Q3 2024: Fed Rate Cuts Finally Arrive and Spark Market Rally

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‍Author: Steve Dean, CFA, MBA, Chief Investment Officer

Q3 2024: The quarter at a glance

Continued progress on inflation and solid, if slowing, economic activity combined with the long-awaited interest rate cut by the Fed to bolster returns across asset classes in the third quarter. The path was anything but smooth as several spikes in stock market volatility in early August and September reflected investor uncertainty about the economic outlook relative to high market valuations.

• The Fed cut rates by 50 basis points on September 18
• The Core PCE index was up 2.7% in August from a year ago
• Unemployment ticked up to 4.2% from 3.7% a year ago
• Stocks ended Q3 up across all indices, many hitting record highs
• The rate cut led to a strong rally across the bond market

50 basis point rate cut from the Fed (finally!)

As it has been for much of 2024, all attention was on the Fed and when and by how much they would cut interest rates. At the start of the year, investors had expected seven rate cuts, but slower progress on taming inflation and a relatively strong economy delayed those cuts. Finally, after Fed Chair Powell indicated at the July FOMC meeting that the “time had come” to begin the interest rate cutting cycle, the Fed cut rates by 50 basis points on September 18.^{[1] [2]} In explaining the relatively large cut, Powel cited “the progress on inflation and the balance of risks”. ^[3] The “balance” is a nod to the “dual mandate” given to the Fed to keep inflation low and employment high. After keeping rates higher for longer than many expected, the focus of the Fed has shifted slightly more towards ensuring that employment does not fall too much.

On those two fronts, inflation continued to moderate towards the Fed’s 2% target, with the headline Personal Consumption Expenditures (PCE) price index up 2.2% and the core (excluding food and energy) index up 2.7% in August from a year ago.^[4] Economic activity also remained strong with Q2 GDP growth up 3% at an annual rate, buoyed by still robust consumer spending.^[5] The employment picture slowed to a more modest pace during the quarter, with 142,000 jobs added in the latest August report compared with a 202,000 average monthly gain over the past year while the unemployment rate ticked up to 4.2% in August from 3.8 a year ago.^[6]

Markets seem to have priced in a “soft landing” rather than a recession in the near-term, but investors will still be testing that assumption and keeping a close eye on the Fed’s rate cuts for the rest of this year and in 2025. Just like at the beginning of 2024, expectations for those cuts may be more aggressive than the Fed is likely to deliver. In a speech on September 30th, Powell indicated as much, saying that the current posture of the Fed members, “would mean two more cuts, it wouldn’t mean more 50s”. ^[7] Regardless of the magnitude and speed, a declining rate cycle could be good for both stock and bond returns.

Stocks overcome spikes in volatility to reach record levels 

Stocks ended the quarter up solidly across all segments with many indices hitting record highs.^[8] In the U.S., equity markets posted the 5th consecutive monthly gain. In July, market leadership reversed dramatically, with small cap and value stocks substantially outpacing the technology and growth stocks that had dominated returns in the first half of the year. Volatility spiked and stocks fell sharply in early August as a result of an unwinding of the Japan “carry trade” and a weaker than expected employment report for July. September began with another spike in volatility and sell off in the markets on rate cut uncertainty, but continued solid economic reports and the Fed’s eventual relatively large cut offset those fears and bolstered stock returns. 

• S&P 500 closed the quarter at a record level, rising 5.89% during the third quarter and is now up 22.08% in 2024, the best first three quarters of a year since 1997.^[9]
• The Dow also hit a record high by the end of the quarter.^[10]
• Small cap stocks surged over 10% in July and held steady for the rest of the quarter.^[11]
• Value stocks led their growth counterparts in large and small cap^[12]
• The NASDAQ composite lagged other indices for the quarter, but returned to the top spot in September.^[13]
• Developed and emerging international markets trailed the S&P 500 for the quarter.^[14]
• China’s equity market surged dramatically at the end of September on rate cuts and substantial market and economic stimulus programs.^[15]
• US sector performance:^[16]
  • Utility stocks led the way in Q3, up 18.46% on a combination of lower volatility characteristics and increased electricity demand related to AI industry growth.
  • The real estate sector continued to rebound, up 16.29% for the quarter and now positive for the year.
  • Technology and communications stocks lagged for the quarter, but remain the leading sectors so far in 2024.
  • Energy was the only sector to post negative returns for the quarter, dragged down by declines in oil prices.

September rate cut doesn’t disappoint

The long awaited Fed move to lower rates finally arrived on September 18th with a relatively large cut of 50 basis points. The cut led to a strong rally across the bond market. The 10-year treasury yield dropped to 3.81%, down 55 bp from the end of Q2. At the shorter end of the curve, 2-year treasury yields fell 95 bp and the 3 month yield fell 105 bp over the quarter. The larger drops for shorter-term maturities led the 10- year less 2-year yield spread to “uninvert” for the first time this year.^[20] Since the rate cut, short-term rates have continued to fall, but longer term treasuries have actually increased slightly.

• Fixed income returns were positive across all segments in Q3 and have now risen for five consecutive months.^[21]
• Higher risk preferred stocks continued to post the strongest returns, rising 6.94% for the quarter and are now up over 12% for the year.^[22]
• Short duration fixed income posted the weakest returns for the second consecutive quarter.^[23]
• Global fixed income returns were strong for the quarter as foreign central banks have been ahead of the Fed in cutting rates.^[24]

Mixed results in private markets

Cliffwater’s most recent alternative investments report released in late August with data through June 2024 shows a continuation of recent patterns.^[25] Private credit funds continued their strong recent performance and have been among the best performing private asset classes since the start of 2021. Private real asset funds, and private real estate in particular, continue to post the weakest returns, but did eke out gains for the most recent month. Private equity had a solid June and looks stronger on the year-to-date and trailing 1-year periods. For private real estate and private equity there continues to be uncertainty as distributions of invested capital have slowed as managers and owners await better exit opportunities.^[26]

Fed rate cuts: too late or just right?

As Fed Chair Powell has repeatedly reminded anyone who is listening, the Fed has two official mandates: to maintain price stability and to ensure full employment. For much of the past two years, the primary focus has been on bringing down inflation from the historically high levels that peaked in June 2022. With the substantial increases in policy interest rates the Fed directed from early 2022 to mid 2023, the goal was to slow economic growth and reduce inflation back down to 2%. Looking at the Fed’s preferred inflation gauge, the Personal Consumption Expenditures price index, inflation has indeed fallen dramatically. The headline measure is now at 2.2% and the Core less food and energy index is at 2.7%^[28]. Noting the declining pattern, investors at the start of the year expected that the Fed would move to lower rates and shift the balance of their policy focus to the employment side of the mandate. That didn’t happen as inflation remained somewhat elevated and labor markets tight. In July, with continued progress on lowering inflation, the Fed signaled it was (almost) time to cut rates and followed with a large (relative to history) 50 bp cut in September and communicated expectation of further cuts over the rest of 2024 and in 2025.

Because monetary policy works with a lags that are “long and variable”, the fear is that the Fed kept rates too high for too long, increasing the risk of a recession at some point in the near future.^[31] While there are certainly pockets of weakness in the economy, broader measures like GDP and corporate earnings continue to show solid growth. Labor markets also remain relatively healthy with a gradual increase in the unemployment rate to 4.2% most recently from a low of 3.4% in April of 2023.^[32] Employment is not considered a leading indicator of economic activity, so its relatively low level is not necessarily predictive of future economic activity. Still, so far, the restrictive monetary policy the Fed has maintained has not led to a recession and the investors appear to have priced in the Fed achieving its dual goals and a “soft landing”. 

Historically, Fed rate cuts have typically been in recessionary periods. A recent study from the Hartford Funds looked at the 22 rate cutting cycles in the US since 1928.^[34] In 16 of those 22 periods, the economy was either already in a recession or fell into one within 12 months of the first cut. The other 6 periods would represent the elusive “soft landing” periods with no recession. The chart below shows that historically there have been performance differences for stocks and bonds depending on whether or not a recession follows the start of the rate cutting cycle. Not surprisingly, stocks have delivered their best performance in the twelve months after the first rate cut in the 6 no recession rate cutting cycles (the “soft landing” periods). Still, stocks have also delivered positive returns on average even in the 16 rate cutting cycles that were accompanied by a recession, with only 6 of the 16 of these “hard landing” periods showing negative stock returns in the 12 months after the first rate cut, with two of those coming in the last 3 cycles (2001 and 2007). Conversely, bonds have performed better in the 16 hard landings periods, with just 3 of those cycles showing negative bond returns.

While the historical performance gives some comfort that the performance for stocks and bonds will be positive during the current rate cutting cycle, confidence in that outcome will be higher if we get a soft landing this time. The only periods where there have been negative stock and bond returns during a declining rate environment were during recession periods. In the current cycle, the Fed is lowering rates in a period of relatively solid economic growth. If that growth deteriorates, then stock returns could be muted or negative while bond returns see relatively stronger growth. On the other hand, if the soft landing scenario plays out as expected, then lowering rates, even at a slower pace then investors expect, could provide an additional tail wind to stock returns.

^[1] https://www.federalreserve.gov/monetarypolicy/fomcpresconf20240731.htm

^[2] https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918a.htm

^[3] https://www.federalreserve.gov/monetarypolicy/fomcpresconf20240731.htm

^[4] https://www.bea.gov/news/2024/personal-income-and-outlays-august-2024

^[5] https://www.bea.gov/data/gdp/gross-domestic-product

^[6] https://www.bls.gov/news.release/empsit.nr0.htm

^[7] https://www.nytimes.com/2024/09/30/business/economy/fed-chair-jerome-powell-interest-rate-cuts.html

^[8] https://www.spglobal.com/spdji/en/index-family/equity/

^[9] https://www.spglobal.com/spdji/en/index-family/equity/

^[10] https://www.spglobal.com/spdji/en/index-family/equity/

^[11] https://www.spglobal.com/spdji/en/index-family/equity/

^[12] https://www.spglobal.com/spdji/en/index-family/equity/

^[13] https://www.nasdaq.com/market-activity/index/comp

^[14] https://www.msci.com/end-of-day-data-search

^[15] https://www.reuters.com/markets/asia/china-stocks-set-best-month-nearly-decade-stimulus-cheer-2024-09-30/

^[16] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices  

^[17] https://www.spglobal.com/spdji/en/index-family/equity/

^[18] https://www.nasdaq.com/market-activity/index/comp/historical  

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

^[20] https://fred.stlouisfed.org/series/DGS10

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

^[22] https://www.spglobal.com/spdji/en/index-family/fixed-income/

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

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

^[25] Cliffwater, Alternative Investments Report, August2024

^[26] https://www.msci.com/www/blog-posts/private-capital-in-focus-q2/04978140068?utm_source=pardot&utm_medium=email&utm_campaign=2024_MSCI+Weekly_09-26

^[27] Cliffwater, Alternative Investments Report, August2024

^[28] https://www.bea.gov/news/2024/personal-income-and-outlays-august-2024

^[29] https://fred.stlouisfed.org/series/PCEPI#0

^[30] https://fred.stlouisfed.org/series/PCEPILFE

^[31] https://www.stlouisfed.org/on-the-economy/2023/oct/what-are-long-variable-lags-monetary-policy

^[32] https://fred.stlouisfed.org/series/UNRATE

^[33] https://fred.stlouisfed.org/series/UNRATE

^[34] https://www.hartfordfunds.com/insights/market-perspectives/global-macro-analysis/how-do-stocks-bonds-and-cash-perform-when-the-fed-starts-cutting-rates.html

^[35] https://www.hartfordfunds.com/insights/market-perspectives/global-macro-analysis/how-do-stocks-bonds-and-cash-perform-when-the-fed-starts-cutting-rates.html

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