Investment Management - Third Quarter 2024
Shake it Off
Unless you live in Kansas City, the only topic discussed more this year than Taylor Swift is artificial intelligence (AI). Meanwhile, investors have focused considerable attention on the Federal Reserve (the Fed), after the central bank acknowledged inflation was trending lower and pivoted policy guidance last December. While it continued to be a “Cruel Summer” for segments of the economy suffering from high interest rates, the Fed acted confidently, cutting short- term interest rates by 50 basis points at their meeting in September.
Though the overall economy is stable, occasionally, growth scares can occur when economic data misses consensus expectations. In August, soft employment data and a continued contraction in manufacturing activity rattled sentiment. Several macro events added to uncertainty, particularly a panic-induced unwinding of carry trades – when institutional investors borrow money in a country with low interest rates and invest it in a country with higher returns – as was seen in August with the Japanese Yen. In addition, political discord, rising tensions with China, and the escalation of “hot conflict” areas, eroded confidence.
During the third quarter, equity indices experienced a correction, defined as a decline of approximately 10% from the previous high. Though losses were not enjoyable, indices ‘swiftly shook it off’ and finished the quarter strong. The large capitalization S&P 500 index rose 5.89%. Medium and these small capitalization companies outperformed large caps, with the S&P 400 advancing 6.94%, and the S&P 600 surging 10.13%. International equities, which benefited from a weak U.S. dollar, rose 7.26%.
Performancei for various indices for the year-to-date (not annualized), one-year, three-year, and five-year periods appears below:
Bond Indices
| Dates | ICE BofA 1-5 Yr. | ICE BofA 1-10 Yr. | ICE BofA 1-12 Yr. Muni |
|---|---|---|---|
| 12/31/23 - 9/30/24 | 5.52% | 5.95% | 2.25% |
| 9/30/23 - 9/30/24 | 9.70% | 11.84% | 7.58% |
| 9/30/21 - 9/30/24 | 1.51% | 0.72% | 0.60% |
| 9/30/19 - 9/30/24 | 2.30% | 2.10% | 1.38% |
Equity Indices
| Dates | Dow Jones Ind. Avg. | NASDAQ Composite | S&P 500 (Large) | S&P 400 (Medium) | S&P 600 (Small) | MSCI EAFE (Int'l) |
|---|---|---|---|---|---|---|
| 12/31/23 - 9/30/24 | 13.93% | 21.84% | 22.08% | 13.54% | 9.33% | 12.99% |
| 9/30/23 - 9/30/24 | 28.85% | 38.64% | 36.35% | 26.79% | 25.86% | 24.77% |
| 9/30/21 - 9/30/24 | 9.97% | 8.84% | 11.91% | 7.47% | 3.99% | 5.48% |
| 9/30/19 - 9/30/24 | 11.78% | 18.81% | 15.98% | 11.78% | 10.21% | 8.20% |
This year, the so-called “Magnificent 7” companies have overwhelmingly influenced profit growth and price appreciation of the S&P 500, because of their size and how indexes are constructed. After a strong period of outperformance, the stocks of large cloud providers exhibited signs of exhaustion. Those companies – Amazon, Google, Meta, Microsoft – reported generally positive results, though all forecast higher AI-related capital expenditures. The narrative of artificial intelligence is a multi-year story. At the moment, beneficiaries are few and shareholders are beginning to question when to expect a return on this massive investment.
Forgotten segments of the stock market conceivably can be as controversial. As interest rates decline, this “Love Story” may wane as economic and profit growth broadens to more cyclical industries and smaller companies, which are inherently more interest rate sensitive. Indices that track small companies have underperformed large caps by a considerable margin over the past decade and exhibit cheaper valuations. Broadening participation is an important step to improve the sustainability of the current expansion and should also enhance equity returns. Though due to long and variable lags associated with monetary policy, rotation into small caps will be a process, not a single event.
It is probable that the Fed delivered a “soft landing” economic scenario, defined as a slowdown of economic growth without a recession. Historically, that outcome is notoriously difficult to achieve, though tailwinds from substantial business investment and government spending on programs for domestic infrastructure have helped. Regarding employment, a rising labor force helps explain higher unemployment and low continuing jobless claims support that thesis. Tight credit spreads, or the excess interest one pays over Treasury yields of same maturity, confirm a benign outlook.
Potential implications of the Treasury yield curve un-inverting after a record length of time of inversion can lead to uncertainty. As an example, the last time the two-year Treasury yielded below the 10-year Treasury was July 1st, 2022.ii While curve inversion has been highly associated with recessions, it is actually the timing of un-inversion that is correlated with the start of economic contraction.iii With “real-time” estimates for GDP growth of 3%, an inversion may not have the same predictive power as it has historically for an economy that is less interest rate sensitive.
The Fed’s Summary of Economic Projections, updated in September, indicated further recalibration of monetary policy. The so-called dot plot shows the median year-end projection for the federal funds rate fell to 4.38% and the median estimate for the end of 2025 decreased to 3.38%, implying materially lower short-term interest rates. Importantly, the Fed was not the first central bank to pivot. According to Bespoke, the central banks of 19 countries are in easing mode, compared 36 central banks were tightening monetary policy in a coordinated effort to fight inflation a year ago.iv This dynamic can lead to significant currency fluctuations, increased capital flows between economies, and potential imbalances in global trade.
China is one country that was already in easing mode. In addition to rate cuts, China unveiled an extensive stimulus package to restore confidence in the world’s second largest economy. Reinvigorating economic growth is vital to their economy, which appeared to be heading towards a deflationary spiral.v Since their housing market peaked in 2021, highly levered developers defaulted and existing inventory weighed on home prices, which accounts for approximately 70% of household wealth.vi
Looking ahead, the upcoming election will likely monopolize headlines. For insight, West Financial held a webinar in early October with Mike Townsend, Schwab’s “Washington Insider.” He noted the presidential race remains tight, and once again the outcome will be decided by a few key swing states. In Congress, slim majorities for both the House and Senate puts the legislative branch in-play for either political party. According to Mike, there is potential for a historic event, as the House and Senate have never flipped in opposite directions in the same election.
Past the elections, there are a few areas of concern. A significant risk to markets is a potential resurgence of inflation. It could force long-term interest rates higher and cause the U.S. Treasury to refinance debt at much higher rates. Externally, there has been a regime change to the geopolitical landscape. Two active conflicts have had limited economic impact domestically, though Europe has not been as fortunate. It’s disturbing to consider how easily the situation may escalate, especially with China’s unhelpfulness and continued belligerence towards Taiwan.
Broadly speaking, there has been little change in our tactical equity positions, relative to the WFS benchmark. Depending on individual risk tolerance, we are maintaining equity allocations in our client portfolios at or above target, with bias towards large caps over smaller companies, and “growthier” industries. For our fixed income allocations, we have extended bond ladders, buying securities with slightly longer maturities. While our intention is to hold bonds to maturity, we proactively sold issues purchased when interest rates were near all-time lows to realize the capital loss and replace with newer bonds with higher coupons and improved yield-to-maturity relative to the security sold. We are also continuing to add municipal bonds to portfolios where appropriate.
In regard to additional growth scares, for the immediate future investors should “Shake it Off”!
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We would like to introduce the newest member of our portfolio management team, Eduardo Wisbrun. Eduardo joined West Financial as a portfolio manager in September 2024. Eduardo earned a Bachelor of Science degree, magna cum laude, in Industrial and Systems Engineering from ITESM in Monterrey, Mexico, and an MBA in Finance, from The Wharton School of the University of Pennsylvania. He holds the Chartered Financial Analyst (CFA) designation and is a great addition to our team here at West. Welcome Eduardo!
Congratulations to Kristan Anderson, Victoria Henry, Laurie Kramer, and Brian Mackin for being named to the Northern Virginia magazine’s Top Financial Professionalsvii listing featured in the September 2024 issue.
As we enter the final quarter of the year, please contact us should you have any questions or issues regarding your year-end tax planning and/or gifting needs. We are compiling year-end capital gain estimates from the mutual funds we invest in on your behalf and will be happy to provide this information to you and/or your accountant upon request. You should be receiving statements directly from your account custodian at least quarterly. If you are not receiving your statements, please contact us.
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President | Chief Investment Officer |
i Each of the S&P 500 Index, the S&P 400 Index, the S&P 600 Index, the MSCI EAFE Index, the ICE BofA 1-5 Year Index, the ICE BofA 1-10 Year Index, the ICE BofA 1-12 Year Municipal Bond Index, the Dow Jones Industrial Average, and the NASDAQ Composite (each, an “Index”) is an unmanaged index of securities that is used as a general measure of market performance. The performance of an Index is not reflective of the performance of any specific investment. Each Index comparison is provided for informational purposes only and should not be used as the basis for making an investment decision. Further, the performance of your account and each Index may not be comparable. There may be significant differences between the characteristics of your account and each Index, including, but not limited to, risk profile, liquidity, volatility and asset comparison. The performance shown for each Index reflects no adjustment for client additions or withdrawals, and no deduction for fees or expenses. Accordingly, comparisons against the Index may be of limited use. Investments cannot be made directly into an Index.
iii https://www.wsj.com/economy/central-banking/a-recession-signal-is-flashing-red-or-is-it-da02b509
iv Bespoke Investment Group. (2024, October 4). The Bespoke Report – Equity Market Pros and Cons.
vi https://www.reuters.com/world/china/china-unveils-broad-stimulus-measures-revive-economy-2024-09-24/
vii To compile the Top Financial Professionals list, Northern Virginia Magazine sent surveys to Northern Virginia financial professionals asking them to recommend other financial professionals whom they would refer to friends and family. The Northern Virginia Magazine editorial staff then vetted those nominated to compile the final list. Financial professionals do not pay a fee to be included on the list. Although some Top Financial Professionals winners choose to advertise in the magazine. The Top Financial Professional listing and the advertising section are separate entities.
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