Market Commentary Q3 2024
Market Breadth Improves as the Fed Pivots
For the first six months of the year, the stock market rally was relatively narrow, driven by superior earnings strength and performance of mega-cap technology stocks. In the third quarter, we saw early signs of a potential shift in leadership with cyclicals and small caps outperforming. Only 25% of stocks in the S&P 500 managed to outperform the index in the first 6 months of the year, the lowest since 1999. Over 60% of stocks outperformed the index in Q3, the highest level since 2002.
We would attribute at least part of this change to interest rates moving lower, as rate-sensitive sectors tended to outperform. In any case, this looks to be a healthy rotation in what has been a very strong two year run for the stock market. As we look out into 2025, earnings growth is expected to broaden out, which may support more expansive market participation, assuming results live up to expectations.
The 2-year Treasury yield dropped more than a full percentage point from July through September, as anticipation for rate cuts gained momentum. The Fed may have had sufficient rationale to lower rates in July following tepid inflation and employment reports, but instead opted for a 50 basis point reduction in September, forecasting another half percent reduction by year-end. Regardless of the timing of future rate moves, we would expect yields on cash to be much lower by the end of 2025, unless inflation resurfaces or economic activity materially accelerates.
Now that we have the long-awaited first interest rate cut of this cycle, many investors may be wondering what that means for the stock market going forward. Looking back to prior cycles would tell us that the subsequent results are mixed, but the economic environment in which the Fed shifts to accommodation seems to matter.
Since 1970, there have been seven instances in which the Fed started cutting rates when the economy was not in a recession. The S&P 500 was higher a year later in all 7 instances, by an average of 15.8%. In the 5 instances in which the Fed started cutting rates during a recession, the S&P 500 was lower a year later by an average of 2.3%.
While things can change, we do not believe the U.S. is currently in a recession, nor on the immediate verge of entering one. Economic growth continues to surprise to the upside, with Q2 gross domestic product (GDP) recently getting revised upwards to 3% growth year-over-year. As of September 30th, third quarter GDP was also projected to grow between 2-3%, according to the Atlanta Fed’s GDP Now indicator.
As pandemic-era stimulus benefits continue to fizzle out, the consumer is starting to face some headwinds, evidenced by rising credit delinquencies, especially on the low-end of the economic scale. Thus far, economic growth has remained resilient, and loosening of monetary policy may slowly help to ease the interest burden for those needing to borrow. Two likely beneficiaries are small companies, who often rely on access to financing tied to floating rates, as well as homebuyers who have stalled on purchasing from the combination of higher rates and rising home prices.
Less clear to us is how the U.S. government ultimately handles its own massive debt burden that continues to compound from rising interest costs and deficit spending. Historically, running such large fiscal deficits has been reserved for emergency responses to recessions, not when economic conditions are as healthy as they are today. The annualized net interest cost on the nation’s outstanding debt recently surpassed the annual defense spending budget for the first time ever. This seems unsustainable, but we don’t see this changing in the near-term, regardless of who wins the election.
“Buy into a business that’s doing so well an idiot can run it, because sooner or later, one will. The U.S. is sort of like that.”
-Warren Buffett
This Buffett quote is more akin to the evaluation of economic moats for businesses, but we might consider that appropriate when evaluating the implications of policymakers overseeing the U.S. economy. Regardless of who wins the election, we still believe the U.S. holds structural advantages for investors over the long-term. American businesses have demonstrated over time that they can adapt and thrive regardless of who is in public office, as evidenced by stock market returns under both republican and democratic leadership.
The upcoming election will likely take at least some of the spotlight for investor sentiment in the near-term. And while elections matter, we believe they matter less as it relates to forecasting expected returns for the stock market. Investors would be better served to leave politics out of their investment decisions, in our view.
Overall, the S&P 500 is off to its strongest 9 months to start a year since 1997. We believe this is driven by above-average earnings growth that has so far lived up to expectations. Expectations are even higher as we look forward into 2025, with stock valuations presumably discounting substantial earnings growth to come.
This sets the bar very high for upside surprises moving forward, likely requiring more expansive participation across the market, supported by a healthy and growing economy.
In conclusion, I would like to take a moment to express my gratitude for your ongoing support of Bridges Trust. As I move forward in my new role as Chief Investment Officer, I am committed to providing valuable insights as we navigate the evolving capital market landscape together. If you have any questions or would like to discuss this further, please don’t hesitate to reach out to your Relationship Manager.
Sincerely,
Jack Holmes, Chief Investment Officer