October Investment Comments

While the S&P 500 remains near all-time highs, markets have been choppy as sentiment has vacillated between belief in the Federal Reserve’s ability to achieve a soft landing versus concerns regarding a more significant slowdown. Progress on inflation set the table for the Fed’s half-point rate cut at its September meeting, as Chair Powell had noted that the balance of risks to the Fed’s two mandates, price stability and stable employment, have changed. Inflation has come down, trending toward the Fed’s 2% target, while the labor market has slowed. Given the increase in downside risks to employment, at the Jackson Hole gathering Powell stated the Fed “does not seek or welcome further cooling in labor market conditions,” clearly articulating the Fed has shifted its focus, opening the door to a rate cutting cycle.

The September rate cut was the first reduction since 2020, marking the end of the policy tightening the Fed embarked upon beginning in March 2022 to combat inflation. Rate hikes resulted in the target range for the federal-funds rate hitting 5.25%-5.5%, a two-decade high, and remaining there for 14 months prior to the recent cut. This hiking cycle had the desired impact as the Fed’s preferred measure of inflation, the core personal-consumption expenditures index (PCE) came down to 2.6% in July, the most recently available data, compared with a peak of more than 5.5% in 2022. Based on consumer and producer price data already released for August, economists expect the headline PCE for August will be approximately 2.3% with the Fed’s own preferred inflation measure, the core PCE, advancing 2.7%. While we are not yet at 2% inflation, the general trend has been in line with what the Fed would like to see, and policy remains restrictive, albeit less so than before the recent cut.

The employment market has cooled from extremely strong levels. Following a weak July employment report, the August jobs report showed U.S. employers added 142,000 jobs in the month, which was below expectations. With the August report, estimates for job growth in June and July were also revised lower by a combined 86,000 jobs. The three-month average monthly payroll growth through August slowed to 116,000 versus over 200,000 as of last December. Further making the case for a slowing labor market, in August the unemployment rate was 4.2%, up from 3.7% at the end of last year. According to the Labor Department, July job openings fell to the lowest level in over three years, down 13% which was below expectations, while the rate of layoffs also rose slightly from the prior month. Those voluntarily leaving their jobs, presumably for better opportunities, have also continued to trend lower and is now below levels seen in the year prior to the pandemic. All these indicate a slowing labor market.

Prior to the September cut, moderating inflation caused the Fed’s policy to appear more restrictive. From the data it is fairly clear the economy is slowing, and it makes sense to begin the rate-cutting cycle. History suggests it is challenging to stop a rise in the unemployment rate once demand for workers has slowed. If the Fed wants to achieve a soft landing, it knows it cannot afford to get behind the curve with easing. Heading into the September meeting, given the labor and inflation dynamics, the bond market was strongly signaling the Fed to commence its easing cycle. Since early July the yield on the two-year Treasury declined from 4.7% to under 3.6%, resulting in the Treasury yield achieving record lows relative to the federal-funds rate. The Fed’s action indicates it understood the market signal.

At least as important as the size of the recent rate cut is the path of rates over the next several months. Projections from Fed officials suggest another half point of easing by year end, with the target rate dropping an additional 1.0% to a level of 3.25%-3.50% by the end of 2025. This stands in contrast with market expectations as implied by the CME FedWatch tool immediately following the rate cut announcement reflecting a more aggressive 2.00% of rate cuts by the end of 2025 to a target rate of 2.75%-3.00%. We would argue investors should favor a scenario more aligned with the Fed’s projections with fewer rate reductions through 2025, as a more aggressive path of rate cuts suggests concern over a hard landing.

What does this mean for stocks? Historically, equities’ response to an initial rate cutting cycle is largely dependent upon whether it is followed by a recession. If not, stocks have generally performed well. However, if cuts come too late to avoid a recession, stocks have fared worse. According to Morgan Stanley, in the 11 rate cutting cycles since 1973, eight were associated with recessions. The average performance of the S&P 500 over the 12 months following the start of a cutting cycle is 3.5%, or less than half longer-term averages, with returns ranging from up 33% to down 31%.

The economy continues to grow at a solid pace. The Atlanta Fed’s GDPNow estimate for third quarter real GDP growth is 3.0%, and for the year real GDP growth is expected to be about 2%. Several companies have highlighted the pressures facing lower-income consumers, upon whom the inflation of recent years has had an outsized impact. However, companies like Walmart have highlighted no discernable change in the overall consumer. The Commerce Department’s headline retail sales data for August was up slightly versus July and better than expected.

Stocks generally reflect the belief the Fed is on pace to achieve a soft landing. Earnings forecasts continue to rise and the expectation for earnings growth through 2025 is not consistent with a recession. Consensus expectations are for 10% earnings growth in 2024 with another 15% growth in 2025. The current forward P/E multiple is approximately ~21x, elevated but down slightly from earlier this year. More granularly, there has been a rotation into more defensive sectors over the past month as growth concerns have risen. According to Bank of America’s global fund manager survey, investors are now the most overweight in utility stocks since 2008. Since mid-July, the shift to a more defensive posture has led consumer staples to outperform consumer discretionary. We have also seen value stocks outperform growth stocks over that timeframe, though growth remains well ahead for the year. Furthermore, participation has broadened out from mega-tech growth companies, with the equal-weighted S&P 500 recently outperforming the market-cap weighted S&P 500.

The general theme of the moment remains uncertainty, and the upcoming election only adds to it. Inflation has trended lower, but the Fed has yet to achieve its 2% goal. Meanwhile, trends in the employment market are softening, leading to increasing concerns regarding a potential recession. The Fed has taken initial steps to move to a less restrictive policy, but the path of rate cuts from here is not clear. Environments such as this argue for focusing equity exposure on high quality, profitable, growth companies and the application of a longer-term time horizon.    

James M. Skubik, CFA