Despite some volatility in the middle, this was another great quarter for both stocks and bonds! For the first time in a long time, the US Aggregate Index outperformed the S&P 500, returning 5.81% vs 5.25% for the S&P. A lot happened over the last three months – President Biden dropping out of the presidential race, inflation cooling further, the unemployment rate continuing to tick higher, and the Fed choosing to reduce the Federal Funds rate by 0.5%. There are plenty of storylines we could focus on for the upcoming quarter, but we want to primarily target three questions that may already be on many people’s minds.
1. What will the Fed do? (Or more accurately, what will incoming data on inflation and jobs force them to do?)
For those of you who aren’t very familiar with the Federal Reserve (possibly because you don’t spend your days analyzing every statement made by every current and former official like I do), the Fed has two main responsibilities: pursuing maximum employment and maintaining price stability. We are coming out of a period where the Fed was laser-focused on inflation, as we were at or near maximum employment while prices were much too high. However, with inflation now only 0.5% above the Fed’s target and the unemployment rate having moved up from the low of 3.4% last year to 4.1%, the Fed must now focus on both sides of the mandate to ensure that in the fight against inflation, they don’t allow unemployment to become an even greater problem.
The market anticipates an additional 0.5% of cuts this year and another 1% next year. In Jerome Powell’s most recent press conference, he emphasized data dependency by saying that the Fed is “not on a preset course” and that the risks (posed by the labor market and inflation) are roughly in balance. This means that the upcoming economic data will have outsized importance in determining the Fed’s next moves, which could create volatility around events such as jobs reports and CPI reports. This began with the latest jobs report showing more jobs created and lower unemployment than was expected, with the market reacting accordingly, sending interest rates higher.
Our view is that the Fed will attempt to avoid a re-acceleration of inflation at all costs, and that may mean disappointing the market by delivering fewer rate cuts than the market expects. If this comes as a result of better-than-expected labor market data, it may continue to be a positive for stocks even if bonds react poorly, but if it comes as a result of a hot CPI print (indicating higher inflation), it may create a short-term period of volatility for both stocks and bonds. Even with heightened volatility, the beginning of a rate-cutting cycle has historically been a positive time for stocks, with the S&P 500 higher three months and six months after the first rate cut seven out of the last seven times. We believe if history repeats itself, it may bode well for stocks through March of next year.
2. How much will geopolitical tensions affect markets?
Geopolitical risk is often the most difficult risk to quantify for markets. Markets tend to ignore geopolitical risk the vast majority of the time because it is difficult to price in the probability of an adverse event. Then, when the risk of an adverse event increases, markets tend to overprice in a worst-case scenario, and when that adverse event materializes, the market can even rally due to how negative of a scenario was priced in. This pattern of trading shapes how we think about some of the current geopolitical risks, such as the Israel and Iran conflict and even some of the risks that could be less imminent, such as the potential of a Chinese invasion of Taiwan. If you look at the last seven major invasions (Israel-Hamas conflict, Russia-Ukraine war, Crimean Crisis, Iraq War, Afghanistan War, Gulf War, and Vietnam War) stocks surprisingly bottomed before the invasion in five of the seven conflicts and rallied as the conflicts unfolded, with Afghanistan and Russia-Ukraine being the exceptions.
A careful observation of the unfolding of events surrounding Israel and Iran in late September and early October and the corresponding weakness in markets show the beginnings of pricing in an adverse outcome. Counterintuitively then, while there could be more weakness ahead, we think an escalation could lead to a rally in markets as it would be a materializing of the negative scenario and could free the markets to focus on other things. Drilling down further (pun intended), we think that the outcome of the Israel-Iran situation will be crucial to oil prices and the performance of the energy sector. Oil prices have gone up significantly in anticipation of a potential Israel strike on Iran’s oil facilities. If that strike does not occur, oil prices will likely come back down to where they were before the conflict began, but if oil prices remain elevated, it will cause an increase in inflation, which could force the Fed to keep rates higher than they would have otherwise.
As for the China situation, we are currently bullish on China due to the People’s Bank of China cutting reserve requirements and interest rates and think they are unlikely to do anything in the near term to disrupt their efforts to revitalize the Chinese economy. However, a Chinese invasion of Taiwan is an event that is not currently priced into markets and therefore any news of potential escalation could have a significant negative effect on markets.
We don’t have time to touch on all of the geopolitical risks but while we do think the geopolitical risk is currently heightened, we do not think geopolitics are most likely to be the primary driver of financial markets in the coming months.
3. What effect will the election have on markets?
If you made it this far, you are either a persevering reader or you skipped the boring stuff straight to my election thoughts. This is the third presidential cycle I have been in the industry for and the questions and fears for clients usually surround how the market will react if the preferred candidate doesn’t win. I have talked extensively in previous commentaries about how the market reacts to Republicans and Democrats in office and what returns have looked like historically for each scenario. I will not rehash all of that here, but in summary, markets prefer a divided government over a unified government. They have been historically positive on average in all scenarios and there is not a meaningful difference in returns based on the party occupying the Oval Office.
The other piece of historical data is that the 2-3 weeks preceding the election have been the worst returning and most volatile period of the election year, with the time between election day and the end of the year returning 3% on average over the last 100 years. I do however sympathize with those who would say all the historical data is nice but that doesn’t tell us anything about the unprecedented risk that might come if a certain policy was enacted, or a certain presidential candidate wins. As an American citizen who cares about the future of our country, I too have views on the issues at stake in this election and have policies I am excited about along with policies I greatly hope are not enacted. However, from a strictly financial markets perspective, I take comfort in the way the market prices in events like this election.
According to Polymarket, Donald Trump currently has a 51% chance of winning the election while Kamala Harris has a 48% chance. This means that the stock market currently views the election as close to a coin flip and yet it has continued to rally. For those worried about a Kamala Harris presidency’s effect on markets, on July 15, Trump had over a 70% chance of winning the election and now, despite a 20% move toward Kamala Harris, the S&P 500 sits 2% higher. For those worried about a Trump presidency, on May 12, Trump had a 44% chance of winning the presidency which then climbed to over 70% on July 15, and over that time the S&P 500 returned nearly 8%. The key takeaway is not to over-extrapolate from those numbers but rather to see that a variety of factors move the stock market, and it is capable of rallying regardless of who wins.
Finally, since the market is a leading indicator, it is always doing its best to price in the likelihood of an event ahead of time. As a result, the events that surprise markets are not ones that have a roughly 50/50 probability of occurring. I would be viewing this election differently if one candidate had a 75% chance of winning, but given the current probabilities, I do not view either outcome as being one that will take the market by surprise.
We do think the playbook at the sector level and asset allocation level is different depending on the winning candidate, and we will talk more about our positioning at those levels in future commentaries once we see who wins in November.
Conclusion
So how do we think about the market, given all that we have discussed? We think the backdrop for stocks remains positive. The major central banks around the world are dovish (meaning they’re keeping interest rates low to boost economic growth) with the Fed recently becoming dovish due to inflation coming down and the PBOC notably going to extreme measures to support the Chinese economy. There is also a lot of data showing cash on the sidelines that may be put to work post-election and should be supportive for the stock market. Additionally, one of the things we’ve talked about in previous commentaries was the need for the market rally to broaden beyond mega-cap tech stocks and we have seen that come to fruition, which is a very healthy sign. As of the end of June, only 17% of the stocks in the S&P 500 were outperforming the S&P 500 over the last year, but in the month of September, that number increased to over 60%. We do think the several weeks leading into Election Day may be a difficult period for stocks but think we would regret getting overly defensive in this current environment.
As for tactical allocation decisions, on the stock side, we like the opportunity in emerging markets and small-cap stocks. Both have underperformed in recent history, but a weaker US dollar, China’s monetary easing, and easier borrowing conditions bode well for both asset classes that are currently significantly discounted compared to large-cap US stocks. Finally, we think in the short term, if the Fed does disappoint markets with the number of rate cuts they deliver, we believe there could be a short-term upward move in the shorter-term interest rates, which may pose a problem for bonds. We plan to keep our duration short in our bond portfolios in an attempt to mitigate the effect on the prices of our bonds.
This is a fast-moving, data-dependent market where each new data release has the ability to change the narrative. We will be making adjustments accordingly but if you have questions along the way, please reach out to see how we are currently thinking about things.
Cheers!
Christian
