Positives
- U.S. Federal Reserve Bank cut interest rates 0.50% and is expected to make 2 more 0.25% rate cuts in 2024
- U.S. unemployment rate remains very low at 4.1%
- U.S. GDP growth extremely strong at 4.9%
- U.S. inflation rate has declined to 2.4% CPI trailing year
Risks and Concerns
- Escalation of the Israel conflict could roil markets
- Artificial Intelligence sector may be leaning toward overvalued
- U.S. Fed’s 0.50% interest rate cut was more than expected & raised concerns Fed may be late to cut rates
- U.S presidential election could cause volatility
The Quarter in Review
In the 3rd quarter, the U.S. economy continued a glide path to a likely soft landing from a period of high inflation and high interest rates. Overall economic growth as measured by GDP was strong at 3% in the 2nd quarter, and very strong in the 3rd quarter at 4.9% (in the advance estimate). Unemployment stayed very low and trended down with a 4.2% reading in August and 4.1% in September. The stock market rally led by the Artificial Intelligence sector continued, driven by strong earnings growth, and other market sectors joined with a notably strong performance from small capitalization stocks. Inflation as measured by the CPI was 2.5% in August and dropped to 2.4% in September. By these aggregate economic statistics, the U.S. economy is very healthy and still headed in the right direction.
Amid this backdrop, the Fed surprised markets by cutting rates by 0.50% instead of the widely expected 0.25%. This signaled that the Fed thinks that inflation is now under control, and they are pivoting to maintaining low unemployment and strong economic growth by removing restrictive monetary policy by lowering rates. The following chart shows all measures of inflation dropping consistently for the past two years and the Fed’s recent rate cut (black line):
Inflation and the Fed Funds Rate
Current Investment Strategy
The dominant investment strategy move this quarter was to further extend bond duration and drastically reduce short-term bond holdings ahead of the Fed’s expected rate cuts. Longer duration bonds typically increase in value as interest rates fall, and short-term bond investments will see income yields drop as rates fall. Therefore, in the weeks prior to the Fed rate cut, we aimed to dramatically reduce our position in ultra short-term bonds and moved proceeds to positions that have significantly longer durations.
Our overall investment theme during the past quarter (and all of 2024) has been increasing risk in both stocks and bonds as the economy remained strong, stocks continued to rally, and interest rates declined (which increases bond values). Our strategy to increase equity weightings back to targets in the 2nd quarter has paid off and we plan to continue this approach as long as economic readings remain strong.
The following chart shows how the U.S. treasury bond market yield curve has shifted year-to-date as interest rates have declined. Note how shorter-term interest rates have declined significantly while intermediate (5-10 year) and longer-term rates have not moved much, and even increased slightly on the long end of the curve. This was expected as the Fed primarily controls short-term rates and is why we chose to move out of ultra short-term bond positions into longer durations:
United States Treasury Yield Curve
Future Asset Allocation Changes and Considerations
Forecasts for the fourth quarter are now expecting two more 0.25% interest rate cuts. The European Central Bank (ECB) is expected to do the same, as the EU’s inflation rate is now below the ECB’s target for the first time in 3 years. As interest rates are expected to continue to drop, we will likely add an investment in the utilities sector. Utilities are primarily income stocks that not only benefit from falling interest rates, but also from rising energy demand driven by the booming Artificial Intelligence sector. The infrastructure and industrials sector investments added last quarter are also benefiting from this increased energy demand. Defense stocks in these sectors have also seen good performance due to rising geopolitical tensions in the Middle East. These tensions may also lead to increased volatility and upward pressure on oil prices, so we will be keeping a close eye on these possible outcomes.
Of course, the biggest upcoming national story will the U.S. presidential election, which is currently polling extremely tightly and will likely come down to a few swing states. Meanwhile, Republicans are projected to narrowly win the Senate while Democrats are projected with a small win in the House. From an investing perspective, a split government is good because it reduces the chances of sweeping legislation being passed that significantly changes the business or economic operating environment. Regardless of the election outcome, we’d like to close this letter by urging clients to stay the course on your investment strategy. Making drastic changes to your investment strategy based on a personal worst-case scenario political outcome has historically been a poor strategy, as the following chart shows. It outlines how staying invested during election years has significantly outperformed a strategy of liquidating a portfolio to cash:
Growth of $1 Always Invested Versus Timing Election Years
Key Investment Takeaways
- In the 3rd quarter, we significantly increased duration in bonds due to expectations of interest rates dropping
- The U.S. Fed made a surprise 0.50% rate cut and is now expected to make two more 0.25% cuts in 2024
- U.S. GDP is now very strong at 4.9% with very low 4.1% unemployment
- Inflation has declined significantly to 2.4% trailing year in September
- Escalation of conflicts in the Middle East and Europe are a potential market risk factor
We will continue to monitor the market risks of this rapidly changing and difficult environment, frequently adjusting to help protect and grow your investment portfolio. As always, please feel free to call or email us with any questions or concerns.
Your Capital Advantage Team
