reserve Bank at a robust 3.4% annual rate in the third quarter. Corporate earnings are strong, estimated to have grown for a fifth consecutive quarter in the July-through-September period by more than 4%. Lower rates and recovering real wages should provide tailwinds into 2025. So should heavy government spending for the near term, even as it adds to a mounting national debt. Spending is likely to increase under either presidential candidate, as mentioned in our next section.
The labor market has not wobbled as most expected. Unemployment has risen off its 3.4% low and job openings have diminished. But a 4.1% jobless rate remains low by historical standards and firms are still hiring at a brisk clip, as evidenced by the 254,000 jobs added in September. Layoffs, too, have not surged as feared when interest rates escalated. The level of new claims for jobless insurance, a reflection of layoffs, has remained relatively low, as have continuing claims. So-called prime-age (25 to 54) employment continues to rise to all-time highs, yet another sign that the labor market is healthy. And wage growth exceeds the inflation rate.
While not rising to the level of a mole that needs whacking, we continue to watch consumer spending closely since it accounts for more than two-thirds of GDP. Spending has continued to rise this year despite the accumulated pressures of high rates and inflation, though it has tapered off. Household debt reached a record high recently as balances on credit cards, auto loans, and other credit continue to climb. Nevertheless, spending on services remains robust and the worries about a big slump in consumer spending seem overblown.
3. The post-election outlook remains hazy due to tight contests.
While elections historically do not have lasting long-term consequences for financial markets, the markets nevertheless have been jittery as this year’s consequential vote goes down to the wire. The VIX Index, or “fear gauge,” jumped higher after a calm summer; dollar volatility hit an 18-month high in October; consumer confidence dipped, and the stock market oscillated in the final weeks as traders sought to be seated in a favorable position when the election music stops.
Veteran policy research analyst Dan Clifton of Strategas Research Partners calls this the closest presidential race he has ever seen, with much riding on it for investors. “As an investor, I have never seen so many assets in play at once to be affected by the election,” says Clifton, who will be the keynote speaker at Altair’s Investment Summit in Chicago on November 12th.
The winning candidate could have an outsized impact on federal tax policy as well as other areas where the two are diametrically opposed in their views. Their ability to enact reforms, however, hinges on the makeup of Congress. The good news for investors is that the stock market generally has delivered solid returns regardless of the configuration of power that emerges in Washington: Republican or Democrat in the White House, single-party control of both the House and Senate, or a divided Congress. Over the two years following elections since World War II, the S&P 500 has averaged double-digit annualized returns in five of the six possible configurations and high single digits in the other.
Here is a condensed summary of where the candidates stand on five important issues affecting the economy and markets:
- Trade: Former President Trump wants a dramatic expansion of tariffs on almost all imported goods, including all imports from China. Vice President Harris opposes across-the-board tariffs but supports some unspecified ones. The Biden-Harris administration specifically targeted China in May by increasing tariffs on electric vehicles and steel and aluminum, among other products.
- Foreign Policy: Trump says he will end the war in Ukraine and has said he is reluctant to send further military aid to that country. Harris favors an active global role for the United States, including in NATO, and wants to continue strong military support for Ukraine – positions bullish for defense stocks. Both support further aid to Israel.
- Taxes: Both candidates are talking about tax increases to pay for tax cuts. Trump advocates an extension of his administration’s Tax Cuts and Jobs Act of 2017, which is due to expire at the end of 2025, and wants to lower the corporate tax rate to 15% from 21%. He would remove tax benefits for electric vehicles and other renewable energy industries. Harris proposes cuts for middle-class families and more tax breaks for small businesses while raising the corporate rate to 28%, the top marginal income rate for individuals to 39.6% from 37%, and the capital gains rate to 28% from 20% for individuals who make more than $1 million a year.
- Budget: Both candidates are more focused on increased spending than on the federal budget deficit, which is on track to exceed $1.9 trillion, or the $35 trillion federal debt. Harris has outlined or endorsed enough fiscal measures – tax increases or spending cuts – to plausibly pay for much of her agenda while Trump has not, according to The Wall Street Journal. There is no tone of austerity from either campaign in this election cycle.
- Immigration: Harris has endorsed comprehensive immigration reform, seeking pathways to citizenship for immigrants in the U.S. without legal status while also endorsing President Biden’s decision to restore restrictions on asylum seekers. Trump wants to carry out the largest domestic deportation in U.S. history, rounding up millions of undocumented immigrants and detaining them in camps before deporting them.
Big policy changes in any of those areas would have the potential to move markets and make investment changes advisable. We believe we are some distance from that point, however. It may take weeks or longer to sort out the winning configuration of power in Washington and what legislation or executive actions come out of it. Much of what elections produce is political noise. What ultimately drives the market, aside from exogenous shocks, are the economy, Fed policy, corporate earnings and consumer spending, all tied closely to the job market. Those are what we care about most.
4. Lower rates can help keep markets buoyant even after this year’s significant gains.
The bull market galloped past the two-year mark on October 12th, raising the legitimate question: How much longer can it last? Even after a nearly 35% runup in 12 months entering the current quarter, we believe this one is capable of running quite a bit further.
Historical statistics do not dictate long-term market performance; economic and financial conditions do. But it is worth noting that if this bull market were to end now after 24 months, it would be one of the shortest on record (the pandemic one in 2020-22 was shorter). The average S&P 500 bull market – defined as a rise in stock prices of 20% or more – has lasted about 57 months and returned 167%, based on our review of data from 15 bull markets since 1928. This one has returned 67% so far.
What gives us confidence besides the power of coming rate cuts is the more recent broad-based nature of this rally, underpinned by solid economic fundamentals in the U.S. and across much of the globe.
U.S. stocks have remained resilient despite the lackluster third-quarter showings of technology (0%) and energy (-2.9%) shares. The broadening to other sectors including utilities (19.4%), real estate (17.2%), industrials (11.6%) and financials (10.7%) underscores the market’s strength.
Small-cap stocks (up 9.2% in the quarter) and especially U.S. REITs (17.2%) are notable recent arrivals to the rally as investors in both were encouraged by the long-awaited move to lower rates. We recently moved our recommended allocation in international REITs, which also had a strong quarter with a 16.3% return, to U.S. REITs, where falling borrowing costs have begun enticing potential buyers back to commercial property investments outside the office sector. The yield that real estate owners receive from operating properties is becoming more attractive relative to that of fixed-income investments as rates fall.
5. Geopolitical instability is a rising risk for the economy and markets.
Rarely if ever has there been a shortage of world hotspots or geopolitical risks for investors to worry about. Certainly not this year, given the intensifying conflict in the Middle East and particularly the dangerous escalation between Israel and Iran. That heads a list of concerns that also includes no end in sight in the Russia-Ukraine war, ongoing attacks by Yemen’s Houthi Rebels in the Red Sea, and China’s tense relations with the United States and others as it takes a more aggressive stance in potential flashpoint areas.
Most of the time throughout modern history the markets, like the economy, have kept climbing higher regardless of wars or other struggles between nations (although past results do not imply future performance). That being said, geopolitical crises threaten near-term economic and investment performance if they disrupt the global supply chain, cause price spikes or shortages of oil and other commodities that could exacerbate inflation. Houthi rebel attacks in the Red Sea have recently resulted in ship detours that have raised global shipping costs, a trend that has exacerbated inflation in the past and could return if the Middle East conflict deteriorates further. We are keeping a close eye on the global situation and commodity markets along with our recommended fund managers and will make portfolio and allocation changes as warranted.
JPMorgan Chase CEO Jamie Dimon caught our eye recently with his warning that the worsening geopolitical situation is the world’s biggest risk. We do not always agree with Dimon; for example, he predicted for much of this year that a U.S. recession was likely before he reversed his opinion to fall in line with our continuing belief that the economy is on track for a soft landing. But a public caution by the world’s most influential banker that geopolitics is deteriorating dangerously should not be taken lightly. At a Georgetown University event, he said: “The most important thing that dwarfs all other things, that’s really important, far more important today than [it’s] been probably since 1945, is this war in Ukraine, what’s going on in Israel [and] in the Middle East, America’s relations with China, and the attack fundamentally on the rule of law that was set up after World War II.”
Beyond the human toll, further provocation of those flashpoints could increase pressure on the global supply chain, weakening the world economy. A full-blown war between Israel and Iran, the world’s seventh-largest crude oil producer, could send oil prices ($72 a barrel at this writing) surging above $100, as was the case when war broke out in Ukraine in 2022. That could cause a spike in global inflation, undoing central banks’ policy restrictions of the past two years.
We are not currently planning to reduce exposure to U.S. or global markets because of the possibility of geopolitical shocks. However, we are constantly monitoring the news, as are our fund managers, and will adjust as conditions evolve. It remains our aim to strike the proper balance between risk and reward in the markets, and we continue to see the potential for substantial reward in this investing environment.
Our Outlook
- Inflation’s continued cooling should enable the Federal Reserve to make two quarter-percentage-point reductions in the benchmark interest rate by year-end and continue gradually cutting in 2025. Further escalation of the Middle East war could jeopardize oil supplies, disrupt the global supply chain and inflame prices.
- The global economy stands to benefit from declining interest rates and inflation in the year ahead. Lower rates should increase economic activity and help stimulate growth by making borrowing less expensive.
- The U.S. stock market’s broadening beyond tech and artificial intelligence-tied companies bodes well for further advances. Significant gains in utilities, real estate, industrial and financial stocks demonstrate the market’s more balanced strength.
- Periods of market volatility are likely between now and year-end given the high uncertainty about the presidential race and control of Congress plus the possibility that extra time will be needed to determine their outcome. With a strong economy, we expect any market turbulence to be short-lived.
- REITs continue to have strong potential with the commercial real estate industry showing signs of turning a corner following years of turbulence. A reduction in borrowing rates and inflation should be broadly beneficial, although the office sector remains stuck in its pandemic slump.
Quotes of the Quarter
“I don’t see anything in the economy right now that suggests the likelihood of a recession is elevated.” – Jerome Powell, Federal Reserve chair
“The global economy is starting to turn the corner, with declining inflation and robust trade growth.” – Mathias Cormann, Organization for Economic Cooperation and Development secretary-general
“AI is a fourth industrial revolution playing out. The surge in AI stocks is not a bubble. It’s a 1995 moment, not a 1999 moment.” – Dan Ives, Wedbush Securities analyst
Market Data
U.S. Stocks
An eventful quarter that saw tech stocks stall and volatility rise nonetheless ended with the stock market at another all-time high. More companies and sectors joined in the year’s impressive rally, boosted by a sharp rebound in corporate profits. The start of the Federal Reserve’s long-promised rate-cutting cycle spurred the iShares S&P 500 ETF to a fourth straight quarter of gains, a 5.8% rise. The 22.0% return through nine months made for the market’s best start in 27 years. The technology sector was flat (0.0%) and the Magnificent Seven stocks (5.4%) underperformed the market index for the first time since the fourth quarter of 2022. But all other sectors aside from energy (-2.9%) were positive as investors spread the gains that had previously gone mostly to tech stocks to utilities, real estate, industrials, financials and elsewhere.
Value and small-cap stocks also jumped into the rally in a big way after lagging in the first half. Value stocks averaged close to 10% gains across cap levels, narrowing the year-to-date performance gap with growth stocks. The iShares Russell 2000 ETF, whose smaller companies had struggled with interest rates at a more than two-decade high, revived with a 9.2% advance that pushed their 2024 return to 11.0%.
International Stocks
A 5% drop in the dollar’s value against other leading currencies, tied closely to the downtrend in U.S. interest rates, contributed heavily to a strong quarter for dollar-based investments in overseas stocks. The iShares MSCI EAFE ETF, which tracks stocks in the developed markets of Europe, the United Kingdom, Japan and Australasia, rose 6.8% in the quarter for a 13% year-to-date gain. Excluding conversion to the dollar, the same index was up only fractionally (0.9%) in local currencies for the quarter.
Emerging-markets stocks benefited from two tailwinds: the dollar’s decline and the late-quarter surge in Chinese stocks after the government announced it was injecting huge stimulus doses into the economy and stock market. The iShares MSCI Emerging Markets ETF advanced 7.7% to extend its year-to-date gain of 14.8%.
Real Estate
REITs outperformed the broader markets in the quarter as investors embraced the prospect of lower interest and mortgage rates. The Vanguard Real Estate Index Fund, which tracks REITs that purchase office buildings, hotels and other properties, zoomed out of negative territory for the year with a 17.2% rise that left it up 13.6% through nine months. A similar rally lifted the Vanguard Global Ex-US Real Estate ETF, which tracks real estate stocks in more than 30 countries, by 16.3% for a 10.7% year-to-date advance.
Hedged/Opportunistic
Investments in publicly traded senior bank loans as benchmarked by the Invesco Senior Bank Loan ETF gained 2.2% for a 5.8% return through nine months. Private credit managers benefited from the higher yields associated with private vs. public loans. Returns in the sector were modest, trailing those of the broad stock market.
Fixed Income
Bonds enjoyed their strongest gains since the fourth quarter of 2023 as a result of easing inflation and the Fed’s half-percentage-point cut in interest rates. The Vanguard Total Bond Market ETF jumped into positive territory for the year with a 5.2% rise for a year-to-date return of 4.6%. Stimulating the surge: the fall of the 10-year Treasury note yield from 4.4% to 3.8% by quarter’s end. Prices rise as yields (and rates) fall.
Altair’s benchmark for municipal bonds, a blend of the Market Vectors short and intermediate ETFs, climbed 2.6% and was up 2.4% through nine months.
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The Closed-End Fund Blended Benchmark consists of 60% First Trust Equity Closed-End Fund TR USD Index, 20% Invesco CEF Income Composite ETF, and 20% VanEck Vectors CEF Municipal Income ETF.
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