Our Outlook
Supply chain disruptions related to the port workers’ strike loom, the impacts of which we know can be incredibly destructive. The not-so-distant memory of supply chain dislocation will hopefully spur action on the part of the administration to facilitate a swift resolution. War in the Ukraine and unrest in the Middle East threaten oil supply at the minimum, but we can only hope that cooler heads have no appetite for world or even worse nuclear war. Finally, there seems to be no desire for economic austerity in Washington. Given the current peace and economic stability, running such a substantial deficit is inexcusable.
Domestically, we seem to be navigating the elusive soft landing. Inflation is cooling in response to rate policy while not crushing growth. Corporate earnings are projected to resume double digit growth, employment imbalances have eased, and mortgage rates are moderating to a level that will ideally promote neither excess nor stagnation. The Fed’s measured and methodical approach to the economic fallout from the pandemic seems to have dodged the economic calamity envisioned by many.
With most central banks cutting rates and bond yields declining around the world, gold has been the major beneficiary. The gold uptrend is especially decisive, and we would posit “don’t fight the tape.” Gold’s 50-day and 200-day moving averages are both rising. A broader explanation for the dollar’s weakness is that above and beyond policy rates, the aggregate picture is one of rate differentials that have narrowed. So even while the Bank of Japan tightened rates and both the European Central Bank and the Bank of England ease, the Pound, Euro and Yen have appreciated versus the US dollar. A stronger dollar threatens gold’s run, but given tepid pessimism for the dollar (i.e. not oversold) we don’t see strength meaningful enough to halt the strength in gold.
Amid America’s deep political divide, the rhetoric endemic to each election suggests the outcome will impact the cultural, economic, and social survival or collapse of America as we know it. Perhaps this enmity is what keeps opposing powers in check as we continue to wade through the turmoil ultimately finding ourselves in the greatest country, without question, on earth.
Third Quarter Review
The stock market experienced a mixture of volatility and steady growth throughout the third quarter. The S&P 500 ended the quarter with a healthy gain of 5.9%. In the first half of 2024, technology and communication services had been the primary drivers of returns but lagged as investor preference shifted to more dividend focused, rate sensitive companies in the real estate and utilities sectors. The rotation was also likely motivated by both sectors’ relative underperformance in the first six months of the year. Despite some third quarter consolidation, the technology and communication services sectors are still up 30.3% and 28.8% through the end of the quarter, respectively, with utilities completely closing the former gap with the Magnificent Seven-heavy sectors up 30.6 year to date.
Also closing a performance gap in the third quarter were the broader growth and value indexes. The Russell 1000 Growth had outperformed the value index by 14.1% through the first half of 2024 after beating it by 31.2% in 2023 leaving a historically wide disparity in performance. This was likely driven by bullishness surrounding real and forecasted earnings strength related to everything AI, but also the compounding effects of index publishers pushing concentrations of those stocks to record levels. The Magnificent 7 peaked mid-July at 56.9% of the Russell 1000 Growth. Compare this to the weight of those same stocks beginning 2023 at 35.3% and 2004 at 47.2% and currently at 54.1%. Similarly, small caps as measured by the Russell 2000, asserted themselves in the third quarter, making up some ground but still lagging year to date versus the large and mid-cap indexes.
First half headwinds for fixed income reversed during the third quarter, as demand picked up primarily due to moderating gauges of inflationary pressures and the Fed’s mildly dovish stance. US Treasury yields fell dramatically over the quarter, reflecting expectations of easing monetary policy from the Federal Reserve. The 10-year Treasury yield ended the quarter at 3.79%, down from 4.37% to start the quarter. But yield curve moves are rarely linear, and the real action occurred in the 1–3-year tenor. For example, the 1-year rate dropped almost 110 basis points in just 90 days. The chart below shows absolute changes in the curve during the quarter. What is not shown is the volatility in yields to which we’ve become accustomed since the arrival of the pandemic. Despite smaller moves in the long bond, given their larger duration, the Bloomberg 20+ Year Treasury index was up 8.0% in the quarter versus the 1-3 Year Treasury index which was up 4.1%, highlighting not only duration risk associated with short term bonds, but also reinvestment risk.
International markets were customarily mixed. After a strong 2023, Mexico and Brazil posted double digit negative year to date returns of -18.5% and -12.9%. Conversely, China’s markets are raging in response to the government’s most aggressive stimulus package since COVID. The announcements came ahead of China’s Golden Week holiday, exacerbating trading volumes and likely speculation. The stimulus package included interest rate cuts and support for the beleaguered real estate and stock markets. The objective is to spur economic activity in hopes of achieving the People's Bank of China's (PBOC) 5% percent growth target for the year. Also introduced were tools to support capital markets allowing funds, insurers and brokers easier access to funding in order to buy stocks.
China's household spending is less than 40% of annual economic output, some 20 percentage points below the global average. Investment, by comparison, is 20 percentage points above. For reference, it took Japan 17 years to raise the consumption share of its economic output by 10 percentage points from its bottom in 1991. The PBOC’s stimulus measures, while not insignificant, are ostensibly handouts involving more debt and more money supply and likely to create lasting impact. The strategy has shown little success in creating real, sustainable economic growth.
With the third quarter behind us we focus on the upcoming earnings season. In aggregate, analysts are more pessimistic about earnings than usual, while companies are less so as measured by revisions to earnings outlooks. Analysts estimates for Q3 2024 have dropped by 3.8% per share since June 30, which exceeds the 5-year and 10-year averages of -3.3%. But 55% of S&P 500 companies have issued negative EPS guidance, below the 5-year average of 58% and the 10-year average of 62%. While S&P 500 earnings for Q3 are now lower than they were at the beginning of the quarter, analysts predict double-digit earnings growth beginning in Q4 2024. Specifically, earnings growth rates are projected to be 14.9% for Q4 2024, and over 14% for the first two quarters of 2025. Annual earnings growth for 2024 and 2025 is expected at 10.0% and 15.1%, respectively. In terms of winners, eight of eleven sectors are forecasted to report earnings growth, with information technology, health care, and communication services showing double-digit growth. The energy sector is predicted to see a double-digit decline. In terms of valuation, the forward 12-month P/E ratio is 21.6, above the 5-year average of 19.5 and the 10-year average of 18.0, as well as the end of Q2’s ratio of 21.0.
Source: Factset
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