The Markets
After a short-lived pull back in the month of August, equity markets ended the 3rd quarter near all-time highs. This advance has been far broader than the concentrated gains seen in the first half of the year. Expectations of larger Fed rate cuts coming earlier supported the growing confidence of a soft landing, or at least, no recession occurring anytime soon.
For the quarter, the S&P 500 gained 5.9%, the NASDAQ +2.8%, while previous laggards – the DOW and Russell 2000 (small caps) gained 8.7% and 9.3%, respectively. Value stocks outperformed Growth, while Mid-caps and Small-caps outperformed Large-caps.
Interest rates moved lower in anticipation of the September Fed Funds rate cut. Markets reacted positively when the expected 25-basis point cut (1/4%) became a 50-basis point cut, leaving bond yields below 5% across the Treasury yield curve.
Investment Strategies
Meritage strategies generally performed well during the quarter, with the exception of smaller gains on the Growth Equity side. The broadening of the equity market favored interest sensitive sectors that are more dominant in Value strategies, while at the same time, some of the enthusiasm around Artificial Intelligence (AI) began to dim over the quarter, pressuring semiconductor and AI-related software companies. Despite lagging its benchmark, the Growth Strategy posted a year-to-date gain of over 15%.
The Value Equity strategy trailed its benchmark slightly in the quarter, but it still remains nicely ahead for the YTD, up almost 19%. Both Small Cap Value and Small Cap Growth had strong quarters besting their peers, and adding to year to date outperformance. SCV was ahead 15.5%, and SCG up 17.2%, primarily due to broadening markets and strong stock selection.
The Yield Focus Equity strategy turned in a strong performance for the quarter and YTD, bringing the nine-month return to 14%. This strategy continues to fulfill its purpose, which is to provide stability, growth and consistent dividend income. All of which becomes more relatively attractive as interest rates decline and the economy slows.
Our Fixed income strategies also benefited from falling interest rates and the long-awaited steepening of the yield curve. Further details can be found in our Fixed Income Update here.
The Economy
While a mixed bag globally, the U.S. economy has remained relatively strong. Labor markets continue to grow and wages continue to rise, albeit at a slower pace. Despite rising to 4.3%, the levels of unemployment remain historically low and job openings are relatively plentiful. Inflation has cooled to around 2.5%, close to the Fed’s target. That said, the actual prices of many goods and services remain 20-25% higher than pre-pandemic levels of 5 years ago. This is the difference between the disinflation we are seeing and a less likely prospect of deflation to actually bring prices down.
Internationally, in September alone, global central banks cut interest rates some 21 times. Further, a number of countries continue to inject liquidity or continue with Federal spending programs to support their economies and labor markets. Most notably, the recent actions taken by the PRC (People’s Republic of China) have boosted their stock market, even though previous attempts to do this very same thing have not had lasting effects. Some non-US markets who trade with China have responded favorably to this stimulus, though the full effect and degree of success will take some time to manifest.
Geopolitics
Global uncertainty will always exist, but the current risk-backdrop has clearly ramped up by the escalation of war-like activities in the Middle East. Growing adversity between the U.S. and China, the ongoing pressures caused by the Russia-Ukraine war, and upcoming U.S. elections certainly add to the mix. Particular attention will be paid to relations between the U.S. and China. While the U.S. has come through the pandemic cycle in a superior way in almost all measures, China remains a key economic force and there remains a meaningful interdependence between the two countries.
Historically, U.S. Presidential elections are generally good for financial markets. The partisanship and polarity around the current candidates and issues add more complexity to the usual uncertainties. With respect to fiscal discipline, both candidates seem to be heading down a path that will create even more government debt over the near term, potentially reigniting inflationary pressures. And good chance, regardless of who wins the Presidency, there will be a new Federal Reserve Chair to deal with these implications.
With some exception, the current geopolitical overhang, as unpredictable as it is, has had limited impact on financial markets. Occupying a similar status is the Federal debt, and markets have been able to look past potentially disruptive consequences. But as long as there is no imminent impact on corporate earnings or consumer behavior, the pattern has been that markets get a free pass. Investors implicitly accept that these extraneous uncertainties don’t matter, until they do.
Outlook
Given the current upbeat financial market conditions, it is easy to suggest past is prologue. The “’Don’t fight the Fed” mantra has a lot of support from both the monetary and fiscal sides. We know that record highs in stock prices can sometimes be confused with an ‘everything must be great’ outlook. Still, we are inclined to approach 2025 with a note of caution, at least in our expectations.
Over the past two years, the economy and corporate profitability have been stronger than expected, justifiably propelling markets higher. Looking forward, double-digit earnings growth expectations for 2025 is a high bar and with higher input costs, it is getting harder for profit margins to expand from today’s record high levels. With consumers taking on additional debt, it becomes more challenging for revenue growth to accelerate from current levels. Higher debt levels from governments and corporations usually imply slower growth at some point.
With respect to valuation, we know markets that are priced at high multiples can always go higher. High valuation, in and of itself, is rarely a catalyst for a market reversal. But it is a good measure of a market’s vulnerability should something else unexpected come along. These events are typically unknowable (that’s why they are unexpected), making it extremely hard to be optimally positioned at the moment, should they occur.
Since we perceive the risk of the investment backdrop to be above average, we want to make sure our normal risk management parameters are not overshadowed by today’s positive consensus outlook. We work to do that by keeping asset mix policy objectives current and asset class allocations in line with client targets. We also rely on our stock selection process that emphasizes attractive free cash flow characteristics, a visible upside to current valuations, and appropriate diversification across sectors and securities.
We won’t be surprised to see the year finish strongly. Our expectation is that a little more caution may come in handy in the coming year.
