Q4 Economic and Financial Market Outlook

By Peter R. Phillips, CFA®, CAIA®
Senior Vice President and Chief Investment Officer
Washington Trust Wealth Management

Moderating inflation and the start of a Fed funds easing cycle, so what does that mean for investors?  

Q3 Recap: The Easing Cycle Begins

With inflation finally moderating, the Fed is poised to begin its highly anticipated easing cycle. The prospect of lower interest rates is keeping investors bullish on the economy and financial markets.

Moderating inflation and a softening labor market provided the Fed opportunity to begin a fed funds rate easing cycle. The Fed’s preferred measure of inflation, the PCE Price Index, continues to fall towards the 2.0% target. In August, the PCE Price Index increased 2.2% on a year/year basis, down from 2.7% at the beginning of the year.ⁱ Further, the U.S. job market is cooling, with an average 186,000 jobs gains per month in Q3, down from an average of 267,000 in the Q1 this year. Citing the progress on inflation and slower job gains, the Fed cut the target range for the fed funds rates by 50 bp to 4.75%-5.0% at its September 18 meeting. Importantly, economic growth remains solid, and consensus estimates expect U.S. GDP growth of 2.5% in 2024. 

Equity markets continue to move higher. The S&P 500 produced a 5.9% total return in Q3 and 22.1% YTD. Continued strong economic performance through the first three quarters of the year provides support for the 2024 corporate earnings outlook, and prospects for the start of a Fed easing cycle is keeping investors optimistic and bullish. Stock performance broadened beyond large capitalization growth stocks with more value-oriented stocks and smaller capitalization stocks leading performance in the quarter. Nevertheless, large capitalization stocks—and especially the Fantastic Five (Nvidia, Microsoft, Alphabet, Amazon and Meta)—continue to be key drivers of both earnings growth and price performance for the S&P 500.

Fixed Income markets returns were strong. The Bloomberg U.S. Aggregate Bond Index returned 5.2% in Q3 and 4.4% % YTD. Moderating inflation and prospects for the start of a Fed funds rate easing cycle drove yields lower, boosting bond prices and total returns. U.S. Treasury yields fell sharply in Q3 and from April highs. Two- and ten-year U.S. Treasury yields fell 108 bps and 58 bps, respectively, in the quarter.

The start of a Fed funds easing cycle is keeping investors bullish on the economy and financial markets.

The Economy Remains on Solid Footing

In the first half of 2024, real GDP (adjusted for inflation) grew approximately 2.3% on a seasonally adjusted annual rate (SAAR). The Atlanta Fed GDPNow estimate for Q3 growth is 3.2%, and the FactSet consensus estimate for full-year 2024 growth is 2.5%. Economist clearly see the economy on solid footing.

Labor Market: Softening But Stable

The labor market has been softening throughout the year, but September job growth surprised to the upside—and overall, the labor market appears stable. According to the government’s establishment (businesses) survey of employment, the U.S. economy averaged monthly job growth of 186,000 during Q3, down from 267,000 in Q1.  Excluding the surprisingly strong payroll growth in September, job growth in Q3 only averaged 150,000 jobs per month.

Separately, the government’s household survey of employment, which is used to calculate the unemployment rate, also confirms a slowdown in employment.  The household survey suggests that over the past 12 months only 314,000 jobs have been created, versus 2.7 million jobs created for the 12 months ending a year ago on September 30, 2023. The number of unemployed workers has increased 7.7% from last September.   

The unemployment rate has increased from a low of 3.4% in March 2023 (and a 3.7% rate at the beginning of the year) to 4.1% in September 2024, with a high of 4.3% in July. Such an increase may be an ominous sign for the economy. The “Sahm Rule,” named after former Federal Reserve economist Claudia Sahm, states that when the three-month moving average of the unemployment rate is 0.5% points or more above its low over the prior twelve months, the early stage of recession is signaled.ⁱⁱ The signal has been triggered in three of the past four months.

The Conference Board Consumer Confidence Index also indicates that consumers are increasingly finding jobs less plentiful and harder to get. 

With that said, the job market, while not as robust as experienced over the past few years, is still fairly solid. The 186,000 average monthly jobs created over the past three months is on par with the 188,000 average monthly job gain for the 10 years prior to COVID; and job losses, as indicated by weekly unemployment claims, appears moderate. Further, job openings of 8.0 million, which while down from a high of 12.2 million two years ago, is well above the estimated 6.8 million unemployed workers looking for jobs in the U.S. 

It is worth considering that the softening of the labor market may be reflecting a natural course correction after the huge employment growth period following the COVID-19 shutdown. Only time will tell if historic indicators like the Sahm Rule are applicable as the economy is still recovering from a pandemic-induced global economic crisis.

The labor market has been softening throughout the year, but September job growth surprised to the upside—and overall, the labor market appears stable.

Personal Income Gains and Consumer Spending

As we know, a stable labor market supports personal income gains and consumer spending. Personal income is growing at respectable 5.6% annual rate (year over year as of August 2024) and despite still relatively high inflation levels, real (adjusted for inflation) hourly earnings and real (adjusted for inflation) disposable personal income (both as of August) are still positive at 1.4% and 3.1%, respectively.  While real income growth rates have decelerated from last year, current stable labor market conditions are expected to keep income gains positive.

Personal consumption expenditures are growing at a 5.2% annual rate (year over year as of August 2024) and on a real basis (adjusted for inflation) are growing at a 2.9% rate.  While overall spending remains solid, there is some recent evidence of slowness in durables spending (autos and household durables), and even in discretionary services spending, such as dining out. 

Despite the stable job market and good personal income growth, consumer sentiment related to consumers’ present situation is deteriorating and at a post-COVID recovery low; and future expectation levels are also low. While not an issue now, deteriorating consumer confidence levels could begin to negatively impact future spending.ⁱⁱⁱ (Note: Personal consumption expenditures are typically the largest component of GDP growth.)

Government Spending

Government spending has also been supportive to the economy and is likely to continue. The U.S. federal government continues to run a significant budget deficit. In fiscal 2023, that amounted to $1.7 trillion dollars, or 6.3% of GDP; and for 2024 the Congressional Budget Office (CBO) estimates a $1.8 trillion deficit, or about 6.4% of GDP.^iv This would bring the cumulative deficit since the pandemic (2020) to over $11 trillion.

Fed Rate Pivot

The Fed’s pivot to an accommodative monetary policy stance could possibly help 2024 and 2025 GDP growth prospects. On September 18 the Federal Open Market Committee (FOMC) lowered the federal funds target rate by 50 bp to 4.75%-5.00%, citing confidence that inflation is moving sustainably towards their 2% target, and that the risks of to achieving its employment and inflation goals are roughly in balance. Members of the FOMC also projected that the fed funds rate would be between 2.9%-4.1% by the end of 2025, with a median projection of 3.4%.^v This implies that the Fed is expecting to lower the Fed funds rate by another 125-150 bp over the next 15 months. The fed funds futures market projects a similar outcome.

Such an easing cycle should lower interest rates across the economy, lowering borrowing costs for businesses and consumers (e.g., auto and mortgage loans), and this could be stimulative to the economy. 

We are optimistic that the economy will avoid recession in 2024 and 2025; however, it is not without some concerns.

Economic Outlook: No Recession but Still Risks

We, like most, continue to be pleasantly surprised by the resiliency of the U.S. economy and are incorporating a much more sanguine viewpoint into our outlook. However, there are still some tangible risks to monitor.

Fed’s Restrictive Policy

Although the Fed has embarked on an apparent easing cycle, there could be some lingering impact of the 525bp of Fed funds rate increases from March 2022 through July 2023, which was the largest and fastest rate increase since 1980. Despite the recent move lower, interest rates and borrowing costs across the economy remain near 10+ year highs due to Fed policy over the past two years. 

The impact of monetary policy involves “long and variable lags” that can take 9 to 24 months to impact the economy.^vi Past Fed fund rate increase cycles have led to a slowdown in economic growth and often recession. 

Further, premature fed funds rate cuts could spark another wave of inflationary pressures, constricting purchasing power and presenting risk to economic growth and financial market valuations. The Consumer Price Index (CPI) for September 2024, released on October 10, came in at 2.4%, year over year, a bit higher than expected and highlighting that inflation risk remains.

Partially Inverted U.S. Treasury Yield Curve  

The 3m – 10y U.S. Treasury spread continues to be inverted by 83 bp as of September 30, 2024—and has been for almost two years. Yield curve inversion has been a very good predictor of economic slowdown and recession in the past. To be sure, the 2y – 10y U.S. Treasury spread recently turned positive for the first time since mid-2022 (+14bp as of September 30, 2024). However, the Federal Reserve Bank of New York’s recession probability indicator, based U.S. Treasury yield spreads, still puts the probability of recession within the next twelve months at a relatively high 57%.^vii

Other Economic Indicators: Caution is Warranted

The Leading Economic Index (LEI)—which includes 10 components across financial, labor, manufacturing, consumer and housing markets—continues to weaken and is at a lower level than during the COVID slowdown; however, the year-over year contraction is moderating, signaling slowdown, but not recession.^viii

The Institute for Supply Management (ISM) indexes for manufacturing activity indicates a slight contraction in activity. Of note, the new orders, backlog and employment components of the index are especially weak, suggesting overall manufacturing activity will remain weak into the near future. The overall manufacturing index has signaled a slower growth environment since October 2022. On a positive note, the services index has strengthened in recent months.

The U.S. housing market continues to struggle. Existing home sales, which fell to Global Financial Crisis (2007-2009) levels in 2023 following a sharp rise in mortgage rates, continue to languish near trough levels (and year-over-year growth still in negative territory – down 4.2%). Housing starts, which had experienced periodic signs of strength through and post the pandemic, are having a challenging 2024. On a positive note, home price gains continue to be a bright spot and helpful to consumers’ net worth and financial outlook, up 5.9% on a year over year basis in July. Further, a Fed easing cycle should eventually lower interest rates across the economy, including for mortgage products, making home purchases and upgrades more affordable.

Consumer confidence levels, specifically the future expectations component, is at a level typically associated with recession. The present situation component of the consumer confidence levels recently weakened as well.

It is worth noting that the unique nature of the COVID-induced recession and the aggressive global government spending and central policy response may render past economic indicators ineffective at assisting with current period forecasts.

U.S. Government’s Fiscal Health

We continue to be concerned about the U.S. Government’s fiscal condition and its potential to negatively impact government spending and tax policy, and in turn economic growth, in the years to come. The gross debt of the United States Government has grown $12.3 trillion, or 53%, since the end of 2019 (just before the pandemic) – and now stands at $35.5 trillion (as of 9/30/24).^ix

Due to the significantly higher debt levels and the sharp rise in interest rates over the past year, the Congressional Budget Office (CBO) estimates that net interest payment on the nation’s debt (or the cost to just service the debt) will rise to over 20% of total government revenue by 2025, up from 14.8% in 2023 and an average of 8.7% from 2013-2022. This has significant implications for government spending and tax policy in the years to come, especially given the U.S. budget already operates in a deficit, which the CBO estimates to be approximately 18% of revenue in 2024, excluding net interest expense.^x

We continue to be concerned about the U.S. Government’s fiscal condition and its potential to negatively impact government spending and tax policy, and in turn economic growth, in the years to come.

Financial Markets

Positive economic momentum is supportive of overall corporate earnings and stock prices, but valuation is at a premium. The start of a Fed funds rate easing cycle should result in lower interest rates, providing a boost to the economy, fixed income total returns, and investor sentiment.

Fixed Income

We continue to see opportunity to add duration to fixed income portfolios but continue with a preference for high quality. With yields still in the higher-end of their 15-year ranges and the Fed embarking on an easing cycle in 2024 and 2025, it may make sense to add duration to portfolios.  Credit spreads are extremely tight and do not appear to adequately compensate investors for the added credit risk; as such, it may be too early to add exposure to lower-quality corporate bonds and other higher-risk, credit-sensitive segments of the fixed income market. Current high money market yields are likely to fall, and potentially rapidly, as the Fed lowers the fed funds rate.

Yields. Treasury yields have moved lower and are now at or approaching two-year lows. With expectations of a Fed rate cutting cycle, yields may continue to move lower. As such, we continue to believe adding to duration is appropriate. 

The 2-year Treasury ended Q3 yielding 3.64%, down sharply from 4.72% at the beginning of the quarter and the 5.21% peak in mid-October 2023. The current yield is still relatively attractive in the context of the 0.09%-5.21% 15-year range and moderating inflation levels. The 10-year Treasury ended Q3 yielding 3.79%, down sharply from 4.37% at the beginning of the quarter and the 4.99% peak in mid-October 2023, but up from 3.88% at the beginning of the year.  The current yield is still relatively attractive in the context of the 0.50%-4.99% 15-year range and moderating inflation levels. 

Inflation readings suggest prices across the economy are on a sustained path lower (at least according to the Fed) and the labor market, while still relatively strong, is showing some early signs of cooling. As such, the Fed has embarked on what is expected to be an easing cycle over at least the next 15 months.  On September 18, the Fed lowered the fed funds target rate by 50 bp, and FOMC members (based on their median forecast) expect another 150 bp of cuts by December 2025. The fed funds futures markets suggest a similar outcome.

Such Fed action would likely result in lower yields, especially for shorter-to-intermediate term fixed income maturities. Longer-term fixed income securities could also see lower yields but are more likely to be impacted by inflation levels—that is, we believe both a lower Fed funds and lower inflation levels are likely needed to see lower long-term yields. Lower yields provide a tail wind to fixed income total returns (bond prices move inversely with interest rates—as rates move lower, prices move higher, and vice-versa).

Of course, yields could begin to rise again, resulting in a head wind for fixed income returns. Inflation could reemerge and force the Fed to hold steady with interest rates. Additionally, “bond vigilantism” may grow if investors become uneasy with the U.S. government’s large budget deficits and growing debt, leading them to begin to demand higher risk premiums (yields) to offset the perceived risk of unsustainable spending and debt accumulation.

Credit spreads. Credit spreads remain at the low end of historical ranges and do not appear to price in any hiccups in the economy—and especially not any significant slowdown and/or recession. Therefore, it may be too early to add exposure to lower quality corporate bonds.

Investment grade spreads at 89bp remain slightly below the twenty-year average of about 149 bp and significantly below spreads during economic slowdowns and recessions. High Yield spreads at 295bp remain significantly below the 20-year average of about 491bp, and significantly below spreads during economic slowdowns and recessions.

Corporate earnings growth is supportive and broadening but appears heavily reliant on a small number of information technology-related companies.

Equity

We continue to have a cautious outlook for stock prices.  With the ongoing stock price rally, stocks do not appear “cheap.” Corporate earnings growth is supportive and broadening but appears heavily reliant on a small number of information technology-related companies. The current price/earnings valuation of 20.9x 2025 earnings estimates leaves little room for any disappointing news.

Corporate earnings. The solid performance of the U.S. economy is surely helping corporate earnings growth, which is supportive of stock prices. Current consensus S&P 500 earnings call for 2024 and 2025 earnings per share growth of 9.3% and 14.8%, respectively, up from 0.4% growth in 2023. We view these consensus numbers as somewhat reasonable given economic growth forecasts; however, we would not be surprised to see some moderation in these growth estimates in the back half of 2024 and into 2025, due to:

• Historical patterns in the trend of annual earnings estimates (i.e., calendar year earnings estimates tend to fall as the year progresses)
• Concerns about earnings growth concentration.  Three sectors (Information Technology, Health Care, and Communication Services) are expected to produce over 60% of the S&P 500’s adjusted net income growth in 2025, with IT alone responsible for approximately one-third of the growth; and the Magnificent Seven (Alphabet, Amazan, Apple, Meta, Microsoft, Nvidia, Tesla) responsible for about 20% of the growth. 

Stock prices

Despite some bouts of price volatility, stock prices (as measured by the S&P 500) continued to move higher and closed the quarter up 5.9% and at an all-time high. The S&P 500 is up 20.1% year-to-date and up 36.4% over the past year. 

Stock prices fell 8.5% in late July thru early August as economic growth concerns were making the headlines. A weaker-than-expected payrolls report and an increase in the unemployment rate to 4.3% generated concerns that the Fed was “behind the curve” in switching to a more accommodative policy position. The decision by President Joe Biden to withdraw from his re-election bid and support Vice President Kamala Harris added another wrinkle to the outlook for financial markets. Stock prices worked higher through these uncertain headlines focusing on the still strong earnings outlook, especially for large-cap IT stocks, and of course, the September FOMC meeting and start of a Fed rate cut cycle.

The S&P 500’s price/earnings ratio (valuation) is at a relatively expensive level. The ongoing rally in stock prices puts the current S&P 500 p/e ratio based on 2025 estimates at 20.9x. This is not a cheap valuation, especially in a still relatively elevated inflationary and interest rate environment.   If inflation and interest rates fail to fall in the coming year, then we see downside risk to valuation.

There is an inverse correlation between inflation and p/e ratios. Higher inflationary environments typically result in lower p/e ratios, and vice-versa. Since 1960, 2%-3% inflationary environments (as measured by the CPI) have resulted in average low and high P/E ratio range of 17x-21x. To be sure, there are certainly times when the P/E ratio is above or below this range, and for an extended period. As such, today’s 20.9x P/E ratio, while at the high end of a range we consider reasonable, does not indicate that stock prices are poised to fall. But it does indicate a higher level of valuation risk, in our opinion.  

While high P/E ratios do not necessarily provide good insight into subsequent one-year stock returns, they do exhibit a higher degree of correlation with longer-term returns. That is, high P/E ratio environments typically see lower subsequent longer-term (5-year) returns, and vice-versa.^xi

Current valuation levels leave little room for any disappointment, whether it be from the economy, corporate earnings, or some other unforeseen risk.

Small- and mid-capitalization stocks. We have a neutral position on small- and mid-cap stocks relative to large cap stocks, but that could change as the Fed progresses with a more accommodative monetary policy stance.

Small- and mid-cap stocks look cheap, especially compared to large-capitalization stocks; however, the small-and mid-cap indices lack exposure to the “growthier” segments of the economy. Small- and mid-capitalization stocks are trading P/E ratios that are at 29% and 26% discounts, respectively, to their 20-year historical P/E valuation relative to large-cap stocks.

The S&P 600 Small-Cap Index and the S&P400 Mid-Cap Index have significantly less exposure to growth sectors of the economy such as Information Technology, Communication Services, and Healthcare. For instance, Information Technology stocks comprise only 12.8% and 9.5% of the S&P small- and mid-cap indices, respectively, versus 32.5% for the S&P 500. Communication Services stocks only comprise 2.8% and 1.6% of the S&P small- and mid- cap indices, respectively, versus 9.3% for the S&P 500.

Until economic growth prospects broaden beyond the IT segments of our economy (such as artificial intelligence), we suspect the small- and mid- cap stock indices will continue to trade at discounts to large-cap stocks. With that said, the Fed’s pivot to more accommodative policy and aggressive rate cuts could also present an opportunity for an improvement in the small- and mid-cap valuation discount relative to large-cap.  Small- and mid-cap stocks have significantly more exposure to cyclical and interest rate sensitive areas of the economy such as Industrials, Material, and Financials.

International equity. We continue to underweight our exposure to international equities but see performance benefits from a weak U.S. dollar. Although valuations appear significantly lower than in the U.S., earnings growth rates across the developed international countries are much less attractive, partly due to their more modest exposure to global scale information and medical technology companies. 

In addition, the Russian/Ukraine and Middle East conflicts have a much greater and direct impact on economies outside of the United States. Across Europe, 2024 and 2025 economic growth projections are relatively poor and below that of the U.S. In the emerging markets, heightened risks keep us cautious—specifically, geopolitical risks related to China.

We do recognize a weaker U.S. dollar will boost unhedged international investment returns. The U.S. dollar fell 4.3% versus the Euro in the Q3, and the consensus forecasts call for further dollar weakness in anticipation of lower U.S. inflation, a more accommodative U.S. Federal Reserve policy, and improving global economic growth relative to the U.S.  As such, we do see value in having some exposure to international equities.

A Word on the Upcoming Election

In general, history suggests financial markets react more to economic conditions than election results – and over long periods, stock prices move higher regardless of the political party in the White House or in control of Congress. While contentious and hotly contested elections can certainly create investor anxiety, any change in investment positioning based on a forecast of election results is purely speculative, especially when polling indicates no clear winners (both in regards to the presidency and control of Congress), as is the case now. As such, investors should stay focused on their long-term financial goals.

Enjoy your fall and please reach out to your Washington Trust wealth advisor team with questions about how the economy and market may impact your portfolio and long-term financial plan.