Fourth Quarter 2024 Outlook

Inflation No Longer an Immediate Concern

After a brief hiccup earlier in the year, inflation has resumed its downward trend. The June Consumer Price Index (CPI) report featured the first negative month-over-month print since May 2020, which sparked a dramatic reaction from investors who suddenly saw real evidence of the “immaculate disinflation” many had been calling (or hoping) for. Through August, year-over-year inflation fell further to 2.5%, pulled down by falling energy prices and continued deflation in durable goods. Except for a few random holdouts (e.g., transportation services and motor vehicle insurance), shelter remains the main source of uncooperative stickiness. Despite market-based measures for rents softening materially, shelter inflation is still rising at an uncomfortable pace, up 5.2% over the last year (accounting for over 70% of the past year’s core inflation). Official measures are still expected to eventually “catch down” to more timely market-derived measures of rents, but the process is taking longer than many expected. Even still, with core Personal Consumption Expenditures inflation (the Federal Reserve’s (Fed’s) preferred measure of price pressures) seeming to settle into a pace of 0.1% and 0.2% monthly increases, 2% feels within reach over the next few quarters.

Labor Markets Aren’t Weak, but They Are Weakening

The labor market continues to expand, albeit at a slower pace, most recently with 142,000 new jobs added in August. Even still, in an analysis of data going back to 2000, the three-month average job growth of 116,000 fell into the 34th percentile, which represents a job market that is cooling from record-setting levels but still humming along at a historically healthy rate.

While the pace of job creation has normalized, the unemployment rate has also been steadily rising from its low of 3.4% in April 2022. That level was among the lowest in history, and when considering that average hourly earnings were growing at nearly 6% at the time, it was obvious that some amount of cooling was needed. The tricky thing about labor market trends is that they tend to compound on themselves. It’s easier to fire people when other companies are doing so, and fear of layoffs can often be self-fulfilling as people cut back on spending as a precaution. Therefore, when the unemployment rate starts to rise a little, it usually winds up rising a lot.

This time around, one of the mains drivers of the increasing unemployment rate have been new entrants and reentrants to the workforce. Additionally, recent surges of immigration are likely not yet accounted for in official statistics. While this may make it more difficult for some to find a job in the short term, keep in mind that population growth is a key structural component to economic expansion, particularly when domestic demographics are weakening.

To be sure, the supply of labor may be increasing, but reduced demand from employers is also a factor, as evidenced by falling job openings in the Bureau of Labor Statistics’ (BLS) Job Openings and Labor Turnover Survey. We believe this pullback in hiring is mainly a function of a “pull forward” of demand from red-hot labor markets during the COVID-19 recovery, rather than a form of hunkering down to weather weakening fundamentals (after all, pretax corporate profits are at all-time highs). Despite hiring at a blistering pace in 2021 and 2022, companies have mostly been hesitant to undergo layoffs and instead may be simply slowing hiring to focus on absorbing its current (and relatively new) workforces.

This can be seen in the “Permanent Job Loss” component of the BLS’s household survey, which typically drives increasing unemployment rates in recessions. This figure has risen slightly but does not explain the overall increase. This means that the unemployment rate is rising, but it’s mostly not because people are losing their jobs. This dynamic is also corroborated by modest weekly jobless claims and layoffs reported by executive outplacement firm Challenger, Gray & Christmas. By finding a way to release steam without actual job cuts, softening labor markets can allow for a reduction in wage pressures without the associated “vicious cycle” between employment and consumption that can occur when people start losing their jobs.

The Fed Finally “Recalibrates”

Falling inflation gave the Fed the luxury of acting proactively to keep labor market softening from spiraling out of control. After clearly communicating its intent in the weeks prior, the Federal Open Market Committee (FOMC) cut the federal funds rate for the first time in over four years in September, ending the record-setting “pause” and moving into a cycle of gradual easing back to neutral.

With the question of “when” answered, the question for the Fed turned to “how much” and “how long.” After considering downward revisions to prior employment statistics, the FOMC opted for a “jumbo” cut of 50 basis points (bps) for its first move. In the press conference that followed the meeting, Fed Chair Jerome Powell tried to stress that the jumbo cut did not come from a place of panic but rather was a proactive step to avoid falling behind the curve, calling the move a “recalibration” and emphasizing that the Fed does not currently see recessionary conditions building. Powell also stressed that the Fed is not in a rush to get back to neutral and reiterated this view on the last day of September in response to substantial upward revisions to past gross domestic product (GDP) and gross domestic income data.

The Summary of Economic Projections, also known as the “dot plot,” showed a moderate pace of further easing, though not as fast as currently priced in by financial markets. The median projection showed an additional 50 bps of cuts for the rest of the year, another 100 bps in 2025 to end next year at 3.4%, and then 50 more bps in 2026 to an eventual terminal rate of 2.9%. As of quarter-end, fed funds futures markets were pricing a more aggressive pace of hikes but were moving in the direction of the Fed’s communications. Safe to say, rate cuts during times of economic strength are rare. Typically, policy rates “take the stairs up and the elevator down,” meaning they are gradually raised to combat inflation but tend to be dropped quickly in reaction to some sort of market crisis or recession scare. With no such crisis in sight, the Fed hopes to take the same stairs back down.  

Volatility Breeds Opportunity in Equity Markets

July’s surprisingly light CPI report sparked a frenzied rotation into previously unloved equity cohorts like small-cap and real estate stocks. Filled with enthusiasm about the prospects of imminent policy easing without the typically associated crisis, investors turned to attractive valuations in cyclical and interest-rate sensitive stocks. At the same time, attention turned away from previous leaders like the “Magnificent 7” and the rest of the technology and communication services sectors. The Russell 2000 Index of small-cap stocks logged an impressive 10% pop in July, while the Nasdaq-100 Index® of technology stocks fell by roughly 2%, closing much of the performance gap that opened up between the two indexes earlier in the year. Breadth also began to show itself within large caps as well, with the S&P 500® Equal Weight Index beating the standard market-cap weighted index by over 3% in the month of July.

Toward the end of July, sentiment began to shift, moving from excitement about renewed progress on inflation to concern about the trajectory of the labor market. Around the same time, several Mag 7 constituents released second quarter (Q2) earnings that were solid but failed to meet the increasingly high bar placed on them by investors. As July turned to August, most equity markets were rolling over. We saw our first hint of returning negative stock-bond correlations, as investors piled into bonds without fear of inflation eroding their fixed returns.

Fears were exacerbated further in early August when Japanese markets fell hard after the Bank of Japan announced a surprise rate hike. The move served as a currency intervention to protect the Japanese yen, which had recently fallen to its weakest point against the U.S. dollar since 1990. This move sparked the unwind of a “carry trade,” in which investors borrow cheaply in countries with low interest rates, convert the proceeds to other currencies like the U.S. dollar, and invest in higher-yielding opportunities. Some have speculated that this yen carry trade was a big source of global funding for investments in U.S. tech darlings, but that theory remains unproven. The yen reversal sparked a rapid sell-off in Japanese markets, with the Nikkei 225 index losing over 12% (in local currency terms)—its worst single day since “Black Monday” stock market crash in 1987.

The carnage spilled over to U.S. markets on the following Monday morning, with the Cboe Volatility Index® spiking to a head-scratching high of 65 in premarket trading—a level typically reserved for the most acute of crises. Markets calmed down after the open and put in a bottom, capping the S&P 500’s drawdown at about 8% (well within expectations for the typical year). As markets recovered, leadership shifted again in August, with small caps taking a breather after a strong July, while tech stocks mostly struggled to regain momentum. New leadership emerged from defensive sectors (e.g., consumer staples) and interest-rate sensitive sectors (e.g., real estate).

The last month of the quarter brought continued volatility, but the S&P 500 eventually set a new all-time high, although the Nasdaq-100 has yet to break its own high set in July. When all was said and done for the quarter, small caps held on to the head start they established in July. Tech and communication services still managed to squeeze out positive quarters, but both sectors took a backseat after a very long winning streak. Utilities, real estate, industrials, and financials emerged as winning sectors. Thanks to falling oil prices, energy was the only losing sector in Q3.

A Solid Earnings Season Leaves Plenty to Look Forward To

Despite market volatility, corporate earnings largely put in a solid quarter, with the S&P 500 posting year-over-year revenue growth of around 5%, as expanding profit margins pushed earnings growth north of 11%. While technology again led the way with 20% growth, we started to see our first signs of participation from other sectors, with double-digit growth also coming from the consumer discretionary, health care, financials, and utilities sectors. Despite strong results in Q2, management teams were relatively cautious about the rest of the year, which drove a downward shift in expectations for Q3, from around 8% growth in June to about 4% currently. Even still, estimates for calendar year 2024 remain solid at about 10%, while analysts are still expecting earnings growth of about 15% in 2025.

While large-cap equities put up a strong quarter of earnings, smaller-cap companies continue to struggle. The S&P SmallCap 600® index posted marginal year-over-year revenue increases, but shrinking profit margins drove an earnings contraction of 15% versus Q2 2023. Looking forward, companies set a low bar to beat in Q3 with earnings projected to be relatively flat, while a recovery is expected to begin in Q4 with mid-teens growth, following through to high-teens growth in 2025. Although the long-awaited earnings recovery for small caps continues to be delayed, we believe policy easing into a strong economy with abating inflation should allow earnings momentum to finally build. That could be a powerful combination when paired with attractive valuations.

Bonds Rally, but Credit Spreads Don’t Reflect Panic

The 10-year U.S. Treasury continued to trend downward from its recent high in April, hitting a low of 3.60% on the day of the September Fed meeting before ending the quarter at 3.80%, which is coincidentally right where it began 2024. As long-promised rate cuts finally became a reality, shorter-term rates fell more, driving a resteepening of the yield curve, with the 10-year and 2-year Treasury yield spread ending the quarter at 15 bps, in positive territory for the first time since mid-2022.

Despite equity volatility in the quarter, corporate credit spreads continue to reflect a relatively sanguine outlook for credit fundamentals, and municipal bond yields also rallied even more than Treasury yields in the quarter to reflect solid credit fundamentals and robust supply. Investment-grade spreads remain anchored near historical lows under 100 bps. High-yield spreads also remain mostly tight, with the overall market sitting just north of 300 bps. Under the surface, there is a substantial dispersion, with higher-quality BB spreads below 200 bps, but the riskier CCC+ cohort has been trading wider since the start of the Fed’s rate hiking cycle. As high-yield default rates have picked up slightly, this group remains pressured and has been trading in the 850–1000 bps range for most of the year, although an end-of-quarter rally drove outperformance for this group in Q3.

China Pulls Out All the Stops, But Will It Help?

China is still struggling to pull itself out of the economic pit dug by a popping of the real estate debt bubble, and the country now looks in danger of missing its 5% GDP growth target for the year. Chinese citizens hold a disproportionate amount of their wealth in the form of property (nearly two-thirds versus about a quarter for U.S. citizens). With a long bull market in housing prices now officially over, negative wealth effects are taking hold in China’s domestic economy, putting a damper on sentiment and consumption. An overly leveraged household sector is now buckling down, reducing spending and paying down debt. Weak demand is leading to falling prices, with China’s GDP deflator indicating contraction in prices in Q2 for the fifth straight quarter.

Meanwhile, the corporate sector is grappling with falling demand for exports from trading partners with weakening economies. Choppy industrial production is struggling to regain pre-COVID trends. After much hesitancy, Chinese authorities finally responded in late September, unveiling a “bazooka” of stimulus measures designed to reignite borrowing, housing activity, and equity markets. Chinese stocks responded strongly, with the MSCI China Index (USD) rocketing 22% higher in the last week of the quarter. After the impressive move, the Chinese index is now up nearly 30% year to date, putting it well ahead of the S&P 500. However, not everyone is convinced the measures will do much to alleviate underlying, longer-term issues like elevated debt loads, stalled foreign investment, tense geopolitical relationships, and deteriorating demographics.

Election Uncertainty Adds to Investor Angst

The 2024 presidential election cycle has been unpredictable and unprecedented. President Joe Biden’s decision to drop out of the race and endorse Vice President Kamala Harris introduced a new level of uncertainty for markets to consider. Vice President Harris and former President Donald J. Trump have starkly different views on taxes and trade policy, but the winning candidate will likely have to deal with a divided Congress, which would subdue the extent of any dramatic policy initiatives. When we looked back at almost 100 years of equity market data, we couldn’t find a strong relationship between the political party that wins the White House and the subsequent 12-month equity market returns. In fact, the odds of making money in the stock market over that one-year period were roughly the same as any other 12-month period: about 75%, regardless of which party won the White House.

Outlook for Q4

• With labor market supply and demand returning to equilibrium, policy easing should curb meaningful further deterioration.
• Solid consumption enabled by stabilizing labor markets should continue to power economic growth at or above longer-term trends.
• Lower rates should begin to help rate-sensitive sectors like manufacturing and housing finally form a sustainable bottom while also easing some of the bifurcated financial situations seen at both the household and corporate levels.
• Equity markets should be able to hang on to strong year-to-date gains, while investors may continue looking in unloved pockets for value as earnings begin to broaden out. Broader earnings momentum within large caps and hints of an earnings recovery in small caps could provide plenty of opportunities at attractive valuations.
• Treasury yields across the curve have already priced in much of the intended easing cycle, limiting room for further price appreciation in a soft-landing scenario. However, yields are still attractive relative to recent history, and the return of negative stock-bond correlations can have a positive portfolio construction impact.
• Credit and municipal bond spreads remain tight, but they are tight for a reason, and we expect them to remain near these levels.
• China’s stimulus “bazooka” may help in the near term, but officials are treating the symptoms, not the disease. We ultimately expect the impact on China’s economy and markets to fade, although investor sentiment had become very one-sided, which can lead to violent reversals like we saw in September.
• Geopolitics remain the key wild card in Q4, but history tells us that remaining rational and “controlling what we can control” is the best way to make it to the other side of difficult periods.
• Election dynamics may influence day-to-day volatility in Q4, but financial market reactions to their results don’t tend to be overly extreme and usually take a backseat to underlying economic conditions.