U.S. equities were buoyant in Q3-2024 as anticipation of an atypically large U.S. interest rate cut, generally strong second quarter corporate earnings and a long-awaited Chinese economic stimulus program triggered a broad rally in financial assets. The quarter was also marked by a welcome change in market and sector leadership as investors repositioned portfolios in response to changing macroeconomic data and high valuations in certain sectors. In addition to the U.S., where the Federal Reserve reduced interest rates by 50 bps in mid-September, the third quarter also saw broad global monetary easing, with rate cuts in Canada, the Eurozone, the UK, and Switzerland.
The rally was that more impressive given that markets shrugged off two distinct periods of sharply higher volatility in which the S&P 500 and Nasdaq fell by 5% - 10%, before ending the quarter at or close to all-time highs. The first was triggered by a “surprise” interest rate hike by the Bank of Japan in July which pushed the Yen sharply higher, upending risk models which forced investors to rapidly close highly leveraged positions. The late August volatility spike was caused by investor reaction to NVIDIA’s (NVDA) Q2-FY2025 earnings which, though well ahead of consensus forecasts, were tarnished by lower margins and a delay in its next generation AI-chip. NVDA shares recovered by quarter end, but some of the air clearly came out of the AI trade. That, combined with U.S. economic growth and labor market data that ushered in improving prospects for Fed rate cuts, provided impetus for a major market rotation during the third quarter as well as improved market breadth. After leading market gains by a wide margin all year, Nasdaq (+2.8%) trailed other major indexes in the third quarter and only turned positive in the last few trading days of the quarter. Similarly, within the S&P 500, the Technology and Communications Services sectors barely eked out positive performance, rising 1.6% and 1.7%, respectively. Utilities (+19.2%) and Real Estate (+17.4%), arguably the most interest rate sensitive sectors, led all sectors, though Utilities have become an indirect technology play due to anticipated capacity increases required to power AI-related data centers. Industrials (+11.6%) benefited from prospects that a more dovish interest rate outlook might reinvigorate the manufacturing economy. The market rotation was also evident in style factor performance for the quarter, with gains led by high-dividend, low-volatility and small cap stocks.
Third quarter U.S. economic data prints increased confidence that a soft economic landing was increasingly in the cards, a sentiment that was further buoyed by an aggressive start to the Fed’s rate cutting cycle. Disinflation continued, though at a slower pace than earlier in the year, and the labor market remained resilient. Final Q2 GDP growth was 3.0% annualized, and the latest Federal Reserve estimate for Q3 growth has moved up to 3.2%. Despite some “noise” from prior quarter revisions, the economy continued to create jobs at an impressive rate and continuing unemployment claims consistently surprised to the downside. Unemployment ended the quarter at 4.1%, better than expectations, and essentially flat compared to Q2’s 4.0%. However, Federal Reserve policymakers cited concern about future labor market weakness, as well as continued progress toward achieving their 2% inflation target, as the rationale for the Sept 18th decision to reduce its benchmark interest rates by 50 bps. The Fed also laid out its forecasts for the size and timing of additional rate cuts, with another 50 bps of cuts expected this year, followed by a further 100 bps in 2025. Equities rallied and government bonds rose sharply as yields fell across the curve in anticipation of - and then in response to - the Fed’s action and its new projections. The yield on 10-year U.S. Treasury bonds dropped 61 bps for the quarter.
After a strong third quarter performance, we believe the prospects for fixed income remain attractive as disinflation continues. Historically, intermediate-maturity bonds have tended to outperform cash during Fed interest rate cutting cycles and we believe investors may benefit from locking in today’s still attractive yields. We remain focused on high-quality bonds which tend to have lower volatility than stocks, providing investors with more stability against a range of economic scenarios. Within the asset class, we seek higher quality corporate credits, and find reasonable value in industrials and financials with strong capital positions. U.S. agency mortgage securities are also attractive at current levels and represent a high-quality compliment to portfolios. Portfolio duration positioning is intended to be neutral yet guided by client cash flow needs.
International markets were also strong in Q3 as they responded to accelerating monetary easing in both developed and select emerging market economies. With inflation coming down at a more rapid pace than in the U.S., and facing stalling growth, we expect developed market rate cuts to at least keep pace with those in the U.S. Japan is the one exception to this dynamic and though the BoJ became more hesitant to raise rates in the wake of July’s Yen-induced market turmoil, it is likely to continue monetary policy normalization in late 2024 and into 2025. A major swing factor for international market performance will continue to be China, where equity markets surged after it announced broad monetary stimulus measures in mid-September, after disappointing investors all year with piecemeal stimulus initiatives. Because monetary stimulus take time to impact economic growth, investors are eagerly awaiting more immediate fiscal measures from China to gauge policymakers’ commitment to their stated goal of reviving its moribund economy.
In regards to the domestic equity market, after such strong returns YTD, we head into Q4 increasingly sensitive to market risks due to high valuations and lofty earnings expectations. In addition, market volatility tends to increase around presidential elections and geopolitical risk remains elevated as the Middle East conflict has widened. On the flip-side, economic growth remains supportive, global monetary easing is accelerating and financial conditions have loosened significantly over the past three months. Market breadth also remains healthy, and despite post-quarter end economic data that sowed doubt about the Fed’s projected rate path and inflation forecast, markets have proved resilient to shocks thus far. However, we suspect that a strong Q3 earnings season and overall positive commentary from management teams regarding the outlook for 2025 is likely required to sustain equity markets, and we lean positively on the prospects for that outcome, particularly for many of our portfolio holdings that are levered to idiosyncratic catalysts. Putting it all together, we believe it is likely that the equity markets will experience volatility as they digest the strong YTD advance ahead of the elections, but are positioned to close the year on a strong note as election uncertainty clears (assuming there is not major election controversary).
Our base case remains a soft landing for the economy accompanied by resilient corporate earnings and continued improvement in market breadth. Within the portfolio we continued to shift to a more balanced stance by adding to both our defensive and cyclical exposure, though we are poised to act if we see signs of the market moving decisively in favor of one or the other. For example, we increased our weighting to the cyclical, rate sensitive Real Estate sector and made several changes to the early cycle Consumer Discretionary sector while also increasing our positioning in typically defensive Consumer Staples. Several longstanding portfolio themes remain intact. These include the broader use of and additional indications for GLP-1 anti-obesity drugs, expansion of domestic semiconductor manufacturing capacity, as well as power generation and transmission systems required to fuel this growth.
Our global equity portfolio remains overweight large-cap domestic stocks relative to foreign stocks, but we again raised our exposure to emerging markets as they should be significant beneficiaries of global monetary easing and valuations relative to developed markets are extremely attractive. We also added exposure to small cap stocks within the international portfolios. On a style basis, we continue to favor high-quality style factors, stable growth, and a selective mix of cyclical value.
Author:
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Bruce Schoenfeld Principal Investment Analyst First American Trust |
Bruce is the Principal Investment Analyst responsible for investment research coverage of various asset classes and equity industry sectors. Bruce has more than 20 years of experience as an equity analyst and portfolio manager. He joined First American from 3P Associates, LLC, an investment and strategic management consulting firm he founded. He previously served as Director of Research at BlueStar Global Investors and as an analyst and portfolio manager focused on emerging markets for Delaware Investments, Artha Capital and Caisse de depot et placement du Quebec, Canada’s second largest pension fund.
Co-Authors: |
Jason Nerio SVP, Director of Investment Research & Strategy First American Trust |
Jason Nerio is the Director of Investment Research and Strategy at First American Trust. Mr. Nerio has more than 20 years of investment research experience. He is responsible for formulating investment strategy and serves as a leading member of the investment committee which monitors and manages the firm’s allocation strategies for over $1 billion in client assets.
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Scott Dudgeon, CFA Director, Equity Research First American Trust |
Scott Dudgeon is the Director of Equity Research at First American Trust. Mr. Dudgeon is a Chartered Financial Analyst (CFA) and has more than 25 years of investment research experience. He also serves as a leading member of the investment committee and has a proven track record for outperforming the markets for our clients. He has been with The First American Family of Companies for 16 years.
The following article is for informational purposes only and is not and may not be construed as legal and/or investment advice. Investments contain risks, no third-party entity may rely upon anything contained herein when making legal and/or investment determinations regarding its practices, and such third party should consult with an attorney and/or an investment professional prior to embarking upon any specific course of action.
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