US equities rallied further in the third quarter and are now back near all-time highs amid a strong economic backdrop. As a result, the S&P 500 is up approximately 20% year to date with breadth expanding beyond Technology stocks and into blue-chip sectors such as Industrials, Utilities, and Financials. Collectively, these dynamics illustrate an economy and labor market that remains strong and expanding even as the pace of growth has slowed from the post-pandemic boom. In fact, this more measured growth is precisely what has helped bring inflation down and enabled the Federal Reserve to finally cut interest rates. With financing and cost pressures coming down, the market sees a better operating environment over the medium term than just a month or two ago.
At that time, the market was in the midst of some late summer volatility amid softening economic data. The jobs market was decelerating quite rapidly with a series of underwhelming reports, bringing fears of recession back to the fore. Improvements in inflation had also slowed and the market was questioning However, since then the market has had numerous positive developments which have helped it climb this “wall of worry” to new highs.
Most prominently, inflation notably cooled in August, enough for the Fed to declare victory in their effort to bring it back towards their long-term target of 2.0%. This, along with the softening labor data, provided the basis for a 50-basis point “jumbo” cut which the market has rallied behind. Moreover, the latest labor data has dampened fears of a major deterioration, with jobless claims and the unemployment rate both dipping slightly despite notable misses on the payroll reports. Lastly, the government reaffirmed Q2 GDP growth of 3.0% with the Q1 figure notably revised up to 1.6%, confirming that the economy in fact accelerated in the middle part of the year after slowing down previously. The stability of long-term bond yields in recent weeks has reaffirmed the interpretation of this recent data.
Corporate health also remains a tailwind with three-quarters of companies in the S&P 500 beating estimates last quarter. Earnings growth continues at a healthy 14% rate with operating margins expanding, due largely to improving profitability in the Technology sector. Earnings from bellwether Nvidia continues to demonstrate the staying power of the “AI trade”, as AI-related spend among the big tech players continues to increase. And now more companies completely outside the Technology space are starting to mention the positive impact of AI on their operations. For example, Walmart, which noted how their use of AI has resulted in a 100-fold productivity gain in the management of their product catalog. Beyond the technology sector, signs also remain cautiously positive on consumer demand. Earnings reports from banks and discretionary consumer companies, for example, continue to paint a picture of a broadly robust consumer benefitting from wage gains, even as higher prices and debt levels make them more discerning. Recent supportive actions in China have likewise boosted stocks of American companies that sell into Asia.
Nevertheless, there are still several factors warranting caution as we enter the fourth quarter. Most notably, valuations remain elevated, particularly in the technology sector, which has powered a good portion of the rally this year. There are already some signs of fatigue there given the incredibly high expectations priced in, most notably the drop in Nvidia’s stock price after another stellar earnings report. Markets are also becoming more discerning on Big Tech to show return on AI investment. Fortunately, on these points, the market breadth is increasing, showing that the rally is expanding from a mostly Tech-only affair into the broader economic expansion trade. This leaves the market less susceptible to a reversal in any one stock or sector going forward.
Next, not all sectors are signaling the same optimism, as Energy stocks have been underperforming of late. Whether or not this is a sign of a slowdown or simply a result of increased Saudi production remains to be seen, but lower oil prices nevertheless warrant some caution. And then lastly, there are growing geopolitical risks with rising tensions in the Middle East and the upcoming US election creating conditions for volatility. While history shows that the overall impact from the election is likely to be tempered, there is potential for large relative movement within the market based on who the perceived winners and losers are. As always, maintaining a disciplined and opportunistic approach to portfolio management will be critical in such a fluid environment.
As we approach year-end, we remain cautiously optimistic on the markets given the underlying strength of the economy. The stock market’s stellar run this year is a sign of approval for a Fed which is close to accomplishing a fantastic feat – a “soft landing” with continued positive economic and labor market growth. We nevertheless remain vigilant given the presence of various risk factors that could cause some volatility in the near term. We will continue to monitor these developments closely and remain on the lookout to add value in portfolios as opportunities present themselves. As we approach the fourth quarter and the holiday season, we wish you and your families well.