Stocks and bonds gained ground during the third quarter despite significant volatility on several occasions. U.S. equities rallied as small cap stocks led the way and value broadly outperformed growth in domestic stocks. Elsewhere, emerging markets performed well and were supported by the announcement of new stimulus measures in China. In bonds, long-awaited rate cuts from the U.S. Federal Reserve, and more expected to come, provided a tailwind for fixed income. As we look forward, economic data has been resilient, and we expect that the focus will now turn to labor markets and consumer spending results in the third quarter. For stocks, we expect positive but slower earnings growth and continued volatility. In bonds, with the Fed’s easing cycle underway and more rate cuts expected, we want to focus on yield from our fixed income positions.
Economics/Geopolitics:
The biggest story of the third quarter was easily the Federal Reserve’s (Fed) historic half-percent (0.5%) rate cut at the September meeting, the first rate cut in four years. After macroeconomic data indicated that inflation was easing and the labor market was continuing to cool, the Fed went bold, actually shifting focus to the labor market and signaling they are committed to full employment and avoiding a pronounced slowdown. The geopolitical landscape remained dynamic, highlighted by a French parliamentary election, rising tensions in the Middle East and President Joe Biden dropping out of the Presidential race in favor of Vice President Kamala Harris.
Domestic Stocks:
After sharply underperforming during the second quarter, small caps produced their second-best quarter since early 2021, while outperforming their large cap counterparts. The Russell 2000 small cap index advanced 9.3% in the third quarter while the Russell 1000 large cap index added 6.1%. Except for energy, all sectors rose across the Russell 2000, led by a 39% rally in telecommunications and strong gains in real estate, financials, and utilities. Higher rates are historically not favorable for small caps, however, the September Fed cut and further monetary easing on the horizon could help the asset class. Turing to year-to-date numbers, both asset classes have printed solid gains; however, large cap equities continue to dominate small caps by nearly 10% based on the Russell Indexes. Volatility for both large and small cap stocks is expected to continue through year end, amid Fed policy decisions and the upcoming U.S. Presidential election.
Earnings were broadly healthy, as the S&P 500 saw the strongest earnings growth since the fourth quarter of 2021. Approximately 80% of S&P constituents beat estimates, topping the five-year average of 77%, with only 67 companies delivering negative guidance – the lowest since the fourth quarter of 2022.
Bonds:
Core bonds (investment grade) were up over 5% for the quarter, proxied by the Bloomberg U.S. Aggregate Index. Bond prices rose ahead of the Fed’s mid-September rate cut; however, prices steadied post-cut as yields inched higher. The bond market’s expectation for the September cut resulted in yields trimming losses, as the bond market expects further cuts over the next 12 months. The updated Fed dot plot, which illustrates committee member’s rate expectations, also indicated continued policy easing throughout 2025.
High-yield corporate bonds the most credit sensitive sector of the bond market, nearly mirrored the returns of U.S. Treasuries, the most rate sensitive sector. After recent outperformance due to a cooling economic environment and reinforced expectations for a soft landing, the Bloomberg U.S. High Yield Index gained 5.3%, only slightly outperforming the Bloomberg U.S. Treasury Index’s 4.7% return. Additionally, the Treasury yield curve steepened notably, while the two- and ten-year yield spread dis-inverted for the first time since mid-2022.
International Markets:
International equities outperformed their domestic peers as the MSCI EAFE Index rose 7.3%, compared with the S&P 500’s 5.9% return. Emerging markets (EM) delivered another solid quarter, once again outperforming their developed country counterparts and the S&P 500, as the MSCI EM Index returned 8.9%.
Europe overcame market jitters around the French parliamentary election to start the quarter, in which the left-wing alliance recorded a surprise win, although no single party secured a working majority. Central banks were active, headlined by the European Central Bank (ECB) cutting interest rates another 0.25%, with central banks in Switzerland and England following suit.
Asia was also a focal point for global markets. The Bank of Japan (BOJ) raised interest rates to a 15-year high, leading to the unwinding of yen carry trades and sparking a brief global market selloff in early August. Chinese stocks boosted EM with a late September surge following an aggressive economic stimulus package aimed at rejuvenating the weakening economy.
Outlook:
Economic data has indicated the overall economic growth is holding up and recession concerns have eased; however, the focus now turns to labor market dynamics and consumer spending results. As investors, we are preparing for the following:
- Measurable labor market cooling. While companies have continued to add payrolls, employment demand is slowing, and weaker full time employment data signals some fourth quarter employment reports could be soft, although not cratering.
- Contained inflation. Price increases have broadly decelerated but continue to inch higher, and the impact on consumer prices will take time.
- More Fed cuts likely on the way. With inflation contained and the Fed’s focus shifting to the labor market, a higher unemployment rate and fewer hirings will likely pave the way for future rate cuts.
The stock market’s strong first half continued into the third quarter, receiving a boost from the bold and long-anticipated Fed rate cut. As we look ahead to the fourth quarter, we are watching the following in equity markets:
- Positive, but slower earnings growth. After the S&P 500 delivered a record-breaking earnings cycle last quarter, consensus forecasts indicate that earnings growth will be positive, but at a much lower rate.
- Volatility is expected. Volatility will likely remain elevated in the coming months as the market waits for more clarity on the economy, elections, and a better seasonal setup.
In fixed income, with the Fed’s easing cycle underway, more rate cuts are on the horizon. While a shifting rate environment can lead to volatility, for the bond market it’s what’s priced in that matters. We are considering the following:
- Current bond yields remain attractive. Despite the 0.5% cut in September, yields have held steady or even moved higher. This move reflects that the bond market already priced in a fairly aggressive rate cutting cycle.
- Focus on income. Historically, fixed income returns primarily come from the income component, and with income levels still relatively attractive, we are considering clipping coupons rather than holding cash.
We continue to constantly evaluate the market to ensure that clients portfolio positions are aligned with our outlook. If you have questions about the market or your portfolio, please reach out to our team.