Quarterly market outlook - fourth quarter 2024

Asset class performance

Looking back at the 3rd quarter

Stocks and bonds rallied in the third quarter, aided by the first Federal Reserve interest rate cut of this cycle and stimulus from China’s policymakers.

Broadening leadership a key theme in equity rally

Stocks posted strong returns in the third quarter, with the S&P 500 finishing at an all-time high. However, unlike prior periods when gains were driven by mega-cap tech stocks, areas of the market that have lagged over the past several years outperformed in the third quarter.

U.S. small- and mid-cap stocks gained roughly 9%, outperforming U.S. large-cap stocks, which rose by 5.9%. At a sector level, it was real estate and utilities that outperformed, each rising by more than 17%. Technology, which has been one of the top-performing sectors over the past several years, posted a modest 1.6% gain.

Fed cuts rates for the first time this cycle and signals additional cuts ahead

With inflation falling and signs of the labor market softening, the Fed cut its policy rate by 0.5% at its September meeting. Updated projections showed Federal Open Market Committee (FOMC) members expect another 0.5% of cuts in 2024 and 1% of additional cuts in 2025.

Bond yields fell in the third quarter in anticipation of easing Fed policy, with the 10-year Treasury yield declining from nearly 4.5% on July 1 to around 3.75% at quarter-end. Bonds rallied in response, with U.S. investment-grade bonds, emerging-market bonds and U.S. high-yield bonds each rising by more than 5%.

International stocks outperform on news of China stimulus

International equities rallied in the third quarter, boosted by additional stimulus from China’s policymakers to help support the country’s sluggish economy and property market. Emerging-market stocks rallied by roughly 9%.

Equity markets in Europe and Japan, which are more dependent on China’s economic growth, rallied as well, with developed international large-cap stocks gaining 7.3% and developed international small- and mid-cap stocks rising by 10.3%.

Action for investors

Broadening leadership was on display in the third quarter, which highlights the importance of diversification. Your financial advisor can help ensure your portfolio is appropriately diversified based on your long-term goals.

Economic outlook

The U.S. labor market is showing signs of easing, while inflation is moderating. We continue to see a “soft landing” for the economy as the most probable outcome.

U.S. labor market in decent shape despite signs of cooling

The labor market has shown some signs of easing in recent months, with the unemployment rate rising from its 2023 low of 3.4% to around 4.2% as of September. Meanwhile, nonfarm jobs added have slowed to under 200,000 in recent months, while total U.S. job openings have also come down to the lows of the year.

The labor market is moderating from its post-pandemic highs, but we don’t see signs that it is collapsing. A 4.2% unemployment rate remains well below long-term average U.S. unemployment rates of around 5.5% to 6%. In addition, the rise in unemployment has been driven in large part by entrants coming into the workforce more so than layoffs or job cuts. This in our view better supports household consumption.

Inflation is also moderating

U.S. inflation has also shown consistent downward trends in recent months. Headline consumer price index (CPI) inflation has fallen from June 2022’s rate of 9.1% year over year to 2.5% as of September.

We believe inflation may continue to move gradually lower toward the Fed’s 2% target in the months ahead, driven by a couple of key factors:

1. The shelter and rent component of the CPI basket should play some catch-up with real-time U.S. housing and rental price gains data, which have moderated since the highs of 2022.
2. The cooling labor market and lower job openings may lead to easing wage growth, which should put downward pressure on services inflation broadly.

Economic growth overall may slow, but the soft landing remains intact.

Overall, we believe the U.S. economy has shown signs of moderation, especially as the labor market has cooled and the manufacturing sector continues to show signs of weakness.

While growth may moderate in the coming quarters, we don’t see any signals of negative growth or recession on the horizon. Retail sales and corporate earnings continue to show solid growth, and the Federal Reserve Bank of Atlanta’s GDPNow tracker indicates a healthy 3.1% annualized economic growth rate for the third quarter.

In fact, as inflation moderates and the Fed cuts interest rates in the months ahead, the cost of borrowing for consumers and corporations should come down. These lower rates should improve costs in areas such as mortgages, auto loans and credit card fees.

We may see U.S. economic growth reaccelerate in the quarters ahead as lower rates make their way through the real economy and likely lead to higher household and corporate spending.

Action for investors

Given the potential for lower interest rates and no recession in the U.S. economy, we recommend investors overweight U.S. equities versus fixed income.

Equity outlook

The U.S. equity market continued to see solid gains through the third quarter, but we would expect the pace of these gains to moderate. While markets may experience bouts of volatility, pullbacks can present opportunities for long-term investors.

Market leadership starts to broaden

While the S&P 500 is up over 20% year to date through September, in the third quarter, stock market leadership rotated. Interest rate-sensitive and cyclical sectors such as utilities, real estate and industrials all outperformed, while technology and communications services underperformed. These underperforming sectors also include many of the artificial intelligence (AI) mega-cap stocks that have led the market higher over the past several quarters.

In our view, stock market leadership should continue to broaden, with some of the lagging parts of the market continuing to play catch-up as the Federal Reserve and global central banks move interest rates lower. We believe diversification — owning growth, value and cyclical sectors, as well as large- and mid-cap stocks — will remain an important foundation for portfolios in the quarter ahead.

Impact of Fed interest rate cuts

In our view, the Federal Reserve’s possible multiyear rate-cutting cycle could support stock market returns for a few key reasons:

• Historically, when the Fed is cutting rates and there is no imminent economic recession, markets have tended to perform well.
• Fed rate cuts typically support an expansion of stock market valuations. We believe the sectors with the largest scope for valuation expansion include non-tech and AI stocks, which have already seen a meaningful rise in valuation.
• Fed rate cuts over time can support consumer and corporate spending, and help reaccelerate economic and corporate earnings growth. This is supportive of better stock market performance.

Volatility could be an opportunity

While we believe equity markets are well-supported in the current backdrop, stocks have had a strong run already this year. We would expect the pace of these gains to moderate, especially as we head into a seasonally choppy October and U.S. elections in early November.

Markets may experience additional bouts of volatility and corrections, which are normal in any given year. Pullbacks can present opportunities to diversify portfolios, rebalance or add quality investments at better prices, as we believe the underpinnings of the bull market expansion are intact.

Action for investors

We recommend overweighting U.S. large- and mid-cap equities. We remain neutral between growth and value, as we believe stock market leadership will continue to broaden in the months ahead. Consider using pullbacks as opportunities to diversify, rebalance or add quality investments at better prices.

Fixed income outlook

The Federal Reserve started its easing cycle in September, cutting its target range for the federal funds rate for the first time in four years. Bond yields remain above their averages over the past decade, despite pulling back from recent peaks. This potentially sets the stage for stronger returns ahead.

Extending duration with intermediate-term bonds and bond funds can help lock in yields for longer ahead of likely additional Fed rate cuts. Emerging-market debt appears more attractive than U.S. high-yield bonds, in our view.

Higher bond yields offer potential for stronger returns

Bond yields rose over the past few years as the Fed hiked interest rates to fight inflation. As shown in the chart above, yields for the major fixed-income asset classes remain above their averages over the past decade. This is despite pulling back from their recent peaks as inflation moderated and markets priced in expectations for Fed rate cuts.

Higher yields mean bonds generate more income. Since income is a key driver of bond returns, it also potentially sets the stage for stronger returns ahead.

Extending duration can help lock in yields for longer

Short-term yields could fall further as the Fed continues cutting rates. This will likely steepen the yield curve and raise reinvestment risk for short-term bonds and CDs. We see particular value in intermediate-term bonds and bond funds, which can help lock in yields for longer.

Additionally, bond prices typically rise when interest rates fall, and vice versa, offering the potential for higher values. While long-term bonds are likely to benefit from Fed rate cuts, their narrow spread above intermediate-term yields implies there may be less scope for long-term yields to fall further.

We favor emerging-market debt over U.S. high-yield bonds

The resilient U.S. economy supports lower-quality issuers, including U.S. high-yield bonds. Credit spreads — which reflect the excess yield above U.S. Treasury bonds — are well below historical averages as a result. We see limited opportunity for them to narrow further.

Emerging-market debt is more attractive, in our view, due to its higher quality and longer duration. It could benefit more as global central banks likely continue cutting rates.

Action for investors

Bond yields remain above their 10-year average, offering the potential for stronger returns ahead. Intermediate-term bonds and bond funds can help you lock in rates for longer. We suggest overweighting emerging-market debt and underweighting U.S. high-yield bonds.

International outlook

After six straight quarters of underperformance, international stocks outpaced U.S. stocks in Q3 on the back of a softening dollar, rotating sector leadership and optimism around China’s stimulus announcements.

With major central banks easing policy, we expect the uptrend in global stocks to remain intact. The U.S. economy will likely continue to lead, but improving prospects elsewhere support the case for an appropriate allocation to the heavily discounted international equities.

China policymakers pull out the stops

A recent major development is China’s surprise announcement of a basket of policy stimulus measures targeting the general economy, the real estate sector and the stock market. Growth trends in the world’s second-largest economy have disappointed amid an ongoing slump in the property market and record-low consumer confidence.

To help stabilize and revive growth, policymakers lowered interest rates and mortgage costs, freed up funds for banks to increase lending, and pledged to provide greater fiscal support. Unlike other efforts in the past two years, the latest measures show a high degree of urgency and determination to deal with the economy’s challenges, triggering a sharp rally in Chinese equities.

Questions remain whether the promises for fiscal stimulus will be delivered and enough to prop up the economy. However, policy support, depressed investor sentiment and cheap valuations should improve the near-term outlook for China and emerging-market equities.

Europe hits a soft patch

After a modest recovery in the first half of the year, European economic activity measures have recently softened, indicating weakening growth at the end of Q3. Germany, the region’s largest economy, has stagnated over the past two years, weighed down by sluggish manufacturing activity. In contrast, Southern European countries have outperformed, boosted by strength in services.

We expect positive but slow growth for the region in the quarters ahead. Together with cooling inflation, this should give the European Central Bank (ECB) confidence to continue gradually cutting interest rates.

Global easing cycle may broaden bull market

A new cycle of central bank rate cuts across most regions (except Japan) can help drive a recovery in global economic activity. Cyclical sectors carry a higher weight in international indexes and could benefit from a pause in tech enthusiasm as sector leadership broadens on the back of easier rate policy.

While the relative earnings momentum remains in favor of the U.S., the record 35% valuation discount of international equities and a softer U.S. dollar suggest overseas stocks may offer catch-up potential and provide diversification benefits.

Action for investors

We recommend overweighting U.S. stocks and underweighting international equities based on the relative economic and earnings trends. Within fixed income, consider overweighting emerging-market debt, which has higher interest rate sensitivity and historically outperforms U.S. bonds in periods following Federal Reserve rate cuts.

The Federal Reserve and cash yields

Cash yields typically rise ahead of Federal Reserve interest rate hikes and drop before rate cuts. As the Fed likely continues cutting interest rates, we expect cash yields to fall further.

Some investors may be overweight in cash, including money market funds. Investments in these funds increased over the past few years as their yields rose along with Fed rate hikes. Holding too much cash can present risks, such as the potential for lower returns over the long term.

Cash yields likely to fall further

With the Fed’s dual mandate of maximum employment and stable prices returning to better balance as labor markets have gradually cooled and inflation has moderated, monetary policy can be less restrictive. Further rate cuts could cause cash yields to decline more than intermediate- and long-term yields, likely steepening the yield curve and increasing reinvestment risk on cash, including money market funds.

Some investors may be overweight in cash

We include money market funds in the cash asset class due to their strong liquidity, high quality and price stability. With the upswing in money market fund investment, some investors may now hold more cash than they need.

Holding too much cash can present risks

Cash can provide important benefits, such as funds for unexpected expenses and emergencies, a specific short-term savings goal and everyday spending. It also can serve as a strategic allocation for investment and a source for investment opportunities.

However, holding too much cash can present risks, including the potential for lower returns, especially when investing for long-term goals. For perspective, since 1981, U.S. large-cap stocks have delivered annualized returns of 11.2%, compared with 6.8% for U.S. investment-grade bonds and 4.1% for cash.

While returns will likely be lower going forward, we expect this general relationship to hold over the long term, with equities outperforming bonds and cash lagging most asset classes. Investors who are overweight in cash may want to consider reinvesting a portion of these funds.

Action for investors

Consider reinvesting excess cash in strategic allocations in equities and bonds. Talk to your financial advisor about potentially overweighting those where we see current opportunities, such as U.S. large- and mid-cap stocks and emerging-market debt.

Strategic asset allocation guidance

Our strategic asset allocation represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class will depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Opportunistic portfolio guidance

Our opportunistic portfolio guidance represents our timely investment advice based on our global outlook. We expect this guidance to enhance your portfolio’s return potential, relative to our long-term strategic portfolio guidance, without taking on unintentional risk.

Visit our monthly portfolio brief for a discussion of portfolio performance.

Investment performance benchmarks

It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.

As of Sept. 30, 2024

Asset class performance

U.S. equity sector performance

Source: Morningstar Direct. Total returns in USD. Three- and five-year periods are annualized returns. U.S. large-cap stocks represented by the S&P 500 Index. U.S. mid-cap stocks represented by the Russell Mid-cap Index. U.S. small-cap stocks represented by the Russell 2000 Index. International developed large-cap stocks represented by the MSCI EAFE Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID Index. Emerging-market stocks represented by the MSCI EM Index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate Bond Index. International bonds represented by the Bloomberg Global Aggregate Ex USD Hedged Index. Emerging-market debt represented by the Bloomberg Emerging Market USD Aggregate Index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer Cap Index. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. Equity sectors of the S&P 500 Index. An index is unmanaged and is not available for direct investment. Performance does not include payment of any expenses, fees or sales charges, which would lower the performance results. The value of investments fluctuates, and investors can lose some or all of their principal. Past performance does not guarantee future results.