This information is presented for educational purposes only and does not constitute an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Markets are shaped by what I call “memory banks.” Experience shapes memory; memory shapes our view of the future. – Peter Bernstein
After the NVIDIA-driven first half of the year, equity markets broadened during the third quarter. Small cap stocks, emerging and developed non-US markets posted double-digit year-to-date gains. Large cap US growth stocks still retain the lead due to their strong performance during the first half of the year. Chinese stocks returned 21.8% year-to-date after a 30+% gain in the last week of September following the announcement of a large government stimulus package. Excluding China, the MSCI Emerging Market Index returned 12.7% through the third quarter. Driven by data center-driven electricity demand growth, Utilities returned 30.6% year-to-date and are the best performing sector within the S&P 500. This performance, along with continued strength in midstream energy stocks, drove strong returns from infrastructure managers.
The broader returns during the third quarter only slightly narrowed the year-to-date outperformance of NVIDIA and other AI-related stocks such as Meta. The top ten stocks in the S&P 500 currently account for nearly 38% of the total value, well above the 27% level reached during the tech bubble period in the early 2000s. Until 2020, the gains in market value of the large tech stocks tracked their earnings growth. Since then, valuation increases outpaced earnings growth. A study by Russell Investments showed that active managers tend to lag during periods where the market concentration of the largest stocks increases and then outperform once it reverses.
Benign growth and inflation data spurred the Federal Reserve to announce a 50-basis point cut on September 18. Until the strong jobs reports in early October, the market believed the fed would cut rates rate below 3% by the end of next year. The news that the US economy added 254,000 new jobs in September, well above the consensus forecast of 150,000, led the market to quickly revise this forecast to the Fed gradually cutting rates down to 3.5% over the next 12 months.
China announced a stimulus package on September 27 that sent Chinese stocks up over 30%, erasing their earlier losses this year. With this announcement, China follows the Fed and European central banks in easing monetary policy. Observers expect the European Central Bank to continue to cut rates through next year, following reductions in June and September. The recent Saudi announcement to abandon its $100 / barrel oil price target and maintain production provides further tailwind to European and Asian markets reliant on imported energy. While this coordinated stimulus perhaps promises a strong finish for financial markets this year, questions remain on the degree to which the monetary stimulus impacts the real economy, contributes to inflation and/or provides a boost for valuations on financial assets. China, which suffers from a hangover from decades of malinvestment in real estate and weak domestic demand, will likely continue to struggle to ignite domestic demand.
The Fed’s rate cut boosted bond prices, erasing the year-to-date declines from the intermediate-term bond indexes. It is difficult to imagine today that the yield on the Ten-year Treasury bond reached a low of just over 0.50% in August 2020. The total return on the Bloomberg Intermediate US Government / Credit Index from that date turned positive on September 30. Municipal bonds, despite a longer duration, fared better, with the Bloomberg 1-15 Year Muni Index delivering a 0.69% annualized return from 7/31/2020. Over the ten-year period ending September 30, both these bond indexes outperformed 30-day T-bills. This outperformance stemmed from significantly higher yields offered by intermediate term bonds during the 2010s. Only tax-exempt municipal bonds offer a significant yield premium at longer durations today.
By the fourth quarter of 2025 the bond market expects an upward-sloping yield curve that starts at around 3.7% for one-month T-bills and climbs to around 4.2% for the 10-year bond. This curve contains a very small premium for taking duration risk. For most of the 2010s, the spread between 10-year Treasuries and T-bills traded between 150 and 300 basis points compared to the expected ~50 basis point spread today. Tax-exempt municipals continue to offer value at longer durations. Additionally, with record Federal deficits and debt levels, municipal bonds offer protection against potentially higher future federal income tax rates.
We do see modest benefits in moving excess liquidity from T-Bills and money market funds to short-term (1-3 duration) bond funds. Yields are generally at a slight premium over expected returns from money market funds and T-Bills once expected rate cuts are factored in. The maturities are short enough that any inflationary surprises that put a pause to rate cuts would not cause significant pain. On the other hand, the yields could offer stability should the economy enter a recession and spur the Fed to cut rates more than what is currently priced into markets. In this duration range, municipal bonds generally only make sense for investors subject to the maximum 40.8% tax on investment income as most of the yield advantage to municipal bonds begins with maturities above seven years.
Treasury Inflation Protected Securities (TIPS) outperformed comparable duration Treasury bonds by over 11% cumulatively over the 5-year period ending September 30 and continue to offer value. The breakeven rates – the inflation rate at which TIPS will outperform a nominal Treasury Bond of comparable duration – remain near 2%. This provides cheap insurance against inflation exceeding the current Fed target.
Agency mortgage-backed securities (MBS), one of the highest quality segments of the fixed income market, are the only major segment of the investment-grade taxable bond market other than TIPS offering value currently. These bonds consist of home mortgages issued by Fannie Mae and Freddy Mac and the US Government guarantees payment of principal and interest, so investors lose nothing if an individual homeowner defaults and gets foreclosed upon. With record low interest rates in 2020 and 2021, most homeowners refinanced so the universe of these bonds overwhelmingly consists of mortgages with 3% and 4% coupons. These bonds currently trade at attractive spreads over Treasuries and do not have the economic sensitivity of corporate bonds.
In October 2011 the S&P 500 traded at 14.0 times current earnings. The P/E multiple stood at 26.3 times at quarter-end. This multiple expansion accounted for approximately 5.0 percentage points of the 15.5% annualized return of the index over that period. The valuation increase accompanied a phenomenal period of earnings growth. Driven by the large tech companies, S&P 500 earnings per share grew at an annual rate of 6.8%. The combination of a low starting valuation plus phenomenal earnings growth led to one of the best bull markets on record. Without assuming further P/E expansion (or contraction), the S&P 500 could return 8.0% if it maintained the 6.8% earnings growth rate (admittedly an ambitious target) and adding the current dividend yield of 1.2%. Multiple contraction and/or slower earnings growth could create a period of significantly lower returns or even a ‘lost decade’ for the index, such as the US market experienced from 2000-2009.
The risks on either side of a base ‘muddle through’ economic case appear balanced between inflation and recession. Record US deficit spending, which has driven gross public debt/GDP above WW2 levels, provides a strong argument for inflation, but a risk exists that the US’s aging population and high debt may eventually lead to Japan-style deflation. After the inflationary supply disruptions from COVID and Russia’s invasion of Ukraine, the potential for a broader Middle East War and /or the now apparently averted Longshoreman strike offer near-term inflationary risks. A weakening dollar, onshoring of production and investment in the electrical grid and other infrastructure constitute other potentially inflationary factors. Slowing US consumers, while not currently alarming, could continue into recessionary territory. A split congress and budgetary constraints from current record deficit spending could make stimulating a contracting economy difficult. Furthermore, US voters have shown great dissatisfaction with the inflation of the past few years and politicians may decide that a recession that impacts a small percentage of the population is preferable to inflation that, by definition, impacts everyone.
Whoever wins the US presidential election, a split congress remains the most likely outcome. This mitigates against implementation of the more extreme economic policies proposed during the campaign, particularly around income taxes and tariffs. Uncertainty remains over the expiration after next year of the many of the changes implemented in the 2017 Tax Cuts and Jobs Act.
While scant few investments could compete with the 15% return of the S&P 500 over the past 10 years or so, many options exist that can compete with a 7-8% S&P 500 return. The record valuation discounts for small cap US and non-US companies create room for multiple expansion and potentially superior returns. With normalized interest rates, income producing assets such as real estate, infrastructure and credit – whether public or private – can deliver competitive returns. A normalized interest rate environment makes bonds more attractive relative to a potentially lower returning stock market. A thoughtfully diversified portfolio will continue to provide the highest probability of meeting investment goals.