October 16, 2024
Market Summary
The Federal Reserve obliged the financial markets by cutting the federal funds rate by 50 basis points at its September Federal Open Market Committee (FOMC) meeting, thereby signaling the start of a new easing cycle and increasing the probability of delivering on the much-hoped-for “soft landing”.
As we anticipated, we saw market participation begin to broaden out in the third quarter. Regrettably, it did not broaden in a way we anticipated. After highly concentrated returns from a select group of mega cap tech stocks for the past year and a half, we saw formerly laggard groups like small caps and value stocks assert themselves during the quarter. The best performing sectors for the quarter included utilities, real estate investment trusts, industrials and financials – areas where we were naturally under-represented since many companies within those respective sectors fall below our minimum growth requirements. Former leadership sectors like technology and communication services took a breather this quarter and were two of the weakest performing sectors, along with energy.
Economic Outlook
The U.S. economy continues to confound the skeptics. Real gross domestic product (GDP) increased at an upwardly revised 3.0% annual rate in the second quarter, up from 1.4% annualized growth in the first quarter, supported by another quarter of resilient consumer spending along with increased private fixed investment. Final sales to private domestic purchasers, a measure of core underlying demand, increased at a healthy 2.8% annualized rate. For the third quarter, the Atlanta Fed’s GDPNow real-time forecasting model predicts another quarter of 3% annualized growth.
The ongoing resilience of the U.S. consumer remains heartening. Consumption has been supported by rising incomes, a reduction in savings, and increases in borrowing. The first two categories are likely to contribute less to overall consumption moving forward. Job and wage gains continue to moderate, while excess pandemic-era savings have been depleted. Borrowing, however, can continue to provide support for consumption, especially as banks become less restrictive in their lending. Lower income households who have been hurt the most by high interest rates on credit card balances and auto loans, should begin to see immediate relief from lower interest rates. Upper income households, who were never really impacted by higher interest rates, should continue to experience the beneficial effect on their balance sheets from rising home and stock prices.
Additionally, we expect the two sectors hardest hit by higher interest rates – housing and manufacturing – to also begin to see some relief at the margin from lower rates. We have increased our estimate for full-year 2024 real GDP growth from +1.5-2% to 2-2.5%.
Meanwhile, inflationary pressures continue to ease. Prices for energy and core goods have declined and food costs are moderating. Shelter costs, however, remain stubbornly high as do certain service categories like auto insurance, auto repair and airfares. The most recent reading for the consumer price index (CPI) for August, showed a year-over-year increase of 2.6%, down from 3.3% at the beginning of the year. The Fed’s preferred inflation gauge, the personal consumption expenditure deflator (PCE), showed just a 2.2% year-over-year increase in August, down from 2.7% at the beginning of the year and nearly back to the Fed’s 2% target. We now expect CPI to fall to the low-end of our prior 2.5-3.0% forecast by year-end.
Emboldened by this moderation in inflation, the Fed turned its attention to the softening labor market. The unemployment rate had risen as high as 4.3%, briefly triggering the “Sahm Rule”, a recession signal with a perfect track record. Fed Chairman Jerome Powell characterized the decision to lower rates as a “recalibration” of policy to reflect the shift in risks to the employment side of its dual mandate, surely cognizant of what the “Sahm Rule” signals – once unemployment goes up by a little, it usually goes up by a lot. Encouragingly, the subsequent September employment report showed strong job gains for the month and a reduction in the unemployment rate to 4.1%, removing the “Sahm Rule” signal for now and thereby reducing any pressure on the Fed to move more quickly with rate cuts. The FOMC’s September Summary of Economic Projections projected an additional 0.5% reduction in the federal funds rate between now and year-end, followed by another 1% reduction, taking the rate down to 3.25-3.5%, by year-end 2025.
The Fed is hoping such preemptive rate cuts will provide an insurance policy against a hard landing. The risk now is a reacceleration in economic activity, fueled by renewed animal spirits, that reignites inflationary pressures. Further escalation in the Middle East could develop into an inflationary shock. Depending on the outcome of the election, policy proposals put forth by both presidential candidates also have the potential to be inflationary. All this makes the Fed’s job a difficult one to perfectly navigate.
The consensus bottom-up S&P 500 EPS estimate for 2024 has edged slightly lower to $241. Based on our upwardly revised GDP forecast we now estimate 2024 S&P 500 EPS of $239, +9% y/y, an improvement from flattish growth last year. We continue to expect moderating EPS growth in the second half of the year for the “Magnificent Seven” at the same time the rest of the market begins to show accelerating EPS growth. We expect this growth convergence to continue into 2025. Combined with falling interest rates, this convergence should lead to a further broadening of the market.
While the medium-term outlook for the equity market has brightened in our view, the near-term set up remains challenging. On one hand, the economy and corporate profits continue to expand at a healthy pace and the Fed is once again the market’s friend. However, stock valuations and investor sentiment both remain elevated, and geopolitical tensions in the Middle East are rising yet again. The month of October in a presidential election year tends to be a challenging one for the stock market due to uncertain outcomes and uncertain implications for policy and taxes. This year is certainly no different. We expect continued market volatility through the election at least.
A diversified portfolio of reasonably-valued, high-quality durable growth stocks remains the best protection, in our view, against a sudden bout of market volatility while still allowing ongoing participation in the current bull market. We stand prepared to take advantage of any such volatility by deploying excess cash reserves. We also anticipate repositioning the portfolio by adding additional cyclical growth exposure in the months ahead, especially in areas likely to benefit from lower rates.