Quarterly Market Commentary – Mosaic Model Portfolios
In their quarterly update, the Multi-Asset portfolio team at Madison Investments discusses the events of the quarter, and provides an outlook for the markets moving forward.
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Market Recap – Third Quarter 2024
After a rough start, U.S. stocks bounced back to generate another impressive gain, with the S&P 500 Index up 5.9% for the third quarter of 2024, pushing the year-to-date total return to a staggering 22.1%, not far off 2023’s outsized 26.3% return, with three months left to go in the year.
If you hadn’t heard the term “yen carry trade” before, it was likely burned into your lexicon by early August. The rapid ascent of the formerly shunned Japanese currency was behind a nasty bout of volatility that took U.S. stocks down nearly 10%, as investors were forced to quickly unwind levered investments and prevent further losses as the yen moved against them. Behind the yen’s rise was a stark contrast in the outlook for monetary policy between the U.S. and Japan, which came to a head in the final week of July when Federal Reserve Chair Powell leaned dovish while the Bank of Japan hawkishly raised interest rates, then a sour U.S. employment report added fuel to the rate cut fire. However, the Bank of Japan yielded via softer comments around future policy and the markets went back to rallying on the belief of much easier monetary policy (lower interest rates) moving forward in the U.S.
The shifting market sentiment towards the anticipation of even lower rates propelled cyclically-based and smaller cap stocks to big gains, especially early in the quarter. Technology stocks were notable underperformers and the mixed performance of the so-called Magnificent 7, along with other mega cap stocks led to a broader and seemingly healthier market advance. Overall, the small cap Russell 2000 Index jumped 9.3% versus the S&P 500’s 5.9% return, and the more economically sensitive Russell 1000 Value Index gained 9.4%, well above the 3.2% return for the technology-heavy Russell 1000 Growth Index.
Big gains were not just for stocks. Bond returns were boosted by a steep drop in interest rates across the yield curve from the increased expectations of deeper Fed rate cuts. Entering the quarter, investors expected the Fed Funds rate to fall just short of 0.5% by year end, and largely expected the Fed to cut by the standard 0.25% for their highly anticipated first rate cut of the cycle on September 18th. However, belief in something bigger built after Chair Powell’s comment that “the time has come for policy to adjust” during his remarks at Jackson Hole in August, as he detailed his growing confidence that inflation is under control and that the Fed is now more concerned about the cooling labor market. As the September Fed meeting approached, market odds firmed around a larger 0.5% cut, and on that fateful day, the Fed delivered with a jumbo half-point cut to kick-off the cutting cycle and guided for another 0.5% of cuts to come by January. However, market optimism ran higher, exiting the quarter with an implied rate 0.75% below today’s level, with dreams of a 3% Fed Funds rate by the end of 2025. The falling interest rate hoopla drove the broad Bloomberg US Aggregate Bond Index to a near S&P 500 matching 5.2% return for the quarter, bringing the nine-month total up to 4.5%.
Outside of the U.S., China pushed the Bank of Japan out of the spotlight by launching a massive stimulus plan during the final week of the quarter. Investors welcomed Beijing’s willingness to turn the monetary spigot wide open by bidding Chinese equity indexes up over 20% in seven days. The upward explosion of Chinese stocks helped boost international stocks and the MSCI ACWI ex-USA Index to an 8.1% return, bettering the U.S. market for the quarter.
Performance
The broadening of the market beyond the small set of very large U.S. companies benefited portfolios for the quarter. The returns of value and smaller stocks helped several of our U.S. equity positions generate outperformance to balance out the underperformance of our energy and technology allocations. Results from our international equity positioning were aided by our positions in emerging Asia but restrained by our overweight stance on Japanese and higher quality developed markets stocks. Our fixed income allocations performed roughly inline with the Bloomberg US Aggregate Index, aided by strong returns from our holdings in mortgage-backed and longer duration positions.
Our cautious stance on equity exposure, which we detail in the next section, was the largest detractor to performance.
Outlook & Positioning
Our primary rationale for remaining cautious in our asset allocation positioning hinges on the dramatic difference in market expectations and pricing between the bond and commodities markets compared to the stock market. Starting with the bond market, as of the end of the third quarter, Fed Funds futures are pricing in nearly 2% of additional rate cuts over the next 12 months, which would bring the Fed Funds rate to around 3%. Cutting rates at that speed and magnitude has historically only occurred in a recessionary environment. The price of oil declined by 20% during the quarter, surveys of manufacturing activity remain contractionary, the index of leading economic indicators has not recorded a positive reading since February 2022, a month before the Fed began to tighten monetary policy. These are not typical signposts of a healthy economy. On the other hand, the S&P 500 charges on to repeated all-time highs, with an atypically-high valuation level and an expectation for nearly 15% earnings growth for 2025. Whatever a “soft landing” might be, we don’t believe this is it. If the bond market is correct, we are headed for an economic reckoning in the near future and stocks are due for a rude awakening. If the stock market is correct, the economic expansion is set to continue without needing a landing. In that case, it’s highly unlikely that we’ll see 2% of rate cuts over the next year and longer-term rates have fallen too far.
What’s clear is that one market has it wrong. The resolution of this condition will likely be quite volatile. We believe the bond market appears closer to fair value than stocks. As such, we remain moderately underweight equities given the highly uncertain and contradictory environment.