As the journey to economic normalization nears its end, the capital markets responded in kind by posting strong returns for both the third-quarter, and year-to-date periods. In fact, year-to-date returns for equities were the strongest they’ve been since the late 1990s.
Many indexes, including some in the fixed income arena, actually outperformed the S&P 500 for the quarter, delivering broader returns that we believed would eventually occur.
Equity returns posted positive results every month this quarter despite some ups and downs influenced by jobs reports, the Asian markets sell-off in early August, and ultimately, the Fed lowering interest rates in September.
Bonds tallied positive returns, as US Treasury yields proved a mirror image to stock prices by declining each month in the quarter.
And interest rates remain at the center of asset returns, driven by the trio of economic growth, inflation and the labor markets. The Fed’s concerns relating to the first two have waned, and we expect their primary focus will be on the health of the jobs market.
That is because we’ve seen meaningful improvement on the inflation front. Specifically, goods prices—everything from detergent to automobiles – have actually been disinflationary for over a year. Services prices have started trending down, but they remain a major contributor to inflation.
Primarily, that’s because Shelter is a major component within Services. Even here, the key indicators are moving down, but the CPI rent component lags home prices by over a year, so it will take some time to realize the full benefit of this in the data.
Refocusing on the labor markets, the Fed will closely monitor conflicting signals such as declining hiring rates and layoffs remaining low and stable, as a gauge for future policy-moves.
Also, good labor markets translate into a healthy environment for consumers. We see that in such areas as take-home pay that remains strong and retail sales residing at pre-pandemic levels.
Collectively, this allowed the Fed to lower interest rates by 50 basis points, with their expectations of future rates cuts aligned more closely with market participants.
As goes the economy, so goes profits. While we saw an improvement in recent earnings growth, future expectations look more modest.
In part, this is due to a sharp decline in future earnings growth expectations for the Magnificent Seven. Instead, we’re expecting a more noticeable level of improvement for the “magnificent others.”
Considering this changing landscape, investors need a keen eye to find attractively priced opportunities with favorable earnings potential.
Examples include various industries within the healthcare and consumer sectors. For instance, specialty retailers and medical device companies.
Global infrastructure spending is driving yet more opportunities. Research estimates that this spend will increase substantially – and for many years.
One notable area relates to the upgrading of the world’s energy systems, which in some regions are over 150 years old.
With the prospect of lower interest rates, dividend-growth stocks stand to be a beneficiary of central bank normalization moves.
In past rate-cutting cycles, those companies with high and growing dividends outperformed the market by over 3 percent. And if we exclude the stress of the global financial crisis, the outperformance was nearly 12 percent.
Another interesting area goes beyond US borders. International stocks are not only a less-crowded trade, but earnings momentum looks attractive. While S&P earnings remain at a higher absolute level, the current rate of change for international stocks is greater.
Falling interest rates are favorable for bond investors as well. And we think time is of the essence to capitalize on this attractive yield environment.
While spreads for high yield bonds are currently low, their yield is still above the long-term historical average.
And history has often shown that the starting point of the yield to worst has been a good indicator of subsequent five-year returns.
Beyond U.S. high yield, other sectors that we favor are US Investment Grade, emerging market US dollar-denominated corporates and high-yield, as well as select securitized bonds.
We believe the normalization process is at the final stage, and with rates expected to go lower, select opportunities remain. Look to take advantage of equity areas where valuations are compelling, and earnings growth prospects appear attractive. In the fixed income markets, rates are still high, and the return streams should likely be rewarding as central banks continue to ease.
Thanks so much and we'll see you next quarter.