Perspectives

Domestic large cap equities posted their fourth consecutive quarterly gain and seventh gain in the last eight quarters, driven by moderating inflation readings, decent economic growth, the beginning of the Fed’s rate-cutting cycle, and aggressive stimulus by China. The S&P 500 Index gained 5.9% in the quarter, pushing its year-to-date return up to 22.1%. Unlike the very narrow participation in last quarter’s rally, this quarter saw broad market strength across large caps, as the S&P Equal Weight Index gained 9.6%, with particular strength among value and interest-rate sensitive names. Utilities led the way, benefiting from both lower interest rates and anticipated incremental demand from power- guzzling AI software. Real Estate and Financials also rallied on lower rates. Industrials were strong, as cyclical stocks were up in anticipation of an improving economic outlook. Energy stocks were particularly weak, the only down sector for the quarter, on lower oil prices. Information Technology and Communication Services were held back by mixed performance among the Magnificent 7.

Broad Market Strength

The Russell 2000 Index of small cap stocks also participated in the broad-market rally, gaining 9.3% for the quarter, and reaching double digits through the first nine months with a return of 11.2%. As they were with large caps, Real Estate, Financials, and Utilities were the sector performance leaders. Communication Services were also strong, as these more leveraged names also caught a bid after struggling much of the year. Energy and Information Technology also brought up the rear among small caps.

With the strength in interest-rate sensitive and cyclical sectors, the performance of Value stocks was quite strong in the quarter, with re- turns among large and small cap Value Indexes up about 10%. This was not nearly enough, however, to offset Growth’s sizable performance advantage versus Value accrued in the first half of the year. The broad rally slightly favored lower-quality stocks, especially among smaller caps, as factors such as low ROE and non-earners outperformed.

Sector Leaders

The Fed finally took the long-anticipated step of lowering rates. Importantly, the Fed has gained confidence that its fight against inflation has been successful, allowing it to sharpen its focus on its other mandate of maximum employment. As such, the Fed’s first step was a 50 basis-point cut, with several 25 basis-point cuts likely to follow over the next 12-15 months. The economy remains rather resilient, as evidenced by solid GDP growth and the still positive ISM Services survey. But there are still some areas of weakness such as manufacturing, so the impact of rate cuts should give support to the more cyclical areas of the economy. There has also been some sluggishness in employment data, with a slowdown in new job creation, so this area too could benefit from further economic improvement. Lastly, the unexpected stimulus program in China, coming late in the quarter, is further indication of a global easing cycle that could help the world economy.

The Fed’s Rate Cuts

Corporate balance sheets remain quite strong, giving support to stocks through share repurchases, dividends and M&A activity. In fact, through mid-September, share buyback authorizations are at a record high of nearly $1 trillion in 2024. Personal balance sheets remain flush with cash, with an estimated $6.7 trillion invested in money market funds whose interest rates are starting to decline in step with Fed ac- tion. This creates pent-up demand for all risk assets as investors seek out investments with higher potential rates of return.

Lest we only focus on the positives, recessionary risk cannot yet be completely ruled out, especially given the end-of-quarter port strike which impacts the flow of several billion dollars of goods in and out of the country each week. There is also the harder-to-analyze impact on both growth and inflation of large fiscal deficits, the presidential election, and geopolitical hot spots that could spill over into wider conflicts.

Risk Assessment

Lastly, our focus on quality companies has not diminished. While this sometimes impacts our shorter-term relative performance when the market favors riskier names, it does not impact our confidence that high-quality companies with leading market positions, strong management teams, and strong financial characteristics should outperform over time.

Read GW&K’s full Quarterly Investment Review for the third quarter here.

With contributions from members of our Domestic Equities Team