Q3 2024: PFM Quarterly Commentary
Well, just like that it’s the end of an era. The third quarter officially featured the conclusion of the most aggressive monetary tightening cycle in forty years when the Federal Reserve cut interest rates in late September for the first time since the onset of the pandemic in early 2020. Over the tightening cycle’s two and a half year lifespan, the Fed’s tardy and arguably draconian response to near double-digit rates of inflation in mid-2022 facilitated the lengthiest and deepest bond bear market in two centuries and the longest equity bear market since 2008.[i] Other than those who have enjoyed high yields on certain money market funds, savings accounts, and short-term bonds, investors are relieved to see this period of restrictive monetary policy end.
Tightening cycles are increasingly rare since the Great Recession. With only one other minor restrictive period in the last twenty years, it’s worth taking a moment to understand just what happened and to consider what may be next.
We spend considerable time communicating about the actions of Central Banks, because as we have reinforced over the years, monetary policy is now the primary driver of asset prices. Unfortunately, we rarely reference the fundamental aspects of financial analysis such as company growth rates, price to earnings ratios, book values, or returns on equity. The simple reason for the omission is that the impact of those well-known measures of value have become substantially less relevant since the Fed ushered in the era of Quantitative Easing in 2008. As a refresher, Quantitative Easing (“QE”) is a controversial monetary policy tool employed by the Federal Reserve. The Fed purchases US Treasuries on the open market for the purpose of artificially lowering interest rates, thereby subsidizing government spending. As a byproduct, the money supply in the economy increases because the Fed is in essence printing the currency required to fund their purchases. Once QE was deployed and interest rates suppressed, companies had nearly unlimited access to cheap debt to fund stock buybacks, acquisitions, and other non-organic methods intended to increase shareholder value. This is financial engineering at its best (or worst). Regardless, the important takeaway is that the impacts from Central Banks’ monetary policies and its contemporary approach to their stated goals of low unemployment and inflation must be closely observed and considered.
With that backdrop, it should come as no surprise just how significant the Federal Reserve’s long-awaited decision to reduce interest rates was on September 18th. This move ended the second longest period without a rate cut since 1971[ii]; curiously, it was met with an immediate bout of selling across the investment markets. While many found this initial reaction confusing, recall that markets move in anticipation of an event long before it actually occurs. In this case, both the stock and bond markets began moving higher nearly a year earlier when Fed chairman, Jerome Powell, set the stage for the monetary easing to come. However, there was another reason for the markets’ nervous reaction to the announcement: its size. Historically, the Fed only drops rates by more than 25 basis points (or one quarter of one percent) during times of duress. Not since the early 1990s has the Fed cut by 50 basis points with the stock market at all-time highs, unemployment historically low, and the Fed’s preferred measure of inflation (Personal Consumption Expenditure) not only above its 2.0% target but rising for the previous three months.[iii] During the press conference, rather than cheering the Fed’s aggressive interest rate cut, most of the media asked Powell if there was some hidden problem in the economy he and his colleagues hadn’t disclosed. Others, puzzled, questioned if the November election was a reason for the unusually large rate cut. While Powell did his best to quell the concerns raised, investors chose to sell first and figure out the Fed’s rationale for the large cut later.
This initial caution proved short-lived, and markets rebounded over the next several days to close the third quarter of 2024 near record price levels. Worth highlighting is that this time, the recent surge in stock prices during the quarter was led by sectors other than technology, a noteworthy change after tech’s many years of outperformance. In fact, the S&P 500’s robust 5.9% quarterly return was driven by just about everything but technology, which managed only a 1.6% gain itself. The most interest rate sensitive sector, utilities, exploded higher ahead of the Fed’s rate cuts by returning over 19% in the third quarter alone. Other market beating sectors included industrials, financials, materials, consumer staples, consumer discretionary, and healthcare, which experienced quarterly returns ranging from 11.6% to 6.1%. Only energy performed worse than technology, returning -2.3%.[iv]
Areas outside of large cap US stocks also outperformed during the quarter. Domestic small companies, precious metals, emerging market equities, international government bonds, long duration US bonds, international developed stocks, and international corporate bonds enjoyed returns ranging from 10.2% to 7.2% for the third quarter, all similarly outpacing the S&P 500.[v] Many of these areas benefitted from the expectation of lower borrowing costs and/or a lower US Dollar which depreciated nearly 5% during the quarter.[vi] Since early 2024, we have communicated our expectation for the market rally to eventually broaden and include other non-tech assets. Specifically, we noted that other historical periods showcasing tech dominance, unevenly distributed equity returns, and outsized company weightings (e.g., Nvidia) distorting major indexes such as the S&P 500 were “typically resolved through underperforming sectors catching up during the next bull market.” In our Q1 2024 letter, we described the outperformance of the utilities sector during the bull market following the bursting of the tech bubble in the early 2000’s, and the emerging signs that utilities – along with other non-tech asset classes – looked ready to once again take the reins. While we were confident enough in our assessment to memorialize it in writing, we were pleasantly surprised at how quickly the rotation out of technology has transpired thus far.
The US and other developed western nations weren’t the only counties to start down the dovish monetary path that drove the S&P 500 to the best annualized return through three quarters since 1997. China announced a series of stimulus measures that are unprecedented. China boasts the world’s second largest economy and stock market, but has been mired in economic stagnation for many years. While higher than most countries, China’s economic growth rate has been steadily falling since 2007, and is now routinely less than 5% per year.[vii] The Chinese government sees this as unacceptable given its own expectations and that of investors. Meanwhile, China’s stock market traded in late September at early 2007 levels, meaning that except for periods of extreme volatility, the country’s main stock index remained unchanged for seventeen years.[viii] Clearly, the politburo had had enough, and implemented a wide array of tools that included several rate cuts, more favorable mortgage terms, support for its banking system, and new borrowing facilities that companies can use to buy stocks. As if this wasn’t enough, they committed to providing more stimulus in the future.
The reaction to the announcement sent Chinese stocks soaring. Over the next five trading days, China’s main equity index, the Shanghai Shenzhen CSI 300 Index, rose over 25%.[ix] This is a staggering figure and is akin to the S&P 500 or the Dow Jones Industrial Average rising 1,450 and 10,600 points in a week, respectively. [x] Someday, books will be written about the actions China took in late September. Fortunately, the emerging market and international equity investments in Peak’s portfolios provided exposure to China’s recent outperformance.
Empirical data indicates just how little exposure investors maintained to many of the unpopular sectors discussed above, such as utilities, emerging markets, and precious metals, due to years of underperformance. In fact, areas like China equities were heavily shorted by investors, meaning, there were record holdings in instruments that would benefit if Chinese stocks fell. We’ve always maintained and espoused the fundamental tenets of investment management: no trend lasts forever, markets are inexorably cyclical, extreme dislocations are temporary and primed for mean reversion, and diversification works. For much of 2024, while the world was enamored with Nvidia, the Mag 7, and all things tech-related, we spoke of an emerging change in leadership which would be driven by forgotten areas of the market. The large dislocations from tech obfuscated the narrow participation in the current bull market and it would be investors’ inability to imagine that tomorrow might be different from today which would cause them to miss the changing of the guard. This wasn’t a popular narrative even several months ago, but one that all the financial media wants to talk about today. In any event, we are delighted that you, our clients, could benefit from the application of sound investment principles and our collective experience.
Thanks for reading. If you have any questions whatsoever and/or have any suggestions for us, please let us know. We’re here to listen and remain committed to improvement.
Regards,
Peak Financial Management
Disclosures:
The views expressed represent the opinions of Peak Financial Management as of the date noted and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. The information contained has been compiled from sources deemed reliable, yet accuracy is not guaranteed.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. Past performance is not a guarantee of future results.
[i] Bloomberg L.P. 2024
[ii] Bloomberg L.P. 2024
[iii] Bloomberg L.P. 2024
[iv] Bloomberg L.P. 2024
[v] Bloomberg L.P. 2024
[vi] Bloomberg L.P. 2024
[vii] Bloomberg L.P. 2024
[viii] Bloomberg L.P. 2024
[ix] Bloomberg L.P. 2024
[x] Bloomberg L.P. 2024