Market Navigator – September 2024 edition

A Volatility Shock

After starting August with an epic spike in volatility on the heels of weaker economic data and concerns about a potential policy error by the Federal Reserve (Fed), interlaced with an unwinding of the yen carry trade, stocks had a V-shaped recovery to finish the month in positive territory.

Indeed, as the month progressed, economic data improved, and corporate commentary, such as from Walmart’s CEO, suggesting the consumer was more value conscious but not fraying, helped aid the market’s recovery. Moreover, Fed Chairman Jerome Powell teed up a September interest rate cut, outlining a clear shift in the committee’s focus to supporting the labor market given the progress made toward its 2% inflation target.

That said, there was a notable shift in market leadership, with defensive sectors outperforming and the 10-year U.S. Treasury yield dropping below 4%, far from the 4.7% high seen in late April.

Aftershocks and a sloppy transition

Kicking off September, markets are again on edge. Indeed, volatility shocks tend to linger and are often followed by aftershocks.

Moreover, whether the economy is simply cooling but still growing, which is our base case, or something more sinister is underway, the transition period tends to look very similar with an abundance of mixed data points.

“There has been a wide divergence in the S&P 500’s one-year forward returns following the first Fed rate cut, with stocks up double digits when the economy is expanding versus generally down when it has fallen into recession.”
 

• Notably, there has been a wide divergence in the S&P 500’s one-year forward returns following the first Fed rate cut, with stocks up double digits when the economy is expanding versus generally down when it has fallen into recession.

• Thus, this is part of the reason why each economic report is being heavily scrutinized and, in our view, over-extrapolated.

And in a bit of déjà vu, markets started September the same way they started August—on the back of a weak ISM Manufacturing report and the Technology sector under renewed pressure. Keep in mind, the manufacturing survey has been in contraction in 21 of the past 22 months, a period where the overall economy remained solid. Thus, it has not been a great barometer for the broader economy.

Still, the market finds itself in a seasonally challenging period, as almost every investor has heard by now, and we tend to see a spike in volatility ahead of the election. Moreover, after previous periods where the S&P 500 was up 9 of the previous 10 months, such as what just occurred, the next month was up only 33% of the time. Thus, choppiness of late is not unusual or unexpected.

Our base case is the bull market trend remains intact, yet the choppier waters we have been writing about are set to continue.

• The good news is the probability of positive returns following previous monthly streaks greatly improves over the next 3 to 12 months and the strong participation we saw during the August rebound tends to be a positive intermediate signal for markets.
• At the same time, forward corporate earnings estimates have moved to yet another record high, and a global monetary easing cycle is underway. Financial conditions have also eased with the pullback in interest rates, energy prices, and the U.S. dollar. 

Elections will come to the forefront and cause a degree of investor angst. Elections matter; however, from a market perspective, our work strongly indicates that other factors, such as the business cycle, monetary policy, corporate profitability, the future of Artificial Intelligence, and global forces collectively tend to matter more.

In fact, our work shows that staying invested regardless of whether a Democrat or Republican is in office greatly outperforms only investing when one party or the other is in power. 

Tactical positioning

From a global asset allocation standpoint, we continue to have a modest equity bias, a preference toward the U.S. and large caps, and remain focused on high quality within fixed income.

U.S. economic trends, while cooling, still appear stronger than most of the globe. Weakness in technology stocks, which we upgraded during the early August selloff, is among the biggest risks to our outlook. However, most of the tech selloff to start September follows a strong rebound from the August low and a bar that was hard to surpass on a short-term basis.

That said, performance for the sector is far from bubble territory, and earnings trends relative to the broader market remain robust. In a cooling economy, we expect investors will continue to pay a premium for these names, but it will likely be a bumpy near-term path as the market awaits the next catalyst.

Small caps’ relative performance may improve near term, but longer term we still prefer large caps. Small caps are a greater beneficiary of lower short-term rates, and valuations are cheap. However, historical trends after the first Fed rate cut are mixed, earnings trends are still weak, and a cooling economy is historically a headwind for the asset class.

On the fixed income side, the good news is bonds are acting like bonds again. Indeed, during the S&P 500’s 8.5% intra-period decline, core fixed income delivered its best performance relative to other equity corrections since mid-2020 and highlighted the value of portfolio diversification. And, given the cooling economy, we would stick with high quality fixed income to provide portfolio stability and income.

We still see diversification benefits from modest positions to gold and commodities. Gold price trends remain positive, moving to an all-time high on the back of lower interest rates, central bank buying, recent U.S. dollar weakness, and continued fiscal imbalances.  However, our diversified commodities position has been lackluster, owing partly to the slowing global economic backdrop. Still, with energy prices at the lower end of its recent range and geopolitical risks still elevated, we are sticking with it for now.

As always, we will continue to follow the weight of the evidence and keep you informed as our views evolve.