Economic growth rebounded in the second and third quarters, with real GDP rising 3.0% in the second quarter, and estimates for third quarter GDP currently at 3.2%. Acceleration in consumer spending and a rebound in private inventory investment were the primary drivers of second quarter GDP growth, when compared to the first quarter. Notably, the acceleration in consumer spending was due to consumers spending more on goods, after demand for goods fell in the first quarter.
Fed begins rate cuts
The Federal Open Market Committee (FOMC) cut rates for the first time since 2020 at its September meeting, lowering the Fed Funds rate by 50 basis points (bps). Throughout 2024, Fed rhetoric has shifted from a focus on taming inflation to the softening labor market, as the unemployment rate has increased from 3.7% at the start of the year to 4.1% as of September.
Today, the Fed is trying to get to the elusive “neutral interest rate.” The neutral interest rate is where monetary policy is neither contractionary nor expansionary, and inflation would not be at risk of reheating while full employment is maintained. In other words, it is the necessary level for interest rates to ensure a soft landing by the Fed.
The problem is the neutral rate is impossible to know or observe in real time, it can only be estimated. Due to the lag for monetary policy to affect the economy, we will not know at present whether or not we are at the neutral rate, we need to see future effects on inflation and the labor market. The September rate cut of 50bps was largely expected by rate markets throughout the third quarter, with 2-year treasury falling from 4.8% to 3.7%, and the 10-year falling from 4.4% to 3.8%. This caused a rally in the bond markets, as bond prices move opposite interest rates. The Bloomberg Aggregate Bond index was up 5.3% for the third quarter.
Examining job market data
Rate trajectory sharply reversed after quarter end, following a blowout jobs report released on October 4, showing nonfarm payroll increased by 254,000 and the unemployment rate fell to 4.1% in September. As a comparison, payrolls increased by only 144,000 and 159,000 in July and August respectively.
The report also highlighted that average hourly wages have grown 4% in the twelve months ending September, which is an increase from levels seen earlier this summer. The concern here is that stubborn wages may increase prices in the services sector, which could flow through to the rest of the economy, stoking a return of elevated inflation. The September jobs report ignited fears that the Fed is cutting into an already strong labor market, and sent rates soaring as a result, with the 2-year and 10-year treasury rates increasing 35bps and 25bps respectively.
Historically, it is not layoffs that increase the unemployment rate, but changes in the hiring rate as it becomes harder for people to find jobs. Since 2022, we have seen an increase in the unemployment rate from 3.4% at cycle lows, to 4.1% as of September, but we have seen no increase in layoffs. Investors should not look to layoffs as a sign of imminent recession.
When layoffs increase, the economy is usually well into a recession as layoffs tend to be last resort for companies. The increase in unemployment this cycle has instead come from a decrease in job growth combined with an increase in labor supply as more people have entered or reentered the workforce. Decreased job growth can be seen as a negative, while more people entering the workforce can be viewed as a positive. Despite the impressive September jobs report, the hiring rate still fell to 3.3%, well below pre-pandemic levels of around 4%.
Consumer spending effects
Consumer spending remains the backbone of the economy and will be the factor determining the success of a soft landing. We can view consumer spending as a function of how much we spend versus how much we earn and borrow. As such, it is primarily a function of consumer savings and wage growth.
Today, consumer spending is higher than wage growth because our savings rate is coming down from the peaks accrued during the pandemic. In 2024, consumers saved around 5% of disposable income, much lower than pre-pandemic levels as well as the long-term average of 8.5%.
Investors should not plan on consumer spending continuing to outpace wage growth without a continued reduction in the savings rate. The expectation is for gradual slowing in consumer spending, as spending meets wage growth over time.
Market updates
Despite a few notable but temporary hiccups along the way, markets had yet another strong showing in the third quarter. With a quarterly gain of 5.9%, the S&P500 was able to best its second quarter performance of 4.3% and climb to new record highs.
While overall performance for the index was not radically different from the previous quarter, there were some notable differences when we look under the hood, including some encouraging signs that market performance is broadening out. Most notably, whereas the second quarter was marked by extreme concentration in a handful of large companies related to AI themes, the third quarter showed stronger performance in other corners of the market.
Performance was also more evenly distributed at the sector level. All but one of the 11 sectors (Energy) was positive for the quarter, with eight sectors outperforming the headline index. This was a notable change from the first half of the year, when only Tech and Communication Services outperformed the S&P500. Unsurprisingly, given the lag from these sectors in the third quarter, Value stocks trounced their Growth counterparts, and Small Cap companies handily outperformed Large Caps.
These outcomes may be surprising to market observers who had previously questioned the market’s ability to pull off this transition and continue to power ahead even in the face of notable weakness from its fearless leaders in the Tech space. However, recent performance should be viewed in the context of a macro environment that continues to be quite supportive of asset prices.
Evidence of the relatively supportive macro backdrop can also be seen in sector level performance for the quarter. Utilities and Real Estate were well ahead of the pack, as these types of companies are often considered to be “bond proxies” which tend to benefit disproportionately from falling interest rates. Next in line were classic cyclicals such as Industrials, Financials, and Materials, all of which could be expected to experience fundamental tailwinds in a soft-landing environment. As mentioned, a noticeable absence from the list of traditionally cyclical outperformers was Energy. This coincided with pronounced weakness in oil prices. To the extent that lower energy prices can be thought of as a tax-break for consumers and most businesses, this was a bit of a welcome development for the economy.
Conclusion
While it is encouraging to see the broadening of strong market performance to other sectors and asset classes, investors should be mindful of the fact that third quarter performance was robust despite ongoing geopolitical risks. Geopolitical risks remain elevated at a time when market valuations are not particularly attractive, and it is far too early for the Fed to take a victory lap.
To illustrate this sentiment, we do not have to look much further than one of the best performing assets for the quarter: Gold was up over 12%, bringing its year-to-date gain to almost 30%. Gold tends to do well during periods of economic uncertainty. Its recent strength stands as a subtle reminder that the world is an unpredictable place and that latent sources of volatility can rear their ugly head at any time. However, by implementing a disciplined approach to diversification and keeping the focus on long-term investment goals, investors can navigate the short-term pitfalls and risks inherent in any market regime.
Matt Kelley is Chief Investment Officer, Cooper/Haims Advisors, an ESL company. In his role, Matt is responsible for institutional account portfolio management and oversees the portfolio strategy team, while supporting the broader ESL wealth entities.
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.
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