Another Goldilocks Moment? – 5 Insights on the Fed, Election, and Volatility in Q4

Dr. David Kelly of JP Morgan Asset Management recently used the individual digits that make up “2024” to predict how the economic benchmarks for this year will ultimately land by year-end:

2 percent economic growth; 0 recessions; 2 percent inflation; 4 percent unemployment

As we begin the final quarter of the year, the economy has defied the expectations of many investors. Rather than falling into recession, the U.S. economy has grown steadily, albeit at a slower pace, and inflation rates have fallen toward the Federal Reserve’s 2% target. At the same time, the unemployment rate has trended upward, but still at a tolerable range of approximately 4%.

As a result, the macroeconomic environment has led to the Fed cutting the key interest rate, propelling the S&P 500 and Dow Jones Industrial Average to record highs and boosting bond returns.

As asked by the Oct. 6, 2024 Wall Street Journal headline, “How Long Can the U.S. Economy’s ’Goldilocks’ Moment Last”, the answer appears to be “a bit longer”. However, quoting WSJ contributor Aaron Back, the article included, “investors should remember that even Goldilocks didn’t have long to enjoy her porridge before the bears showed up.” (WSJ, Heard on the Street, 10/6/24)

Of course, there are always risks. Looking ahead, the path of Fed policy is uncertain, and investors are already debating the size of the next rate cut. The presidential election is still close and there are wide-ranging implications for tax policy, regulation, trade, and more. Geopolitical conflicts are worsening with possible implications for global stability, supply chains, and oil prices. Market swings are always possible, especially with valuations and earnings expectations at heightened levels.

Facing risks is unavoidable when it comes to investing and planning for the future. How investors choose to react to those risks is ultimately what determines investment and financial success. Following is a Q3 market recap and perspective on five important factors impacting the market and what they might mean for investors in the coming months.

Third Quarter 2024 Market Recap

Moderating inflation, stable/falling interest rates, and modest economic growth have traditionally been strong tailwinds for equities.

Accordingly, market performance this year is favorable.

Source: YCharts
**in US dollars

Five Factors Impacting The Market

1. The market achieves many new all-time highs during bull markets

First, the market has experienced many new all-time highs this year, including during the past quarter. While this performance is encouraging, it can also create unease among investors who may worry that we may be “due for a pullback.”

During bull markets, stock indices have historically reached many new all-time highs, as shown in the following chart. This is almost by definition and is a result of sustained earnings, economic growth, and improving investor sentiment. New all-time highs have not been a reliable predictor of market pullbacks since it’s the underlying market and economic trends that matter. Attempting to time the market based only on index levels often proves counterproductive for this reason.

Of course, market fluctuations are an unavoidable part of investing, and a decline will inevitably occur at some point. However, predicting the timing of such declines is challenging, maybe impossible. For example, the pullbacks that occurred in April and August this year are a reminder that the market can sometimes recover faster than many investors expect. While the past is no guarantee of the future, it is advised to stay invested rather than jump in and out of markets.

2. The market has performed well under both political parties

Second, many investors are concerned about the potential impact of the presidential election on the economy. As the race intensifies, it’s crucial to remember that while elections are important for the country and as citizens, it’s important not to vote with our portfolios and savings.

History shows that the stock market has experienced long-term growth under both major political parties, as seen in the following chart. It is not the case that the market or economy crashes when one political party is in office. This is because the underlying drivers of market performance – economic cycles, earnings, valuations, etc. – are far more important than who occupies the White House. Short term, politics do not impact the economy as much as the economy impacts politics.

According to Y-Charts, regardless of which party controls the White House, higher average annualized returns have occurred during a divided Congress, where one party controls the House or Senate and the other party holds a majority in the second chamber. Since 1950, irrespective of which party controls the executive branch, lower returns have come during Democratic majorities in both the House and Senate, while higher returns have come under Republican control of both congressional chambers. 

That said, policies can certainly affect taxes, trade, industrial policy, regulatory frameworks, and more. However, policy shifts often occur gradually, and their timing and impacts are frequently overestimated. What politicians promise is often different from what is ultimately enacted. Thus, investors should focus on long-term economic and market trends rather than daily poll results.

3. The Fed is expected to cut rates further

Third, inflation continues to moderate, with the most recent data showing the Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation measure, increasing just 2.2% from a year earlier, approaching the Fed’s target rate of 2%. Meanwhile, the labor market shows continued signs of slowing with unemployment at 4.2%, still low by historical standards.

These economic conditions set the stage for the Fed’s first 50 basis point reduction in interest rates in September, with more cuts expected through the rest of the year and in 2025. The market has been anticipating cuts of various sizes all year and rallied in the days following the announcement.

Historical rate cuts are difficult to analyze because why the Fed cuts rates is more important than when or by how much. The Fed has typically cut rates during economic and financial crises, such as in 2008 (housing crisis) or 2020 (Covid). These are times when the economy and market are expected to struggle for extended periods.

In contrast, the current situation is one of achieving balance or a so-called “soft landing,” just as the Fed did in the mid-1990s. The Fed’s rapid rate hikes in 1994 were followed by cuts in 1995 once inflation fears faded. This then paved the way for a long economic expansion and bull market. While this is only one example, it is important to draw the correct historical parallels when it comes to Fed policy.

4. The fixed income landscape is shifting

Since 2022, long term interest rates have been lower than short term interest rates, which is abnormal and referred to as an “inverted” yield curve. In Q3, short-term and long-term interest rates returned to a more normal yield curve.

Fed rate cuts have resulted in lower interest rates across maturities, as well as a “disinversion” of the yield curve. In many ways, this is a reversal of the bear market in bonds experienced in 2022 when rates were on the way up.

Bond prices move in the opposite direction of interest rates. This is because already-issued bonds with higher rates become more valuable as market rates fall. Thus, bondholders today not only benefit from higher-than-average yields, but could experience price appreciation if rates continue to trend lower.

For the economy, lower rates improve borrowing costs for corporations and individuals, potentially boosting economic expansion and investment prospects. This can be positive for economic growth which then translates into better earnings and corporate fundamentals. Thus, despite the challenges bonds have faced in the past few years, it’s important to maintain balance across asset classes.

5. Geopolitical conflicts are worrisome but do not directly impact markets

Finally, tensions have risen in the Middle East as the conflict between Israel and Hezbollah has intensified. This adds to global geopolitical tensions including the ongoing war between Russia and Ukraine. While these events have major real-world impacts, their effects on the economy and stock market are less clear cut, and any impact on investors’ portfolios is typically fleeting

One channel through which regional conflicts can impact the broader economy is oil prices. The escalation in the Middle East has caused a slight rise in oil prices, but the increase is modest compared to previous crises. Importantly, oil prices remain below their 2022 highs. The U.S.’s position as the world’s largest oil and gas producer may provide some insulation from global events.

Despite geopolitical uncertainties, the stock market has experienced only two 5% or worse pullbacks this year, emphasizing the importance of staying invested and focusing on broader market trends rather than reacting to headlines.

The bottom line? It is a bit of a Goldilocks moment, with approximately 2 percent economic growth; 0 recessions; near 2 percent inflation; and slightly over 4 percent unemployment. However, with the Fed cutting rates, the election on the horizon, and markets near all-time highs, it is more important than ever to stay focused on long-term financial goals rather than short-term events.