The Federal Reserve answered the long-awaited question of when it will start its easing process, and more crucially, by how much. Last week, the Fed announced a notable 50 basis point rate cut, with Chair Powell and the FOMC emphasizing their intent to avoid falling “behind the curve” in terms of easing. While the outcome—whether the economy will experience a “soft or hard” landing—is still uncertain, the markets reacted positively to the decision. Steady progress on inflation, slowing payroll growth, and an unexpected rise in the unemployment rate convinced policymakers it was time to ease up on monetary tightening. Although growth remains robust (with the Q3 Atlanta Fed GDPNow still projecting a 2.5% pace), we are closely monitoring signs of slowing economic indicators.

The Economy

With a plethora of data points out there that relate to growth, labor markets, and inflation, it can be tempting to focus on just one or two to create a story on the direction of the economy. However, when we step back and examine all the data in their entirety, the picture is one of an economy in expansion. Real GDP grew at an annual rate of 3.0% in Q2 and is projected to grow another 2.5% in Q3, according to the Atlanta Fed’s GDPNow model. The Federal Reserve anticipates solid growth powered by strong consumer spending for the rest of the year, with overall growth of 2.0% in 2024.

The unemployment rate has risen over the last several months, causing some fears over the direction of the labor market. However, unemployment remains very low when we examine it in a historical context. The unemployment rate hit a multi-decade low of 3.4% in mid-2023 as employers quickly snapped up workers coming out of the pandemic. Since then, the unemployment rate has slowly crept higher, reaching its current level of 4.1%. Consumer confidence surveys and job openings data point to a labor market that has normalized, with jobs harder to find than they were in 2022 and 2023. However, layoff data and initial unemployment claims indicate layoffs have not risen much over the course of the year. Taken together, the labor market has likely returned to a more neutral position where jobs are not overly plentiful, but layoffs are not escalating.

On the inflation front, price pressures have continued to subside over the last few months. The August Consumer Price Index (CPI) showed inflation expanded just 2.5% over the past 12-months, the slowest rate of increase since February 2021. Prices for goods and energy declined over the past year, with goods prices falling 1.9% and energy prices declining 4.0%. Food prices showed modest growth, with prices expanding 2.1%. The stickiness in inflation remained in services, which includes shelter, transportation, and insurance. Shelter inflation, which encompasses both homeowners and renters, expanded 5.2% year-over-year.

In summary, the economy continues to expand, the labor market has normalized, and inflation is easing. The economic soft landing the Fed desires appears to be progressing, for now. Risks do remain, however, to both the upside and downside. Recent rate cuts from the Fed paired with solid economic growth could cause inflation to re-accelerate, a scenario which happened roughly fifty years ago in the 1970s. This could force the Fed to pause rate cuts, or even reimplement rate hikes, to combat inflation. The other scenario is the labor markets weaken further, weighing on consumer sentiment and spending. This could cause the economy to dip into recession, forcing the Fed to cut rates significantly at a rapid pace. While neither of these scenarios are our base case, we will continue to watch growth, employment, and inflation data to decipher where we are in the economic cycle.

The Federal Reserve

The Federal Open Market Committee slashed rates by 0.5% in their September meeting, lowering their policy rate from 5.3% to 4.8%. The move came as inflation data eased and labor market data softened, prompting the Fed to shift its focus from price pressures to employment. The cut ended fourteen months of inaction from the Fed, with the last policy move being a hike in July 2023. It also marked the first cut from the Fed since its oversized emergency cut during COVID in March 2020.

The Fed’s dot plot, an aggregation of the committee members expectations for the policy rate, showed the Fed expects to cut two more times in 2024, and another four times in 2025. Under such a scenario, the short-term rate would end 2024 at 4.4% and 2025 at 3.4%. Accompanying the dot plot were the Fed’s projections for growth, employment, and inflation over the next several years. The committee is forecasting respectable real GDP growth of 2.0% in both 2024 and 2025. However, they did raise their unemployment rate forecast to 4.4% for both years, highlighting the softening seen recently in labor markets. Finally, the Fed sees price pressures easing back to target over the next two years, with inflation ending 2024 at 2.3% and 2025 at 2.1%.

Much like at the beginning of the year, the market is more dovish than the Fed. Futures contracts are pricing in three more cuts this year followed by another six cuts in 2025. This would bring the policy rate down to just 3.0% by the end of next year. Under this scenario, it would be likely that the labor market softens more than expected, prompting the Fed to rapidly cut to avoid a recession.

While market pundits will undoubtedly argue over the size and pace of rate cuts over the coming fifteen months, we believe the big relief for markets over the next several quarters will simply be the fact that an easing cycle has started. A recent poll of CEOs and CFOs of public companies showed their biggest worries for the near future where interest-rate policy and the November election. With the Fed now on the move lower and the election coming up in just four weeks, it seems that both worries will be behind C-suite executives in the coming months.

The Election

Americans will be heading to the polls in one month’s time to decide who will be president for the next four years. They will also be voting to decide who will represent them in the House of Representatives and Senate. The results of the election will have consequences on fiscal and foreign policy over the coming years, which in turn could impact markets.

The two most immediate issues are tax and trade policy. The Tax Cuts & Jobs Act (TCJA) is set to expire at the end of 2025, which would see income tax rates increase back to their pre-TCJA levels. Trump has pledged to extend the expiring provisions while Harris is likely to let tax rates shift back to where they were pre-TCJA. Harris has also called for raising the corporate income tax from 21% to 28% while Trump has called to lower it further. On trade, Trump has called for a 10% across-the-board tariff while Harris will likely follow the same trade policy implemented under Biden. It is likely that both candidates will maintain a tough-on-China stance when it comes to trade.

Longer-term the focus could shift from more immediate policies to issues surrounding fiscal spending. The U.S. will run close to a $2 trillion dollar deficit in 2024, amounting to roughly 6% of GDP. The federal debt has surged in recent years as the government borrowed to stimulate the economy during the pandemic. The debt load has recently surpassed $35 trillion and now equals around 100% of GDP. The Congressional Budget Office projects debt will continue to grow in the coming years, reaching 130% of GDP in 2040. While the size of the deficit and debt load are manageable for now, the fiscal path the U.S. is currently on is unsustainable in the long run.

Ultimately, elections are typically seen as clearing events for the market. The uncertainty leading up to the event causes volatility, but once the event passes and the outcome is known, volatility subsides. The long-term performance of markets tends to rely more on corporate, economic, and monetary factors rather than political. This explains why average market performance is roughly the same regardless of who controls the White House and Congress. While investors are entitled to their political opinions, they should not let those opinions drive investment decisions. Sticking to a financial plan and making objective decisions will reward patient investors over the long term.

Equities

US stocks put together another solid quarter with the S&P 500 rising 5.8%. The market environment shifted the past three months, with value and small cap stocks outperforming growth stocks. The Russell 1000 Value and Russell 2000, indexes for value and small cap stocks, rose 9.4% and 9.3% this quarter. Buoyed by the exploding demand for artificial intelligence solutions, technology stocks have significantly outperformed over the past two years. However, value and small cap stocks benefited this quarter from declining interest rates and broader earnings growth. One quarter does not make a trend but a declining interest rate environment, rising corporate earnings, and high valuations among technology and communications stocks could support a continued broadening out of performance throughout the rest of the year. With that said, the starting valuations in U.S. equities are well above historical averages, indicating caution and a focus on defensive, quality companies are warranted.

Earnings growth continued this quarter with companies reporting an 11% year-over-year increase in profits. This marked the highest growth rate since Q4 2021 when the economy was rebounding from the COVID pandemic. Earnings growth was strongest in utilities and technology stocks as increased energy use for data centers and demand for semiconductors drove earnings for these two sectors higher. More cyclical sectors like industrials and materials reported weaker earnings as commodity prices fell and demand for durable goods shrank after elevated spending in 2021 and 2022. Looking ahead, analysts are predicting 10% earnings growth in 2024 followed by 15% growth in 2025. Both growth rates are above long-term historical averages and highlight the optimism among equity investors that the Fed can achieve a soft landing.

Fixed Income & Alternatives

Interest rates dropped this quarter as the market adjusted to decelerating inflation and rate cuts. The 10-year U.S. Treasury yield fell 55 basis points over the second quarter to end the period yielding 3.8%. The decline in rates lifted bond prices, leading to a 5.3% return for the Bloomberg U.S. Aggregate Bond, an index of taxable debt, and a 2.7% return for the Bloomberg Municipal Bond, an index of tax-exempt debt. Despite the recent drop in yields, forward looking returns for fixed income are still at some of the highest levels in the past fifteen years. Investors looking for income and diversification from equities should be well served investing in fixed income at current levels.

With the democratization of alternatives well underway, we continue to review alternative asset products for inclusion in portfolios. When allocating to alternatives, we look for products that can provide adequate levels of income or capital appreciation, with lower relative volatility and limited correlation to public markets. We continue to like private credit which offers double digit percentage yields with very low volatility. The coming market environment also sets up well for private real estate, which should see rising property values as interest rates move lower. We intend to continue researching alternative assets in the hopes of finding solutions that will enhance client portfolios from both a risk and return perspective.

Conclusion

Various uncertainties exist in the short- and intermediate-terms, both in geopolitics and global tension. Stock markets have historically experienced greater volatility leading up to U.S. Presidential elections. In addition, escalations in the Middle East and continued conflict in Eastern Europe could add to market swings, particularly in commodities and materials. However, the current economic landscape in the U.S. suggests cautious optimism. The Federal Reserve’s recent rate cut signals a pivotal moment in monetary policy, reflecting a balanced approach to managing economic growth and inflation. The combination of steady GDP growth, a normalizing labor market, and easing inflation creates a framework for potential stability. Vigilance will be essential as we navigate the intricate interplay of economic indicators and external factors. As we move into the final quarter of the year, staying informed and adaptable will be key. Our focus will remain on diversification, protection, and a disciplined approach, while searching for opportunities.

– The Aurdan Capital Management Team

IMPORTANT DISCLOSURES

The views, opinions and content presented are for informational purposes only. The carts and/or graphs contained herein are for educational purposes only and should not be used to predict security prices or market levels. Advisory services offered through Aurdan Capital Management, LLC., an Investment Adviser registered with the U.S. Securities & Exchange Commission. The information presented in this piece is the opinion of Aurdan Capital Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but we cannot guarantee the accuracy or completeness of the information, no liability is accepted for any inaccuracies, and no assurances can be made with respect to the results obtained for their use.  The information contained herein may be subject to change at any time without notice. Past performance is not indicative of future results.

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