4th QUARTER 2024 MARKET OUTLOOK
10/07/2024
Investors may want to consider rotating from cash to Treasuries and/or corporate bonds.
Thrivent Asset Management contributors to this report: Kent White, CFA, head of fixed income mutual funds; David Spangler, head of mixed asset markets strategies; John Groton, Jr., CFA, director of administration and materials & energy research; Matthew Finn, CFA, head of equity mutual funds; and Jeff Branstad, CFA, model portfolio manager
The economy should achieve a soft landing and inflation should ease, with the Fed likely lowering interest rates later this year.
We continue to favor high-quality assets in both stocks and bonds.
It is prudent to both maintain a diversified portfolio and remain nimble.
When the U.S. Federal Reserve (Fed) cut interest rates by 50 basis points (bps) in mid-September—in an attempt to support economic growth—it supported an important evolution in the stability of the U.S. economy: Recessions are becoming less frequent and more moderate.
While a recession in the current economic cycle is still a possibility, the chance of a recession soon is not only unlikely from a historical perspective, but also less probable given the current economic, monetary and policy conditions. Furthermore, should there be a recession, it is very likely to be short and shallow if only because the Fed would presumably respond quickly and aggressively to stimulate growth. Also, to the lack of large economic imbalances that can precipitate sharp downturns are lacking. And, in our view, exogenous shocks—such as geopolitical tensions turning to more widespread wars, or a very contentious U.S. presidential election—are more likely to cause bouts of market volatility than to severely disrupt the economy in the coming quarters.
Inflation has fallen significantly from its post-COVID surge, and Fed Chairman Jerome Powell recently clarified that “recent data indicate further progress toward a sustained return to 2%,” which is the Fed’s long-term average inflation target1. In our view, the use of the word “sustained” is important as it signals the Fed’s expectations that inflation will continue to fall despite its attempts to boost the economy through lower interest rates.
However, it will not be a smooth process. Solid economic growth and a resilient labor market risk stalling progress on inflation. We will likely have short periods when inflation rises, particularly from the cost of housing, strong wages or as a result of seasonal effects. While seasonal effects were distorted by the pandemic, and there is much debate about whether the government is over- or under-adjusting its impact, it may take time before they recede, and could result in more inflation volatility than the market would prefer.
Nevertheless, it is also important to keep in mind that the Fed raised rates more aggressively than at any time since the 1980s in response to an equally atypical surge in inflation. Despite the recent 50 bps cut, the Federal Funds rate (The Fed’s benchmark interest rate) is still above its “neutral” rate—the rate at which interest rate policy is being neither restrictive nor accommodative. While there is much debate about where the neutral rate lies, and whether it has evolved as the global economy has evolved, the Fed’s most recent projections reveal a full 1.0% further reduction in interest rates over both 2024 and 2025.
The market is currently a bit more pessimistic on growth which makes it more optimistic on the speed of rate cuts, pricing into the bond markets modestly more than the Fed’s own projections. As such, there is room for disappointment. Our projections are for two rate cuts of 25 bps each in the remainder of this year, though the Fed could cut less or more depending on labor market data, which has fluctuated significantly in recent months and is frequently revised. Looking ahead to 2025, we have no reason to believe the Fed’s projections for four cuts of 25 bps is too little or too much.
While economic data is often volatile as economies turn—and some of the data suggest the economy is still slowing—the balance indicates growth is stabilizing. Lower interest rates amid healthy consumption, strong earnings growth and a stabilizing job market will only help the economy recover. Consumer spending, which is about two-thirds of the total U.S. gross domestic product (GDP) has been well supported in 2024, and any improvement in the jobs market should only boost consumer confidence. Lower interest rates can also directly—and quickly—help consumers by lowering the interest payable on borrowing, including credit cards, auto loans and home mortgages. Finally, lower interest rates should support the more cyclical sectors of the economy such as real estate, industrials and materials.
We have been and remain of the view that investors are better served by not trying to time the market but instead remain invested and only adjust their portfolio allocations as economic, political or other risks ebb and flow. Insofar as economic recessions have become less frequent and it seems the Fed has achieved the long coveted soft landing in the current cycle, we continue to advocate for maintaining a well-diversified portfolio.
Over the long term, we generally favor a strategic bias to being overweight equities relative to bonds as we believe investors are rewarded for the additional performance returns equities typically generate relative to fixed-income investments, albeit at a greater level of risk. But in the current environment, we continue to favor a more modest overweight to equities. Despite our optimism that the U.S. economy will rebound in the quarters ahead, we think caution is warranted (particularly given current political and geopolitical risks) as we await clearer signs that the economy has turned the corner. And, we remain positive on the outlook for fixed income. While yields have fallen recently, they are still high compared to the average yield over the last decade and thus remain attractive for long term buy-and-hold strategies. Furthermore, their steady income and potential for capital appreciation if the economy should weaken more than we expect, make them an attractive holding in a diversified portfolio.
After the Fed’s September interest rate cut, long-dated Treasury yields rose. This is counterintuitive unless the (somewhat unexpected) size of the cut raised concerns that aggressive monetary easing could boost economic growth enough to risk higher inflation.
As our base case remains that the Fed will manage monetary policy in accordance with the economic data (especially inflation and employment), we believe shorter-dated yields are likely to fall in line with a lower Federal Funds rate, while longer maturity bond yields should remain relatively range bound. If inflation continues to decline, longer-dated yields could fall further. And should inflation remain “sticky,” we expect the Fed will reduce the volume or pace of its rate cuts, providing some support for longer-dated yields. However, concerns about fiscal policy are likely to remain, at least through the upcoming presidential election. As the risk of larger fiscal deficits increases with the length of the loan an investor provides the government (the length of the bond they purchase), upward pressure is likely to remain on longer-dated yields.
Turning to corporate bonds, valuations in the investment-grade market have been relatively expensive for a few years, and we expect they will remain so. However, current yields are still far higher than they’ve been over most of the last 15 years, and corporate balance sheets are generally healthy.
The high-yield segment of the corporate bond market carries more risk but could see more benefit from lower interest rates. When the Fed was raising rates to fight inflation, the interest rate burden on these companies made it more difficult for them to borrow, invest and service that debt. But in a rate-cutting environment, each rate cut will lower the cost of that borrowing. However, given the greater sensitivity of high-yield bonds to investor sentiment and the economic cycle, we again recommend caution.
RELATED VIDEOS
How consumers are affecting the markets
Equities markets have been influenced by the large-cap technology companies, but that breadth is narrowing. Cyclical sectors, on the other hand, are highlighting how the U.S. economy is at an inflection point, which is heavily influenced by consumers feeling pain points of higher prices, fewer job openings and even affordable housing.
How has inflation affected consumers?
With low interest rates during the pandemic resulting in consumers borrowing at lower costs, followed by high interest rates as the U.S. Federal Reserve worked to contain high inflation, inflation has been a big factor for both consumers and the markets over the past few years.
U.S. large-cap growth stocks have been the market leaders for much of the past year, and while our optimism about a soft landing could tempt investors to broaden their exposure within the S&P 500® Index or rotate more of their portfolio to mid-cap, small-cap or value stocks, we believe it is still early to make significant strategic commitments.
To be sure, returns within the sectors of the S&P 500 Index are already broadening. The S&P 500 equally weighted index has recently performed better than the benchmark capitalization-weighted index, and we are seeing mid- and small-cap stocks performing a bit better than they did in early 2024 or 2023. As such, we are increasingly more positive on the outlook for mid-cap stocks, and continue to monitor small-cap stocks. Both may benefit from a resurgence in the willingness to take risk if geopolitical tensions subside, the U.S. election is less chaotic than the market fears, and most importantly the economy continues to grow at a solid pace. But as small-cap stocks, in particular, are notoriously volatile (for better or worse) as sentiment shifts, we favor taking longer-term views and waiting for more sustainable fundamental factors that can create durable rallies before we overweight small caps.
Broadly speaking, small-cap company fundamentals are weak relative to the asset classes’ history, with relatively high debt levels and a large number of which are unprofitable. While a stronger economy will help for the more cyclical companies, and lower interest rates will help the more indebted companies, we believe these effects will be on the margin and take time to fundamentally alter their long-term outlook. Additionally, the growth path for small-cap stocks has been changing. A decade ago, a small-cap company would grow into a large-cap company through public stock issuances. But today, these companies are increasingly staying private, supported by the now huge private equity markets. And, large (particularly technology) companies have been very aggressive in buying promising small-cap companies. Microsoft Corporation, for example, has taken a large stake in OpenAI—arguably one of the more interesting smaller market capitalization companies in America.
Finally, both small-cap stocks and value stocks have indeed historically performed better as economies transition out of recession, but it is important to remember that the U.S. economy is not in a recession. In the past, recessions have created more damage to the real economy, depressed market valuations and eliminated some of the weaker companies. But in today’s world of less dramatic business cycles, and our forecast for a soft landing, there isn’t such a dramatic bottom from which these stocks could rebound in a strong cyclical upturn.
Our primary reluctance to increase allocations to international markets is our continued concerns about the European economy. Compared to the dynamism of the U.S. economy, the European economy is relatively static. Not that Europe is lacking on an absolute basis, but that the U.S.’s financial ecosystem—its spirit of entrepreneurship and the resulting volume of startup companies, together with more developed capital, private equity and venture capital markets—is unparalleled.
On a more tactical basis, consumption in the eurozone has been weak, while China’s increasing reliance on competitive exports and Europe’s likely embrace of import tariffs will only weigh on the economy. As such, relative to the U.S., we continue to maintain our recommendation to be strategically underweight Europe, the largest of the international economies. To be clear, this is not a tactical recommendation based on short-term factors in either the U.S. or Europe, but a bias over the long term to favor the more dynamic U.S. economy.
Within the emerging markets, we remain more positive and are positioned roughly neutral, but caution that China’s lackluster growth and worrying structural problems remains a drag on the outlook for emerging-market economic growth. China has recently announced additional monetary stimulus (including supporting mortgages, equity markets and lowering borrowing rates), which should help, but doesn’t fully address the substantial problems within its real estate market and its extremely low levels of consumer confidence. If China were to address these issues more aggressively, with massive fiscal stimulus (in addition to monetary stimulus), the Chinese stock market could more sustainably rebound and have significant spillover effects throughout the rest of the emerging-market economies. Thus, the situation warrants monitoring, but it is too early to make assumptions about the longer-term outcome.
U.S. unemployment has been rising and is near the level at which—in normal times—it could continue to rise and possibly accelerate in a vicious spiral. However, these are not normal times, and we are not seeing significant layoffs that could hurt consumer sentiment (slowing consumption), in turn hurting corporate sentiment. Instead, companies have been reluctant to fire or lay off employees, choosing to bet on a recovery given the costs of hiring and training new employees when demand for its goods or services increases.
Meanwhile, geopolitics and domestic politics remain a source of significant uncertainty. Whether it is the ambitions of Russia, its growing alliance with China, the fate of Taiwan, Iran joining the Middle East conflict, democracies failing in Latin America or coups and wars in Africa, the world has not seen such a breadth of places in conflict that could erupt into something big enough to disrupt the global economy in a long time.
While the risks of a sudden change in the geopolitical landscape does concern us, it is important to keep in mind that all or most of these concerns have been present to some degree throughout the year and yet the U.S. stock market is still setting record highs. That is, to the extent tensions can remain relatively contained, disruption can be minimal. But should something somewhere boil over or result in a significant disruption to commodity supplies (recall the effect food shortages had on inflation soon after Ukraine was invaded), equity volatility will likely spike.
While the original source is debated, there is a phrase increasingly paraphrased in the recent press which goes something like this: “There are decades in which nothing happens, and there are days where decades happen.” We suspect it has gained popularity because any of the current global disputes we’ve mentioned could confirm its point, and the U.S. presidential election is no exception. Historically, markets are generally indifferent (over the long term) to which party wins the presidency or takes control of Congress. But in the short term, markets do not like uncertainty. It raises volatility and thus risk premiums, prompting greater caution from investors and thus lower prices. Insofar as consumer confidence surveys already show the election to be a key concern, confirmation of a contested outcome could heighten concern, raise volatility and dampen economic activity.
There may be a risk that inflation rises, the U.S. economy weakens more than we expect or global or domestic politics boil over. But in our approach to investment management, we believe the prudent response to these concerns is not to withdraw from the markets, but to remember the importance of having a diversified, actively managed portfolio.
With a longer-term view, we remain constructive on the outlook for the U.S. economy, the stability of the country’s political system and the ability of the global economy to weather a multitude of surprises. Consider the sudden emergence of COVID-19: It threatened to devastate the global economy, but the S&P 500 Index set a new high just six months later. Investors, in our view, should maintain their exposure to stocks and bonds, continue to favor equities with a long-term view, consider the opportunity to lock-in long-term yields in U.S. government and corporate bonds, maintain a diversified portfolio and work with an active manager who is vigilantly monitoring the risks and looking for potential investment opportunities.
Media contact: Callie Briese, 612-844-7340; callie.briese@thrivent.com
All information and representations herein are as of 10/07/2024, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
This article refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.
Past performance is not necessarily indicative of future results.
1 Fed’s Powell says rates will ‘over time’ reach neutral level, not preset, Reuters. https://www.msn.com/en-us/money/markets/feds-powell-says-rates-will-over-time-reach-neutral-level-not-preset/ar-AA1ruaUi. September 30, 2024.
