Investment Commentary – October 28, 2024

Market Observations

A positive corporate profit backdrop and expectations of Fed rate cuts have sustained the risk on phase. Although policy rate cuts will likely not match the expectations previously priced in the US forward market, the Fed will likely ease more over time. For now, the positive outlook of global profits and lower policy rates favor risk assets. After several weeks of largely ignoring the bond market, last week’s stocks seemed to be finally sliding in the face of rising yields – the S&P 500 down ~1% and the Russell 2000 small cap index down ~3%. However, the biggest market-moving event last week was rising treasury yields. The 10-year Treasury yield rose to 4.25% on Friday, up by 60 basis points from the day before the Fed’s 50bps rate cut (when the 10-year yield was 3.65%), and up by 5 basis points from a week ago. This 4.25% is a milestone of sorts. The 10-year yield has now reached the highest point since July 25. On July 25, longer-term yields began to speed up their decline as the bets on Fed rate cuts kept gaining momentum on less-than-hot labor market data and cooling inflation and kept declining until the Fed cut by 50bps on September 18th. Shortly afterward, longer-term yields headed higher instead of dropping further. Everything from 3-year through 20-year yields has risen by 60 basis points or more since the rate cut. The twoyear Treasury yield has been above 4% the entire week and on Friday closed at 4.11%, the highest since August 1. It has come up in part because the aggressive rate-cut expectations are waning as investors continue to see signs of resilient economic GDP growth of around 3% and increased focused perception that neither political party seems focused on the budget deficits. The US federal government deficit remains high and is tracking 6.6% this year (similar to Italy) despite generating 3% average GDP gains over the past eight quarters – begging the question of what happens to the deficit when the economy slows to its long-term trend. We believe that if the next few inflation readings are benign, and the labor market data re-weakens, the 10-year yield will likely back off from these levels.

Equities

The S&P 500 returned -1.0% for the week as traders took a breather from the relentless march upwards, rates moved higher, and mixed earnings announcements from major companies. Consumer discretionary (+0.9%) and technology (+0.2%) were the only sectors in the S&P 500 to eke out positive returns; materials (-4.0%) and healthcare (-3.0%) were the laggards. EAFE markets returned -2.0%, with Japan (-4.0%) and Europe (- 1.4%) dragging on returns. EM markets returned -1.8%, dragged down by India (-3.7%) and Korea (-2.3%). From a valuation perspective, most markets are within ±1 standard deviation based on historical forward P/E ratios, though the S&P 500 is at +2.1 and the NASDAQ is at +1.3. For the next 12 months, EPS growth for S&P 500 is expected to be 8.8% (vs. 7.2% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 17.1% (vs. 12.7% annualized over the last 20 years). All major world indices, including the S&P 500 (US Large Cap), NASDAQ, Russell Midcap (US Midcap), Russell 2000 (US Small Cap), MSCI EAFE (Non-US Developed Market Equities) and MSCI EM (EM Equities) trade at or above their 20-year averages based on forward P/E ratios.

Fixed Income

Investment grade fixed income sectors were negative as rates spiked higher across the curve. Municipals returned -1.2% following a major sell-off early in the week followed by a small rally. The yield for intermediate national composite went from roughly 2.7-2.8% to 3.0-3.1% and then down to 2.9% in the matter of a week. US AGG returned -0.9%. Yield in agency mortgage securities looks attractive at ~150bps over treasuries (vs. ~110bps average) while non-agency mortgages look attractive, offering ~6.5% yield with a duration of less than 3 years. US IG returned -1.0% as credit spreads remain tight. HY bonds returned -0.4% while bank loans returned 0.1%. EM debt returned -0.4% as the US dollar rose 0.7%.

Rates

Rates spiked higher across the curve as traders continued to pare back expectations of aggressive Fed cutting. The recession-watch 3M-10Y spread compressed 15ps and closed the week at -41. The 2Y-10Y spread was unchanged at +14. Rates rose in other developed economies as well other than in Japan. The BTP-Bund spread is at 1.21%. 5-year and 10-year breakeven inflation expectations rose and now sit at 2.31% and 2.29% respectively; the 10Y real yield rose 17bps to 1.95%. The market now expects the Fed to cut between one and two times vs the Fed’s guidance of two cuts. At year-end 2024, the market expects the Fed Funds rate to be 4.4%.

Currencies/Commodities

The dollar rose 0.7%. The commodities complex rose 2.8% as energy prices rose 4.7% for the week. Brent prices rose to $76/bbl. US natural gas prices rose 13.4% on expectations of colder weather, while European gas rose 10.7% as traders set up for an Israel strike on Iran.

Market monitors

Volatility rose for equities and bonds (VIX = 20, MOVE = 128); the 10-year average for each is VIX=18, MOVE = 78. Market sentiment (at midweek) fell to 8 from 20 but remains bullish.