Q3 Market Commentary: A Look Back & Ahead
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As evidence-based investors, we use an approach fueled by data with over 50 years of research, rooted in diversification and tax conscious investment options. Time has proven the value of investing. While these quarterly market reviews are helpful for staying informed, we also love to remind our clients and community: focus on what you can control, remember the big picture, and stick to your plan.
market snapshot
Global equity markets produced solid returns in the third quarter with international stocks leading the way. Small value stocks flexed their muscles during the quarter both domestically and internationally with U.S. small value stocks outperforming the broad U.S. market by 4.0% and international small value outpacing broad international markets by 2.8%.
Fixed income returns were buoyed by dramatically lower interest rates in the third quarter as it became more and more clear to the market that a Fed rate cut was likely coming.
Why did the Fed decide to Lower its Target Rate?
To answer this question, we need to look at what economist Milton Freidman coined “the long and variable lag” of monetary policy. This refers to the length of time it can take for changes in monetary policy to begin influencing the economy. While estimates vary, Atlanta Fed President Raphael Bostic noted in a 2022 piece (1) that changes in monetary policy generally take anywhere from 18 months to more than two years to make a significant impact. You can clearly see the monetary policy lag in action when examining the most recent Fed tightening cycle. While the Fed began raising interest rates in March 2022, personal consumption expenditures price index (PCE) inflation remains above the Fed’s 2% target, over two years since the cycle began, but is continuing to moderate.
With the economy beginning to show signs of slowing, the Fed felt comfortable lowering interest rates now because the effects won’t be felt for several months. The Fed believes the lag will keep policy restrictive in the short term, enabling inflation to move below the Fed’s 2% target. Eventually, this should provide the spark needed to reignite the economy before it tips into recession, allowing the Fed to achieve its goal of a soft landing.
inflation continues to moderate, fed policy shifts
Main Takeaway
The economy has remained resilient, with strong real GDP growth in the second quarter and inflation easing in the U.S. and globally. However, the economy is beginning to show some signs of stress, as unemployment has started to tick up and job growth has slowed. Against this backdrop, Federal Reserve Chair Jerome Powell signaled a significant policy shift was appropriate, with the Fed cutting the federal funds rate 0.50% at its September meeting.
Top Risks
With their recent rate cut, Fed policymakers signaled that they believe a slowing U.S. economy is becoming the primary risk. Moving forward, the markets will be watching consumer spending and unemployment closely to determine if the Fed can engineer a soft landing. U.S. national debt continues to be a concern with the debt-to-GDP ratio approaching 100%. A protracted outcome to the U.S. presidential election could lead to additional market volatility.
Sources of Stability
Globally, inflation continues to moderate with the Fed now joining other central banks, such as the Bank of Canada and the European Central Bank, in reducing their respective target interest rates. The combination of lower interest rates and strong wage growth is expected to spur businesses and consumers to increase spending. Although unemployment has begun ticking higher, this is likely because more people are returning to the workforce as permanent layoffs have stayed relatively constant.
KEY ECONOMIC INDICATORS: AREAS TO WATCH
U.S. Economic Growth
The U.S. economy has remained resilient with third-quarter GDP expected to come in around 3.1%. Consumer spending on services has remained robust and is now approaching pre-pandemic levels. (2) Manufacturing, on the other hand, continues to sputter with August seeing the largest contraction in basic materials production since early 2023. (3) While unemployment has risen slightly and job growth has slowed, positive real GDP growth is expected for the next four quarters. (4)
Inflation Trajectory
Inflation continues to moderate with August CPI coming in at 0.2%, or 2.5% year over year, the lowest reading since February 2021. Motor vehicle insurance and shelter costs were two of the biggest drivers of inflation over the past 12 months, rising 16.5% and 5.2% respectively. (5) Despite the recent downward trend, inflation is expected to remain above the Fed’s 2% target over the next 12 months due to a robust consumer and government deficit spending (currently 7% of GDP). (6)
Monetary Policy
As the market expected, the Fed began the easing process by lowering the federal funds rate 0.50% at its Sept. 18 meeting to a range of 4.75%-5%. According to the Fed’s latest Summary of Economic Projections, also known as the dot plot, the committee is expecting to lower interest rates another 0.50% by the end of 2024, with additional cuts expected next year, which would bring the target rate to the 3.25%-3.50% range by the end of 2025. However, Chair Powell also stressed the Fed is not on a preset course and will adjust policy based on incoming data.
Fiscal Policy
The U.S. continues to operate in the red with the Congressional Budget Office (CBO) estimating the 2024 federal deficit to be $1.9 trillion, or 7% of GDP.6 Total debt is expected to end the year at roughly $28 trillion (99% of GDP) and grow to over $50 trillion (122% of GDP) by 2034.6 The large uptick in debt coupled with higher interest rates means the U.S. government is now paying $3 billion in interest daily. (7)
Labor Market
The labor market has been gradually cooling with unemployment ticking up to 4.2% in August from 3.8% a year ago. (1) Job growth has also slowed recently with the three-month average falling to 116,000 compared to 211,000 in August 2023. (2) Labor Department data showed that employers are hiring at their slowest pace since 2014 while workers are quitting their jobs at the lowest rate since 2018. (2) The good news is permanent layoffs, a traditional harbinger of recession, have been relatively stable. (2)
Consumer Lending
Although the U.S. economy continues to chug along, households are showing signs of stress. Credit card and auto loan delinquency rates continue to rise with credit card delinquencies now topping out at 10.9%. (3) Fed data also shows household debt continues to eat into savings with the personal savings rate falling to 2.9% in July from 4.4% the previous year. (4) There are signs of life, though, as consumer credit card balances grew at a lower rate of 8.6% in the second quarter. (5)
Global Economy
Inflation continues to moderate globally with Canada and eurozone inflation falling to 2.5% (6) and 2.2% (7) respectively. Central bankers are continuing the process of easing monetary policy with the Bank of Canada and the European Central Bank cutting interest rates for the third and second consecutive meeting respectively in September. The U.K. saw a slight uptick in inflation (8) causing the Bank of England to pause momentarily in its rate cutting cycle, but the bank is expected to resume cuts in November.
Yield Curve
Under normal circumstances, yields on longer-dated bonds are higher than shorter-dated securities. Since July 2022, the yield curve has been inverted with the 10-year Treasuries yielding less than two-year Treasuries. Historically, an inverted yield curve has been one of the biggest leading indicators of a recession. Recently, the yield curve has normalized with 10-year Treasury yields finally breaking above two-year yields (9) possibly indicating a decreasing probability of a U.S. recession.
Thanks to our reliance on long-term evidence-based investing principals, we know that short term data is too noisy to determine our investing choices. Yet, we always like to offer our review of markets because we believe this information should be accessible to all!
