October 2024: Volatility increases on changing expectations of rate cuts and election uncertainty

October 2024: The month at a glance

Solid economic reports throughout the month with little change in inflation caused investors to recalibrate expectations of the speed and magnitude of the Fed's rate cutting path. Futures markets are now pricing in both fewer rate cuts and a higher ending rate for this cycle than in September.^[1] This shift dragged down both stock and bond returns and added volatility during the month. While equity markets have historically paid little attention to which party occupies the White House, additional market volatility came from investors positioning themselves for the outcome of what is projected to be an extremely close presidential election.

• US real GDP rose 2.8% in Q3, down slightly from 3% in Q2.^[2]
• The Core PCE price index was up 2.7% in September from a year ago.^[3]
• The unemployment rate remained at 4.1% despite weak job gains on strike and hurricane impacts.^[4]
• Stocks ended the month on a weak note as Q3 earnings were mixed for some bellwether tech companies.
• Equity market volatility increased on heightened focus on earnings and the election.
• Interest rates have moved up since the Fed rate cut in September.

Not so fast (or so low)

There has been a relatively significant shift in the expectations on future Fed rate cuts after the 50 basis point cut in September.  Investors now seem to be back to pricing in a “higher for longer” rate environment. Indeed, the Fed’s own projections show the expected end point of this rate cutting cycle will be a Fed Funds rate of between 2.75 and 3% by the end of 2026.^[5] That would be 250 more basis points of cuts spread over a much longer period than expected a few months ago. As a result, interest rates moved up for all but the shortest maturity Treasuries, with the two and 10-year rates up over 50 basis points over the month.^[6] Still, the Fed has clearly said that this path is data-dependent and that if the economy weakens (notably employment, part of the Fed’s “dual mandate”), they have room to act more aggressively. 

The Fed is projecting a more gradual decline in interest rates because economic growth remains relatively solid across several measures, and inflation, while still above target, is not showing signs of reigniting. Advanced estimates of Q3 real GDP growth in the US showed a moderating, but still healthy, 2.8% annual rate of change.^[7] Consumers have continued to spend, with retail sales for September up 0.4% from August and 1.7% from a year earlier.^[8] Consumer confidence also jumped in October, with a more positive outlook on the job market and the economic outlook overall.^[9] The number of jobs increased by only 12,000 in October, reflecting a continuation of the slowing in labor markets but also the impacts of the strike at Boeing and hurricanes Helene and Milton.^[10] At the same time, progress on inflation moderated and still remains a key concern for consumers. The headline Personal Consumption Expenditures (PCE) price index was up 2.1% from a year earlier, down from 2.3% last month, but the core (excluding food and energy) index that the Fed focuses on was up 2.7% in September from a year ago, the same rate as the prior two months.^[11]

The reduced expectations for aggressive rate cuts weighed on both stock and, especially, bond returns in October. In addition, there was concern that the economic growth has become more uneven, with job gains coming from relatively few sectors and consumers beginning to shift expenditures to lower-cost items. Finally, the expected tight presidential election has added another element of uncertainty as investors position themselves for policy changes that could impact taxes, trade and immigration, and regulation.

Stocks pull back from record levels 

After hitting record levels early in the month, equity markets ended October with a sharp sell-off in the last two days. After leading the way for most of the month, the US large cap growth and tech stocks fell the most in the final days on mixed Q3 earnings results. Microsoft and Meta were the culprits on the last day of the month as their results suggest sharp increases in AI investment costs, which disappointed investors.^[12] Given their lofty valuations, anything other than perfection in both the current results and guidance going forward risks downward pressure on prices. Still, technology stocks fared relatively well for the month, while sectors more sensitive to rate cuts, including small cap and international stocks, lagged.

• With the significant declines on the last two days of the month, all major indices posted negative returns for the month.^[13]
• The NASDAQ posted the least negative returns, but the broader S&P 500 Growth index shows the largest gains for the year.^[14]
• Small cap stocks trailed large cap stocks in both the US and internationally.^[15]
• Developed and emerging international markets trailed US stocks for the month.^[16]
• China’s equity market slipped 5.91% after surging in September.^[17]
• US sector performance:^[18]
  • Financials led the way in October on the back up in rates.
  • Communications Services and Energy were the only other positive sectors.
  • Cyclical sectors had the weakest returns for the month.

Fed cuts, but rates rise

After the Fed lowered the short-term policy target rate by 50 basis points in September, interest rates rose across all but the shortest-maturity bonds in October. Both 2 and 10-year Treasury yields increased over 50 basis points over the month.^[22] Much of those gains were the result of investors understanding that the continued strength in the US economy would cause the Fed to not be as aggressive cutting interest rates. The change in expectations for that path necessitated a repositioning of longer maturity rates that were aligned with faster, deeper cuts this year. The rising rates hurt fixed income performance across the board.

• Fixed income returns fell in all segments except ultra short duration treasuries.^[23]
• Higher risk preferred stocks and high yield bonds held up relatively well and continue to have the highest returns for the year.^[24]
• International bonds declined most for the month with sovereigns showing the greatest weakness.^[25]

Tech dominates earnings and returns

The sell-off in equity markets on the last two days of the month was closely connected to Q3 earnings reports from several of the largest US technology companies. Going back over a year, a small set of these companies, the “magnificent 7”, have accounted for an unusually large share of the gains in the US equity market. The substantial price increases relative to other companies have been accompanied almost equally by substantial earnings gains relative to the rest of the market. Still, the expectations built into the high prices for these companies leaves little room for slowing in current or projected future growth. They are indeed “priced for perfection”.

The chart shows how the Magnificent 7 companies accounted for essentially all of the earnings growth for the S&P 500 for the year ending September 30, 2024. While this discrepancy in fundamentals at least partly explains the massive differences in stock price performance between the 7 and the other 493 stocks in the S&P 500, the lack of breadth in the market is remarkable. It also underscores why investors would be so hyper-focused on the earnings results and projections for these companies. A more equitable contribution of returns across the entire S&P 500 will require more equitable earnings growth. Encouragingly, as the chart also shows, analysts forecast that the other 493 stocks in the S&P 500 will start to close the earnings growth gap with the Magnificent 7. The 7 stocks are expected to continue to deliver outsized earnings growth, but that is likely already reflected in their stock prices. If the forecasts for the other 493 are realized, then we would expect less dispersion in returns between the two groups. That would be a healthy development for the US stock market.

Staying invested beats politics

As what looks to be an especially tight presidential election draws near, investors and market commentators have naturally turned some of their attention to the investment implications of the outcome of the election. While the policy differences between the two candidates are interesting to dissect, the market has historically not been influenced by which party occupies the White House. As the chart shows, it just hasn’t been a good bet to move money in and out of the equity markets based on politics. Other views paint a similar picture: In the 12 months after each of the 10 elections since 1984, the S&P 500 has returned an average of 17.6%.^[27] Five of those elections were won by Democrats and five by Republicans and only one of the ten periods had a negative 12-month post election return (following the 2000 election).

These historical results do not mean that there aren’t specific impacts from many policies, it’s just that over time at the broad market level, those impacts are swamped by the overall engine of US economic growth. There are large differences in the candidates proposed policies for taxes (who pays and how much), regulation (what activities and sectors of the economy are favored or discouraged), trade (how high and broad are tariffs), and immigration (how many new entrants to our labor force are allowed in). Many of these policies will affect the current and future earnings of specific groups, so adjusting investment decisions for those groups seems warranted. Of course, it is also true that most proposals advanced on the campaign trail never make it to an actual policy in their original form. One area where cynics (or realists?) tend to agree is that both parties have found it difficult to reign in the federal deficit, and it’s a good bet that the debt will continue to climb regardless of who wins on November 5th.

What ultimately matters to equity markets are the earnings companies deliver over time and the interest and inflation rates used to discount those earnings. These components are in turn a function of all the things that investors have been focussed on this year: the pace of economic growth, inflation and monetary and fiscal policies. Uncertainty has been high on many of those dimensions this year and the election cycle has brought another source of uncertainty. 

With history as our guide, while some individual client positioning changes may be warranted, it seems wise to not try to time market investments based on election predictions or outcomes. Rather, keep focussed on the path of the economy and earnings, especially the earnings trajectory of the leading AI-oriented companies.

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^[1] https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

^[2] https://www.bea.gov/news/2024/gross-domestic-product-third-quarter-2024-advance-estimate

^[3] https://www.bea.gov/news/2024/personal-income-and-outlays-september-2024

^[4] https://www.bls.gov/news.release/empsit.nr0.htm

^[5] https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918b.htm

^[6] https://www.federalreserve.gov/releases/h15/

^[7] https://www.bea.gov/news/2024/gross-domestic-product-third-quarter-2024-advance-estimate

^[8] https://www.census.gov/retail/sales.html

^[9] https://www.conference-board.org/topics/consumer-confidence/press/CCI-Oct-2024

^[10] https://www.bls.gov/news.release/empsit.nr0.htm 

^[11] https://www.bea.gov/news/2024/personal-income-and-outlays-september-2024 

^[12] https://www.reuters.com/technology/facebook-parent-meta-platforms-forecasts-holiday-quarter-revenue-above-estimates-2024-10-30/

^[13] https://www.spglobal.com/spdji/en/index-family/equity/

^[14] https://www.spglobal.com/spdji/en/index-family/equity/

^[15] https://www.spglobal.com/spdji/en/index-family/equity/

^[16] https://www.msci.com/end-of-day-data-search

^[17] https://www.reuters.com/markets/asia/china-stocks-set-best-month-nearly-decade-stimulus-cheer-2024-09-30/

^[18] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices

^[19] https://www.spglobal.com/spdji/en/index-family/equity/

^[20] https://www.nasdaq.com/market-activity/index/comp/historical

^[21] https://www.spglobal.com/spdji/en/index-family/equity/

^[22] https://www.federalreserve.gov/releases/h15/

^[23] https://www.spglobal.com/spdji/en/index-family/fixed-income/

^[24] https://www.spglobal.com/spdji/en/index-family/fixed-income/

^[25] https://www.spglobal.com/spdji/en/index-family/fixed-income/

^[26] https://aptuscapitaladvisors.com/the-market-in-pictures-october-25/

^[27] https://www.capitalgroup.com/advisor/insights/articles/what-expect-between-election-day-inauguration.html

^[28] https://www.downtownjoshbrown.com/p/advising-harris-trump

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