Two years ago, many market pundits were sure the US economy was entering a recession in response to the Fed’s aggressive monetary tightening. Financial markets were having their worst year since the 1970’s, with the S&P 500 Index in a bear market and the Barclays Aggregate Bond Index down nearly 20%. Yet here we are today with the Federal Reserve widely expected to achieve a “soft landing” as the economy grows, the labor market remains healthy, and inflation trends downward. In response, financial markets have rallied (S&P 500 is up over 60% from the October 2022 lows) and volatility has dampened. Good long-term investing is not about making great decisions, but about consistently avoiding big mistakes. Instead of taking preemptive action in response to the consensus “recession,” we focused on the building blocks of successful long-term investing – committing to an appropriate asset allocation based on risk tolerance and time horizon, rebalancing portfolios to target allocations, managing duration of fixed income portfolios, optimizing returns on cash balances, and managing portfolios with eye towards tax efficiency including tax loss harvesting. We believe these actions have and will continue to serve our clients well. That said, we do believe a lot of good news is priced into financial markets today and we are prepared to see more volatility. Whether from central bank policy, the upcoming US presidential election, geopolitical tensions, or something else unexpected, we cannot be sure. But volatility is a price investors must pay to benefit from the long-term equity premium that investing in stocks has provided.
The US economy, as measured by GDP, grew 3% in the second quarter versus a year ago, highlighting the strength and resilience of the US consumer (page 8). Consumers have shifted their spending preferences from big ticket items during the pandemic (cars, appliances, renovations) to experiences (travel, hotel, and dining). This brings the economy back to a more normal and sustainable level, resembling pre-pandemic activity. We have also experienced a huge wealth surge, with over $50 trillion of wealth added in the last five years from appreciating home and equity prices. This “wealth effect” is powering spending, particularly in upper-income households. But not all households are benefiting equally. Higher borrowing costs are hurting over-levered consumers (and companies), and delinquency and default rates are starting to move higher (page 18). The labor market is healthy on the surface with unemployment at 4.2% (page 10). We do not read too much into the volatile month-to-month payroll numbers, but instead focus on the bigger picture trend which shows the economy continuing to produce jobs albeit at a slower pace (page 12). Overall, we expect the economy to continue to grow into 2025, but likely closer to the 2% trend growth we have seen historically. We are cognizant that decelerating growth typically makes the economy more susceptible to unexpected “shocks,” but expect any slowdown to be mild given the absence of financial excesses in the economy. For now, financial markets are riding a strong economy that bodes well for continued consumer spending and future corporate earnings.
Against this economic backdrop, US Large Cap Equities, as measured by the S&P 500 Index, returned +6% in the third quarter of 2024 and are +22% for the year (page 22). The index overall has traded at and around 21x forward earnings for much of the year, well above its long-term average of 17x (page 23). A bright outlook for corporate profits has supported these valuations, with S&P 500 earnings expected to grow +15% in 2025 to $275 and another +13% in 2026 to $310 (page 24). If these estimates are achieved, then the market is trading in line with historical averages at current prices. But if they are not, there may be some disappointments and devaluations in response. We believe the largest companies in the index are most at risk, ten of which now account for over a third of total market capitalization of the S&P 500. These ten companies trade at 31x forward earnings, while the remaining 490 stocks trade at 18x (page 25). While investors have undoubtedly benefitted from owning shares in these great companies, we believe the opportunity going forward in these companies is much more limited as compared to the rest of the market. US Mid Cap Equities (S&P 400 Index) returned +7% in the third quarter and US Small Cap Equities (S&P 600) returned +10%, with the returns coming on the back of the Federal Reserve messaging that it would be lowering rates in 2024. At 16x forward earnings multiples, these asset classes remain historically cheap on both an absolute and relative basis. Lower interest rates should help these companies, which are typically more reliant on floating rate debt. But they are also more reliant on broad economic growth to deliver earnings, which has been a headwind as the Fed actively tries to slow the economy down. We remain Neutral weight to US Large, Mid and Small Cap Equities in our asset allocation models.
Outside of the US, the MSCI EAFE Index of Developed Market Equities returned +7% in the third quarter of 2024 and is +13% for the year. Improving economic growth has fueled a pick-up in expectations for corporate earnings. However, continued geopolitical tensions across various regions make the path forward less clear. And many of these developed economies are not on as strong a footing as the US. We believe this has kept valuations well below historical averages at 14x forward earnings. We remain Neutral weight to Non-US Developed Market Equities. The MSCI EM Index of Emerging Market Equities returned +9% in the third quarter of 2024 and is +17% for the year. China’s raft of policy easing measures were recently announced to stabilize stock and property markets and boost consumption growth. Central banks across other developing countries have begun to ease monetary policy as well, which should help stimulate growth and support corporate earnings. At 12x forward earnings, we believe long-term investors are being adequately compensated for the risks involved in these markets. We remain slightly Overweight to Non-US Emerging Market Equities.
The Federal Reserve cut interest rates by 50bps in September, bringing the Federal Funds target range to 4.75 – 5.00%. Expectations currently call for another 50bps cut in 2024, and at least 100bps in 2025 (page 26). But as we have seen, the market has not done a good job of forecasting short-term interest rates (page 33). If the economy continues to prove more resilient than expected, it may take more time to lower interest rates than currently expected. Remember that a cardinal sin of central banking is to lower interest rates too quickly, and then have to reverse course due to more persistent inflation. Chairman Powell undoubtedly feels this pressure, particularly after getting caught so far behind inflation three years ago. But inflation continues trending towards 2% with headline PCE currently at 2.2% and core PCE at 2.7%. Two recent drivers of inflation, auto insurance and shelter costs, are both decelerating, albeit slowly. Intermediate to long-term interest rates continue to be volatile, with the 10 year Treasury ending the quarter at 3.8%. Despite the volatility, we continued to purchase high quality bonds at attractive yields to lock in income for client portfolios as rates are expected to decline in the future. Thankfully, we seem to be past the era where investors were willing to buy 100 year bonds at 1% yields, as they did for Austria’s century bonds. We remain Overweight US Investment Grade Bonds. Strategic (Non-Investment Grade) Bonds, as measured by the Barclays High Yield Index, have returned +8% in 2024. Credit spreads over Treasuries – the premium charged by investors to hold Non-Investment Grade bonds – have narrowed considerably and are well below their long-term averages (page 28). We remain Neutral to Strategic Bonds and have gradually increased the credit quality within our portfolios. The US presidential election is now only weeks away and will continue to take center stage of the news cycle. Elections are important for a lot of reasons, and this election should be no different. But history has shown the outcome of elections tends to be less consequential for financial markets and the economy than most people think. We will spend more time on the election and potential implications on our Capital Markets Conference Call, but there is not a meaningfully clear correlation between which political party controls the White House and Congress and the long-term performance of equity markets. Having said that, we will be watching the developments closely as the government make-up will influence the course of tax policy with key policies set to expire at the end of 2025. Current polling has the Presidential race as a toss-up, but a divided Congress looking more likely. Financial markets tend to like a divided government in that they tend to avoid policy extremes. We will all be following the outcome closely and will discuss the implications for tax policy and planning as we enter 2025.
