The U.S. economy grew at an above-average pace in the second quarter and appears to be on track for comparable results in the third quarter. Inflation continued to decline, prompting the Federal Reserve to cut rates for the first time in September. These factors created a positive backdrop for financial assets, leading to strong gains for both stocks and bonds.
U.S. Economic Growth Remains Strong
The U.S. economy grew 3% in the second quarter, raising the year-over-year (YOY) gain to 3.1%. This is well above the 2.1% average pace of the last 25 years. The key driver behind the economic strength is consumer spending. Consumers are benefiting from several tailwinds noted below:
- Low fixed-rate mortgages have protected homeowners from higher interest rates
- Wage growth has been strong, currently at about 4%
- Inflation continues to decline, increasing purchasing power
- Stock prices and home equity are at all-time highs
- Interest income from bonds and cash is the highest in years
The Consumer Price Index (CPI) for August fell to 2.5%, down from 3.4% at the start of the year. The improvement in inflation gave the Federal Reserve confidence to lower the Fed Funds rate by 0.50% in September. This marks the start of a rate cut cycle that is expected to last through the end of 2025.
While the ISM manufacturing index remains in contractionary territory, the September ISM services sector index rose to a 17-month high. The ISM composite index also reached its highest level since early 2023, indicating that above-trend growth continues. Current estimates for third-quarter economic growth are around 3%.
Stocks Climb to Record Highs
The U.S. stock market weathered major turbulence over the summer before rallying to record highs. The S&P 500 ended the third quarter up almost 6%, lifting year-to-date (YTD) gains above 20%. International stocks produced even stronger results, rising more than 7% for the three-month period.
| MARKET SCOREBOARD | 3Q 2024 | 2024 YTD |
|---|---|---|
| S&P 500 (Large U.S. stocks) | 5.89% | 22.08% |
| MSCI EAFE (Developed international stocks) | 7.26% | 12.99% |
| Bloomberg Aggregate Bond (U.S. taxable bonds) | 5.20% | 4.45% |
| Bloomberg Municipal Bond (U.S. tax-free bonds) | 2.71% | 2.30% |
| Wilshire Liquid Alternative (Alternative investments) | 2.56% | 6.32% |
Source: Morningstar Inc., September 30, 2024.
Though, the path to all-time highs was bumpy. On August 5, the CBOE Market Volatility index surged the most ever in a single day. U.S. stocks dropped more than 3%, which was the worst day for the market since September 2022. The combination of an unwind of the “Yen carry trade,” excessive optimism around technology stocks, and renewed fears of recession all contributed to the losses.
Fortunately, the turmoil ended as quickly as it began. In a matter of days, volatility dropped back to normal levels and stocks fully recovered their losses. Importantly, the rebound in prices was characterized by broad participation across sectors and stocks, an encouraging sign for a market that has been dominated by the largest technology stocks for the past two years.
From a fundamental standpoint, the U.S. stock market’s valuation continues to be rich. At quarter-end, the S&P 500 forward price-to-earnings (P/E) ratio was 21.5. This premium valuation has been supported by strong profit margins and the prospect of lower interest rates. Going forward, it will be crucial for companies to meet or exceed earnings expectations to maintain this level.
During the recent period of volatility for stocks, bonds posted steady gains. This provided a welcomed risk buffer in diversified portfolios. Strong coupon income and modest price appreciation puts bonds on track to make another solid contribution to balanced portfolio returns in 2024.
Labor Market Cools
The jump in the July unemployment rate became a hot topic this summer and raised concerns about a recession. The unemployment rate rose to 4.3% in July from a low of 3.4% in April 2023. When unemployment increases this much, it historically tends to rise further.
Job losses are often the reason behind a rise in the unemployment rate. Fewer jobs mean less spending, which starts a vicious cycle of more unemployment and even less spending. Until something breaks the cycle, unemployment continues to move up. This economic sequence often leads to recession.
But this time around, job gains remained strong while the unemployment rate rose. Average monthly job creation since April 2023 has been 213,000, which is very robust.1
So, what gives? As it turns out, the recent increase in the unemployment rate has been driven by a surge in the number of people entering or re-entering the workforce. When the number of new workers exceeds the number of new jobs created, the unemployment rate rises. This situation is unique, illustrating a reversal of the pandemic-era trend when many chose to leave the workforce.
While the labor market has cooled, it still appears to be sound and consistent with continued economic expansion. That said, the recent rise in the unemployment rate does not appear to be a harbinger of recession.
Federal Reserve Cuts Rates for the First Time
The Federal Reserve has a dual mandate: 1) to pursue maximum employment and 2) to promote price stability. For the past two years, the Fed has focused on the latter, reigning in inflation. After peaking over 9% in 2022, inflation has gradually declined toward the Fed’s 2% target. The August CPI reading was 2.5%. Given the improvement in inflation, the Fed’s focus has shifted to maintaining favorable employment conditions.
Acknowledging the risk to the job market of keeping rates too high for too long, the Fed cut rates for the first time in September. Some viewed the super-sized 0.50% rate cut as a sign of tough times ahead. This is because larger rate cuts have historically been reserved for times when the economy was struggling, or when the country was facing a crisis.
However, the economy appears to be in decent shape overall despite some data weakening. Growth is above trend, the unemployment rate is still relatively low, consumer spending is solid, and inflation continues to move down. In our view, the initial 0.50% cut was a jumpstart to the easing cycle, rather than the Fed’s response to economic weakness
Market Outlook
History shows that market volatility increases in the months leading up to a presidential election. Investors experienced this in August, as U.S. stocks suffered a peak-to-trough drawdown of about 9%. While there were other factors involved, election angst played a role as well. But consider that drawdowns of around 10% happen during most calendar years for one reason or another. Volatility is an inherent characteristic of stock market investing and can be viewed as the price investors pay for access to the strong returns that stocks offer over time.
Political rhetoric will likely continue to escalate between now and November 5. Fortunately, election year uncertainty will end soon. Markets normally rally through year-end once the presidential election is over, irrespective of which candidate wins. However, any positive post-election reaction may be tempered in 2024 since YTD stock returns are already among the strongest ever leading up to a presidential election. Longer term, the balance of power in Congress will be important in determining policy and regulatory changes that could impact markets.
The much-anticipated Fed rate cuts have begun and should continue throughout next year. Rate cut cycles have generally been positive for financial assets, assuming they do not coincide with an economic downturn. With most economic reports continuing to show growth, lower interest rates are expected to provide a tailwind for both stocks and bonds through the remainder of the year and into 2025.
For the last five years, diversified portfolio returns have been powered by above-average gains for U.S. stocks. Much of this excess return has been driven by expansion in the price-to-earnings multiple, which is now toward the upper end of the historical range. This implies that U.S. stock returns should moderate going forward. However, over the same time period, bonds and international stocks have produced below-average results. Conditions are in place that should allow the performance of these asset classes to improve. A more balanced return contribution across asset classes tends to improve the consistency and sustainability of returns over time.
Please contact your Forvis Mazars Private Client advisor if you have questions about your personal portfolio strategy or financial situation. Thank you for your trust and confidence!
- 1Source: U.S. Bureau of Labor Statistics, July 2024.