Market Commentary: September 2024

Written as of October 14, 2024.

Highlights this Month

• Looking closer at what has been driving returns in U.S. stocks.
• The Federal Reserve cut the Fed Funds rate by 50 basis points.
• So why cut rates, and why by so much?
• In September, the path to lower rates became more complicated for the Fed.
• Consumer spending should benefit from lower rates, as should the housing market.

September in Review

A strong September capped off the best start to the year for U.S. stocks since 1997. The S&P 500 rose 2.1% in September (total return in U.S. dollars) and is up 22.1% year to date. For the third quarter of 2024, the S&P gained 5.9% but trailed many other large-cap country stock indices.

Canadian stocks have made 26 record highs in 2024 (as of the end of September), with the S&P/TSX Composite Index closing above 24,000 for the first time on September 26. The index closed the month up 3.1% (total return in Canadian dollars). The Canadian stock index increased 10.5% in the third quarter but trails gains made south of the border year to date with a 17.2% return.

Global stock returns in 2024 have been strong, making it challenging for traders to make bearish bets. According to Bloomberg, defensive exchange-traded funds (ETFs) underperformed last month as markets continued to move higher.

Similar to stocks, bonds have also delivered positive returns. Bloomberg highlights that U.S. Treasuries are in the midst of a five-month winning streak, the longest since 2010. According to Charlie Bilello at Creative Planning, a broad fixed-income mandate comprising both Treasuries and investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) has returned 8% since the end of April, marking their biggest five-month gain since 1995. Like Treasuries, investment-grade credit is on a five-month winning streak of its own, the longest since 2020, and is up nearly 8.5% over the same period.

As for high yield, Bloomberg’s non-investment-grade index is up 7.4% over the last five months and 8.0% year to date. Below, we take a closer look at both stock and bond performance in September and the third quarter, and discuss how each was influenced by two events last month: the Federal Reserve’s 50-basis-point cut in the funds rate and China’s stimulus package.

Looking closer at what has been driving returns in U.S. stocks, Bloomberg highlights how the rally has broadened over the last three months, with the S&P Equal Weighted Index outpacing the cap-weighted index by the most since the fourth quarter of 2022. Most of this outperformance occurred earlier in the quarter.

According to the Financial Times, investors were focused on sectors that would benefit from weaker growth (consumer staples and healthcare) and falling rates (real estate, financials, and utilities) during the summer. However, the structure of the rally in U.S. stocks changed in September, with technology and cyclicals leading the way. This shift occurred despite concerns that the Federal Reserve needed to cut rates aggressively.

As pointed out in a recent Wall Street Journal article, investors need to be cautious when generalizing the behaviour of stocks grouped together in certain sectors, especially given the influence of large companies and artificial intelligence. The consumer staples sector, which typically performs well in a weakening economy, has outperformed consumer discretionary so far this year. This is unusual, given consumer discretionary should have outperformed in a resilient economy. Consumer staples’ strong performance was mainly due to three big stocks: Walmart, Procter & Gamble, and Costco, while the lagging performance of Tesla and Amazon has weighed down the consumer discretionary sector.

Using equally weighted sector returns solves the anomaly, with consumer discretionary stocks outperforming the consumer staples sector so far this year. With the utilities sector, which like staples is typically considered a defensive sector, using equally weighted sector returns doesn’t solve the anomaly, as investors have been bidding up the price of the entire sector due to the expected increase in demand from a power-hungry artificial intelligence industry.

China also played a role in the market’s changing outlook for global growth last month. The country’s economy has been slowing, with consumer confidence at low levels. According to China’s National Bureau of Statistics, consumer confidence collapsed in April 2022 when Shanghai and many large cities were locked down and hasn’t recovered since. Chinese stocks reflected this mood, consistently underperforming for most of 2024.

In September, however, China announced some stimulus in the form of monetary easing and support for housing and the stock market. Chinese stocks responded positively, with the Shanghai Composite’s 17% rally in September being the largest monthly gain since 2015. However, more fiscal support will likely be needed to materially change the trend in the Chinese economy.

China is the world’s second-largest economy, and stronger Chinese economic growth should mean stronger global economic growth. The prospect that China might be taking a more proactive stance in stimulating its economy likely helped cyclical stocks globally, including in the U.S. and Canada. This is one of the reasons the market structure changed last month to favour sectors that benefit from stronger economic growth.

The positive performance in bonds should be easier to analyze, given that falling rates and tighter credit spreads lead to higher bond prices and returns. One nuance to explore, however, is longer-term yields like the 10-year, which started to trend higher again in the second half of September.

As highlighted in the Bear Traps Report, the spread between the 2-year and 10-year Treasury yield has steepened as 2-year yields have fallen more than 10-year yields in what is referred to as a bull steepening. A bull steepening typically occurs in a slowing economy, when the Federal Reserve is forced to cut rates quickly. Long and short-term rates both fall (prices go up), which is why it’s called a “bull” steepener, but short-term rates fall more.

Last month, however, 10-year rates were moving higher, creating what is referred to as a “bear” steepener (long rates up, so prices down). A bear steepener is more common when the market anticipates future growth, either real or inflation-induced, which results in longer-term yields moving higher to discount this growth or inflation.

Two charts from Bloomberg help highlight the market’s changing view on rates. For all of the third quarter, the decline in rates was driven by a decline in both real rates and inflationary expectations. In September, however, real rates still declined, but inflation expectations started to move higher, offsetting some of the decline in real rates.

While longer-term rates may be pointing towards the potential of stronger growth, short-term rates like the Fed Funds rate paint a much darker picture. As highlighted recently by Apollo, the amount of cuts the futures market is currently pricing in suggests a recession rather than a soft landing. Goldman Sachs calculates the 12-month forward market implied change in the Fed Funds rate translates to a 98% probability of recession starting in the next year. Both Goldman and Macrobond recently highlighted the big difference of opinion stock investors have regarding the probability of a recession versus the financial market’s pricing of short-term rates. Stock investors see a low chance of recession, while rate investors are much more bearish. As pointed out by Macrobond, recession probabilities don’t evolve smoothly, and changes can happen very abruptly. Either stock investors or rate traders are wrong, and the verdict can be delivered in a very sudden and harsh correction. 

Last month, the Federal Reserve cut the Fed Funds rate by 50 basis points. Most believed the Fed would cut rates, but according to The Bear Traps Report, 90% of economists expected only 25 basis points. Market participants were more evenly split, with about a 60% probability of a 50-basis point cut priced into the Fed Funds futures price. Economists were looking at factors like financial conditions, corporate earnings, and consumer spending. As highlighted by the Bear Traps Report and Bloomberg, the last time the Fed cut rates with financial conditions as loose as they are presently was 32 years ago, and according to Bank of America Research, it’s rare for the Fed to cut rates when corporate earnings are recovering. While credit creation has slowed, Bridgewater highlights how retail spending, supported by higher incomes, has held up. 

From an economist’s perspective, the Fed should be cutting rates when the economy looks at risk, but this doesn’t appear to be the case right now. According to the Citi U.S. Economic Surprise Index, U.S. macroeconomic data is currently exceeding expectations with the Bureau of Economic Analysis reporting GDP has been revised higher. According to the Institute for Supply Management (ISM) purchasing managers index, U.S. manufacturing has shrunk for six months in a row, but services are far more important to U.S. economic growth and the ISM Services PMI expanded in September by the most since early 2023, ending the month firmly in expansion territory. 

So why cut rates, and why by so much? While economists believe financial conditions are loose, market participants see something different. According to a recent Bank of America Fund Manager survey, a majority of fund managers believe monetary policy is actually “too restrictive.” With the expected change in the Consumer Price Index (CPI) over the next 12 months below 2% and Fed Funds at 5.5%, real rates were nearly 3.5%. This is well above what many believe the “neutral” equilibrium rate to be. While this may seem high, Société Générale Markets points out most easing cycles have started with an even more restrictive real Fed Funds rate. The key remains where inflation goes from here. If it continues to move lower, as forecast with the expected 12-month CPI, real rates would move even higher if the Fed didn’t start cutting rates. 

The November 5 Presidential election adds another layer of complexity. By aggressively cutting rates, the Fed risks giving the appearance of favouring the Democrats, a point former President Trump is likely to emphasize. While it might seem natural to conclude the Fed will strive to appear bipartisan by staying on the sidelines this close to the election, historically this has not been the case, and it likely won’t be this election either. They have already cut 50 basis points and may continue to ease as they see fit. Inflation remains on their radar, but the labour market appears to be the priority right now. According to Bloomberg, 12 Fed officials saw risks to unemployment as tilted to the upside at the last Federal Open Market Committee (FOMC) meeting, compared to three Fed officials who saw risks to core inflation as tilted to the upside. According to Bank of America Research, S&P 500 futures have been more reactive to job numbers than any other major economic data, and Bloomberg recently highlighted how much employment numbers have impacted the bond market this year. 

In September, the path to lower rates became more complicated for the Fed. The U.S. was expected to add a net 150,000 jobs last month but ended up with a higher-than-expected 254,000 new workers, the most in six months. Additionally, the previous two months’ totals were upwardly revised by 72,000 and the unemployment rate fell from 4.2% to 4.1%. Also exhibiting strength in the labour market were U.S. job openings, which according to Bloomberg jumped to a three-month high in August. There are still some cracks forming, though. According to Strategas, temporary workers, which can be a leading indicator, continue to weaken, and the U.S. workweek dipped slightly to 34.2 hours. Another leading indicator recently highlighted by Société Générale is also pointing to future weakness in the job market. Using data from the Conference Board, Société Générale charts the ratio of jobs hard to find versus plentiful and compares it to the unemployment rate. The ratio has been rapidly deteriorating of late, with respondents reporting a growing trend of jobs becoming hard to find versus plentiful, thus foreshadowing a potential future increase in the unemployment rate. 

The contradicting signals extend to the consumer. As reported by Bloomberg, U.S. retail sales posted a surprise gain in August and the University of Michigan Consumer Sentiment Index rose to its highest level in five months in September, but the Conference Board’s U.S. Consumer Confidence Index suffered its largest drop in three years last month. 

Consumer spending should benefit from lower rates, as should the housing market. According to Strategas, housing is already showing some early signs of thawing, with mortgage applications for purchase and refinance recently turning higher. Based on data released by the Commerce Department, U.S. housing starts rose nearly 10% in August to 1.4 million, which is likely why, as Strategas points out, homebuilder stocks continue to perform well. It’s a double-edged sword for the Fed. Housing is very interest rate sensitive and plays a large role in the economy, so if the Fed wants to stimulate growth by lowering rates, the housing market is a prime target. At the same time, higher housing costs are one of the major reasons why inflation has remained higher for longer, and home ownership has become unaffordable for many Americans. 

We have to admit, we side with the economists and were surprised by the Fed’s 50-basis-point cut. We just don’t see the urgency with the economy still reasonably strong. The September job report only reinforced our view. As highlighted by Deutsche Bank, it’s unusual to see such a strong payroll report at the start of a Fed easing cycle.

While there was only one dissenter in the FOMC meeting to cut 50 basis points rather than 25, meeting minutes suggest others also had reservations about the larger cut. According to Bloomberg Intelligence, a scoring of the minutes reveals the September meeting was the most hawkish since April. Expectations for the November meeting remain volatile. After peaking above 60%, the probability of a 50-basis-point cut in November plummeted to zero following the September job report.

For markets, loose monetary and financial conditions are positive, and according to Macrobond, global liquidity has rarely been higher. This is another reason China’s new monetary stimulus was positive for risk assets last month. As Goldman Sachs recently pointed out, with the Fed now easing, other countries will have more room to ease without putting too much pressure on their currencies. As highlighted in a recent Bloomberg article, sharply declining rates usually mean sharply declining profits, but that is not what we are seeing so far. While it is possible the evolving soft landing is really just the start of a hard landing, it is also possible that the economy is more resilient than expected and monetary easing, in combination with steady earnings growth, will provide the fuel to take this bull market even higher. Stocks are not trading like a recession is imminent, and neither is credit. Only short-term rates and expectations for more cuts in the Fed Funds rate seem to be discounting a hard landing. Even long rates appear to be signaling stronger growth. 

It’s a tough call on where the Fed goes from here, and even tougher for traders to make money from it. According to Bloomberg, stocks fell and 30-year yields rose after the Fed’s larger-than-expected rate cut. Of course, it was only unexpected by the economists. The market had largely discounted the 50-basis-point cut, so maybe the counterintuitive move in stocks and bonds was a classic “buy on rumour, sell on fact” scenario.

Rather than spend too much time postulating on where rates are going in the short term, perhaps the real question for investors is where rates are headed longer term. To put it another way using investment industry jargon, where is the neutral rate? According to the New York Fed’s Survey of Primary Dealers (big U.S. banks and dealers approved to trade securities with the U.S. government), the median estimate is 3.1%, while the Fed’s estimate is 2.9%. According to Bloomberg, Bill Dudley, President of the New York Fed from 2009 to 2018, believes the neutral rate could be as high as 4%.

There are several reasons for believing the neutral rate has risen and is going higher. Wars are inflationary and cost a lot of money, as does the capital needed to build out the green energy transition, climate change mitigation, and artificial intelligence. The growing economic competition between the U.S. and China and the desire to increase supply chain redundancy could also be inflationary and help raise the neutral rate.

Top of mind for most investors, however, are the growing government deficits and debt levels, and the increasing percentage of available investment capital they will require in the future. Perhaps this is what the bond market is starting to discount with the 10-year yield rising. Perhaps bond investors are starting to demand a higher term premium for holding longer-term bonds.

The November 5 presidential election is less than one month away. Neither candidate has paid much attention to the growing U.S. government debt, though it is projected former President Trump’s policies will result in higher debt levels than Vice-President Harris’s. Higher fiscal spending is good for economic growth and corporate earnings in the short term, but is unsustainable longer term, especially if longer-term rates move higher. Watching the 30-year bond yield on election day might be just as important as the election itself.