As the final quarter of 2024 begins, there are a number of factors – fed interest rate target, presidential election, ongoing international conflicts to name a few – that could influence the overall markets. Our investment management team has provided a thorough review of the previous three quarters as well as an insightful look into what might lie ahead. With equity markets having a stellar year and bond yields still remaining higher for longer, our strategic portfolio positioning has capitalized on a rather unusual market scenario.
The market, as measured by the S&P 500 (SPY), continued its positive performance in 2024 by returning 5.5% in the third quarter. However, in a reversal of recent trends, large cap domestic stocks lagged in performance relative to other equity indices. Small Cap stocks, as measured by the Russell 2000 (IWM), led the pack with a solid 10.2% return, while international markets (ACWX, EEM, EFA) all performed within a tight range of 6.6%-7.5%, making the third quarter a strong one regardless of market capitalization or geography.
We believe the strong quarter in riskier stocks was driven by short-term reactions to external factors. Small cap stocks rallied in advance of the Fed’s September rate cut, and continued when the rate cut came in larger than expected at 0.50%. In addition, Emerging Markets (EEM) received a boost on September 24th when China rolled out is biggest stimulus package since the Covid pandemic in 2020. China makes up 25% of the MSCI Emerging Markets index 1. According to Reuters2:
The broader-than-expected package offering more funding and interest rate cuts marks the latest attempt by policymakers to restore confidence in the world's second-largest economy after a slew of disappointing data raised concerns of a prolonged structural slowdown. But analysts questioned how productive the People's Bank of China's liquidity injections would be, given extremely weak credit demand from businesses and consumers, and noted the absence of any policies aimed at supporting real economic activity. "This is the most significant PBOC stimulus package since the early days of the pandemic," said Capital Economics analyst Julian Evans-Pritchard. "But on its own, it may not be enough," he added, saying more fiscal stimulus may be needed to return growth to a trajectory towards this year's official target of roughly 5%.
We believe emerging markets do not offer an attractive long-term risk/return trade off, therefore we intend to continue an underweight positioning to not only emerging markets but also small cap equities.
As we look deeper into the performance drivers for US Large cap stocks, it is important to contextualize the largest holdings of the index known as the “Magnificent Seven”. Because the S&P 500 is a market cap weighted index, the largest companies of the index drive the bulk of the performance. And, as you can see below, Nvidia (NVDA) actually lost share value, along with Amazon (AMZN), Microsoft (MSFT), and Alphabet (GOOG) during the third quarter. That said, NVDA is still positive 136% year-to-date, which far exceeds any of the other “Magnificent Seven” companies. Tesla (TSLA) was the star for the third quarter returning 24%, although the year-to-date results are now in the low single digits. These movements illustrate why we believe leveraging broad-based large cap indices, rather than attempting to pick individual stocks, is the most beneficial for portfolio performance. Picking the correct stock at the correct time, then selling at the exact right time is extraordinarily difficult. In fact, active managers, or those who attempt to outperform their respective indices, tend to underperform. According to S&P Global’s SPIVA Scorecard3, 91% of actively managed domestic equity funds underperformed their comparison index for the ten-year period ending 2023. Therefore, we believe seeking alpha and diversification from alternative investment products is the exceptional portfolio construct. It is important to note that virtually all alternative asset products are actively managed.
The yield curve moved dramatically over the course of the third quarter with anticipation of a rate cut by the Fed. The movement leading up to the rate cut was a great indicator because, by the time the rate cut occurred, there was very little movement in the curve. The chart below4 illustrates how Treasury bond yields were actually higher on April 30th and moved steadily lower over time based on expectations – not an actual rate cut. When the rate cut did occur in September, the short-term portion dropped as expected, but the longer dated portion of the curve (beginning at the 3-year mark) barely changed, meaning the bond market accurately predicted the Fed’s actions.
The steady drop in yields over the course of the third quarter boosted fixed income funds with duration (or, interest rate sensitivity), so the performance of Aggregate Bonds (AGG) and High Yield bonds (HYG) substantially outperformed Floating Rate bonds (FLOT). Note the impact of duration on bond performance is inversely related, meaning bonds with duration gain value when rates fall and lose value when rates rise. We believe the market has not only priced in the first 50 basis point move but also more aggressive cuts in the future, so we have continued to overweight Floating Rate bonds.
The chart below illustrates the impact that duration had on fixed income investments in the quarter with High Yield (HYG) and Aggregate Bonds (AGG) returning almost 6%. Floating Rate has very low duration, and therefore did not benefit from the drop in yields.
The market remains positive for taking risk in the portfolio, although geopolitical and political risks are increasing. Cheaper capital (i.e. lower rates) generally benefits risky/levered assets and is supportive of economic growth. In particular, the conflict in the Middle East continues to escalate and the war in the Ukraine continues to grind on with no clear end in sight. The outcome of the US election remains another important unknown, though the impact on the markets may be muted if majorities in the house and senate do not coincide with the winner of the White House.
Our positioning in equity markets remains the same with a distinct overweight to domestic large cap stocks. In fixed income we took profits in Agg and High Yield bonds, and are again overweight Floating Rate bonds that still pay a relatively attractive yield (8%+) as compared to other fixed income products. As mentioned earlier, it is our belief that the market has already anticipated more aggressive rate cuts than will occur, so the benefits of owning duration are outweighed by the risks. If there is a pullback in these expectations and a corresponding increase in yields, we will selectively lengthen the duration of our fixed income portfolios. Allocations amongst the alternative asset classes did not materially change over the course of the quarter, and we maintain an overweight to private credit with the allocations effectively split between upper middle market, lower middle market, and opportunistic credit managers. We continue allocating to private equity as we believe the market dynamics favor buyers of secondaries over the sellers. However, we are monitoring the private real estate class to potentially move out of an underweight positioning since real estate is a heavily levered asset class and stands to benefit from lower cap rates.
Our team is always happy to discuss strategic portfolio positioning, especially how it relates to individual goals and objectives. Our team of investment managers and trusted advisors believe a comprehensive financial plan must include a sound investment policy statement to guide investment decisions, and we encourage conversations around aligning a portfolio with wealth goals. Reach out to our team today to have a better understanding of what you need to feel confident in your financial future.