Q3 recap: continued market appreciation, coupled with volatility and new Fed movement.

The major development in 3Q24 was the Federal Reserve’s decision to cut interest rates by -0.50%, the first rate cut of this cycle. It came as the Fed shifted its focus, with unemployment rising to a 33-month high and inflation moving back to target. In the equity market, stocks ended the quarter higher despite some turbulence, including a brief but sharp sell-off in early August. The S&P 500 posted its fourth consecutive quarterly gain and ended September near an all-time high.

In 3Q24, the Fed started the process of normalizing interest rates after a volatile five years. The Fed cut interest rates to near-zero during the COVID pandemic to support the economy, and it kept rates near 0% until March 2022. From March 2022 to July 2023, the central bank raised rates by +5%, one of the largest and fastest rate-hiking cycles in recent decades. The Fed held interest rates steady for over a year as it waited for inflation to return to its 2% target, and after 14 months, it started the rate- cutting cycle with a -0.50% cut at its September meeting.

The Fed’s transition to cutting interest rates comes as its focus shifts from lowering inflation to supporting the labor market. Since the last rate hike in July 2023, inflation has dropped from 3.3% to 2.6%.

However, over the same period, unemployment has risen from 3.5% to 4.2%, the highest level since October 2021. The key question for the Fed and investors is what the labor market softening over the past year represents. Is the labor market simply normalizing after experiencing significant disruption during the pandemic, or is it an early sign of weakening labor demand?

Investors expect the Fed to cut interest rates at its two remaining meetings this year, with further reductions expected throughout 2025. The market expects an additional -0.50% of rate cuts by the end of this year, followed by another -1.50% by the end of 2025. History indicates the actual timing and amount of rate cuts will depend on the economy’s path. A weaker economy would justify more rate cuts, while a stronger economy could require fewer rate cuts.

Higher interest rates appear to be weighing on manufacturing, housing, and loan growth. However, the main engine of the economy, the consumer, continues to spend. The data suggest that the current level of interest rates is restrictive, and the Fed’s goal in lowering rates is to stimulate interest-rate-sensitive sectors and prevent a deeper slowdown. Economists will monitor these data points in the coming months and quarters to gauge the impact of the Fed’s interest rate cuts on the economy.

In early August, the stock and bond markets experienced significant volatility. Signs of investor angst started to appear during earnings season in July, when investors raised concerns about the high costs of developing artificial intelligence (AI) and whether future revenues would justify the expensive investments. A few weeks later, investors were spooked as unemployment rose from 4.1% to 4.3%. Investors worried the Fed had waited too long to cut rates and risked tipping the U.S. economy into a recession that could be hard to reverse.

This sudden surge in market volatility caused investors to sell stocks and buy bonds, leading to a significant deleveraging event across global financial markets. The S&P 500 traded down nearly -8% from mid-July through the first week of August. However, the volatility was short-lived, and the S&P 500 rebounded to end August with a modest gain. There was some residual volatility in early September as investors returned from summer break, but the S&P 500 again recovered quickly and set a new all-time high later in the month. The rise in market volatility marks a significant shift from the past 12 months of steady S&P 500 gains, but so far, investors have brushed it aside.

Despite the volatility, the S&P 500 set multiple new all-time highs in 3Q24, adding to its list of new highs from earlier in the year.

However, it was the change in stock market leadership that made headlines. The Equal-Weighted S&P 500, the Russell 2000, and the Value factor all outperformed the S&P 500, while the Growth factor underperformed. The Technology sector lagged the market rally, ending the quarter flat after outperforming in the first half of the year.

Two key events, the Fed’s first interest rate cut in September and growing concerns about AI’s profitability, led to the change in market leadership in 3Q24. In the first half of 2024, uncertainty around Fed policy and concerns about the economy pushed investors toward large-caps and AI stocks. Meanwhile, smaller companies underperformed due to worries about their sensitivity to higher interest rates. With the Fed now officially cutting interest rates and doubts emerging about AI’s monetization potential, investors sought out new investment opportunities in 3Q24.

International stocks outperformed U.S. stocks in 3Q24 for the first time since 4Q22. International stocks benefited from two themes: a weaker U.S. dollar and AI companies’ underperformance during the stock market rotation. However, despite outperforming in 3Q24, the two major international indices are still underperforming year-to-date due to their lack of exposure to AI stocks.

In 3Q24, bonds traded higher as investors prepared for the start of the Fed’s rate-cutting cycle. The 10- year Treasury yield fell from 4.37% at the end of June to 3.79% at the end of September. The 2-year yield, which is a proxy for investors’ rate cut expectations, fell from 4.72% to 3.64% over the same period.

CCC-rated bonds, the lowest-rated and most sensitive to economic conditions, produced a total return of over +11% as corporate credit spreads tightened. The group’s outperformance suggests that investors expect interest rate cuts to stimulate economic growth and make refinancing easier. On the other end, AAA-rated bonds, the highest quality and most sensitive to interest rate changes, gained over +6% as the market priced in the first rate cut and yields fell. Together, the two groups’ outperformance indicates that investors expect rate cuts to boost economic growth and relieve pressure on highly leveraged companies.

Credit spreads remain tight by historical standards. The investment grade (IG) spread stands at 0.92%, meaning that investors are earning an extra +0.92% of yield by owning IG over similar Treasury bonds. Since 2004, the median IG spread has been 1.35%. The situation is similar for HY bonds, where the current spread is 3.14% compared to a median of 4.37%.

The takeaway is that corporate bond investors are receiving less yield compensation for taking on corporate credit risk compared to the past 20 years. Credit spreads are often used to gauge financial conditions and investor sentiment toward the economy. Today’s tight spreads signal economic stability, strong market liquidity, investor willingness to buy risky assets, and low perceived default risk.