Market Volatility Has Surged Ahead of the U.S. Presidential Election

Efforts by the U.S. Federal Reserve to begin lowering short term interest rates are being challenged by stubbornly low unemployment, low(er) yet persistent inflation, and steady domestic economic growth. Scheduled to meet next week, the FOMC is widely expected to lower the Fed Funds rate by 25 basis points. The market has been reigning in expectations for more aggressive cuts, however, as the yield on the 2yr Treasury has surged from 3.54% in late September to 4.12% as we go to press.

The Unemployment Rate for October came in as expected at 4.1%, with no change from the prior month.  Nonfarm Payrolls increased a mere 12k, however, versus expectations for a rise of 100k. Average Hourly Earnings ticked up slightly higher than expected at +0.4% MoM, and have risen +4.0% YoY. The Labor Force Participation Rate came in at 62.6%, slightly below expectations. Although lagged, the JOLTS number for August showed 8,040k job openings, while the weekly Initial Jobless Claims data suggest a still strong labor market.

Inflation data for September came in slightly hotter than anticipated with headline CPI up +0.2% MoM (versus expectations for +0.1%) while core CPI rose +0.3% (also higher than expected). Year over year consumer prices rose +2.4%, while ex food & energy prices are up +3.3%.  At the wholesale level, final demand was flat on the month, while core PPI rose +0.2%. PPI was up +1.8% for the year while core PPI rose +2.8%. Lastly, the Core PCE Price Index rose +0.3% in September, and was up a stronger than expected +2.7% YoY.

Third-quarter GDP growth came in slightly weaker than forecast at +2.8%, also down from Q2’s +3.0% rate.  Personal Consumption, however, showed a strong +3.7% growth rate, signaling that US consumers with paychecks are stilling willing spenders. Consumers account for nearly 2/3 of the US economy. The Housing market was an area of weakness, as higher mortgage rates have stymied existing home sales (-1.0% in September), while Housing Starts dipped -0.5%. Mortgage Applications dropped -17% in mid-October as the surge in interest rates made its way into the mortgage market.

Market volatility has surged over the past month as investors attempt to position portfolios ahead of the US presidential election. Bond yields have surged as both candidates make unrealistic spending promises. The Fed will be hard pressed to deliver the number of rate cuts currently anticipated by the market, given the ongoing strength of the US economy. Next week should bring more clarity, assuming there is a clear winner in the election, and the Federal Reserve delivers further guidance on monetary policy. Investors should brace for a volatile period ahead.

U.S. equities sold off to close the month of October, with the benchmark S&P 500 index losing 0.9% during the period to close at 5,705. For the year, equities have risen sharply, with Large-Caps gaining 21.0% on the year as the U.S. economy has strengthened. Mid- and Small-Caps, as measured by the S&P 400 and 600 indices, diverged in terms of performance. Mid-Caps gave back -0.7%, while Small-Caps lost -2.6% during the quarter.

The spread between Mid- and Small-Caps may be attributable to the strength in the economy, as GDP in Q3 rose at a 2.8% annualized rate. Economic data has continued to surprise to the upside for the better part of the past quarter, and Mid-Caps (with their large exposure to Industrial sector companies) tends to be highly correlated. Small-Caps on the other hand should benefit from domestic economic strength, but may be held back by higher interest rates. As economic data has strengthened to the upside, interest rates have risen in tandem, reflecting better growth prospects.

From a sector perspective, 8 of 11 sectors finished the month in the red. Those sectors posting positive returns included Financials (2.7%), Communication Services (1.9%), and Energy  (0.8%). Financials and Communication Services have been top performers for much of 2024, with the former benefitting from a steepening yield curve and better economic activity, and the latter from a boom in artificial intelligence (AI). Energy has been a laggard, as the world remains awash in crude oil, which has put downward pressure on oil prices despite geopolitical risks flaring around the globe. Oil doesn’t seem to command the geopolitical risk premium that it once did now that supply has outstripped demand globally.

Looking ahead, investor attention should remain focused on the strength of the U.S. economy. A virtuous cycle of a strong labor market and lower inflation should continue to fuel robust consumer demand, ultimately propelling the economy and buoying corporate profits.

International markets as a whole experienced a challenging month in October as most major indexes were down. The MSCI ACWI Index, which covers about 85% of the global investable equity opportunity set, was down -2.2% on the month. While international developed markets, as measured by the MSCI EAFE index, were down -5.4% and emerging markets, as measured by the MSCI EM Index, were down -4.3%.

In the Eurozone, the annual rate of inflation was broadly in line with the European Central Banks (ECB) target in October, increasing the likelihood that policymakers will lower borrowing costs for the third consecutive meeting. After Russia’s invasion of Ukraine in 2022, inflation sored throughout Europe as an energy shock droves prices higher across the continent. In turn, the ECB lifted rates to some of the highest levels in nearly two decades. Since then, Inflation has moderated to 2%, according to the Eurozone’s latest consumer prices reading, while the unemployment rate has remained low at 6.3%, evidencing that a soft landing is still a possibility. The ECB is widely expected to cut rates by 25 basis points at its next meeting in December.

Meanwhile, across the globe, Chinese growth came in cooler than expected as the economy expanded 4.6% in Q3, compared to a year earlier, vs 4.7% growth in Q2, well below their 5 % goal. To meet growth targets, expectations remain high that Chinese legislators will sign a new fiscal package that could inject hundreds of billions of dollars into the Chinese economy. Some stimulus has already been introduced. In late September, the central bank Governor announced plans to cut interest rates to support China’s lackluster stock market. Homeowners were told they would be able to refinance their mortgage at lower rates, which could help bolster an abysmal Chinese property market. There have been early signs of a turnaround in Chinese property as home sales during the country’s 7-day holiday earlier this month saw homes double from a year earlier. However, there remains a long road to recovery.

It has been an eventful month and a half since the Federal Reserve cut rates by an aggressive 50 basis points in mid-September. Chair Powell decided to go big on the first rate reduction of the cycle. Unfortunately for him, the economic data that has come out since that decision has been fairly strong, casting doubt on the need for an oversized rate reduction, and the likelihood of future interest rate cuts that the market had already priced in.

The next Federal Reserve meeting is just after the Presidential election, November 6-7th. Expectations are that we will see a traditionally sized 25 basis point reduction in the Federal Funds target rate, followed by another 25 basis point cut at the December meeting, although some debate has begun on whether a pause could be warranted. Unless economic data weakens considerably between now and then, there could be a legitimate case for delaying future cuts.

In the month of October, as market expectations for future rate cuts decreased, yields rose across the maturity spectrum by roughly 50 basis points. This put pressure on Fixed Income returns, as bond prices declined broadly. All benchmarks tracked posted negative October returns.

Single A rated investment grade corporate bonds saw yield spreads hold steady, while BBB rated corporate bonds experienced roughly 7 basis points of spread tightening. It was not enough to boost the monthly performance beyond the general range experienced by the Government Index, and the broader Aggregate Index. All three indices declined by close to 2.5%.

The High Yield Index significantly outperformed. The spread tightening experienced was not markedly more than that of the BBB investment grade corporate bonds, so that did not drive performance. The outperformance noted was due to the significantly shorter Duration (less interest rate risk) of the High Yield Index, combined with the higher coupon income. These characteristics combined to allow for a relatively attractive drawdown of ~50 bps in the month of October. This month’s strong performance compounds the trend for 2024, and widens the outperformance of HY, far ahead of the crowd YTD.

Municipal Bonds cheapened in the month. Longer maturity bonds offer attractive tax-free yields for those in the highest tax brackets.

Alternative investments had mixed results in October. Broad commodities, as measured by the Bloomberg Commodity Index, were down -2.2% for the month.

After falling in Q3, the U.S. Dollar appreciated +2.9% in October compared to a basket of other major currencies. The U.S. Dollar strengthened against most other currencies and rose significantly against the Yen due to diverging interest rate paths. The Dollar’s recent rise is most likely driven by strong economic data, the possibility for increased spending by both political parties after the election, and an expectation that the Fed won’t have to cut rates as quickly as once expected. Although the U.S. election and its policy aftermath may garner the majority of attention, exchange rates will also be driven by how successful other countries’ economic growth is compared to the U.S.

Gold continues to grab headlines, with the metal rising +4.2% during October and hitting multiple all-time highs intra-month. Demand has been driven from a variety of sources, from central banks and Chinese buyers at the beginning of the year to U.S. investors now seeking a safe haven ahead of a closely contested U.S. election. Renewed worries about government spending and inflation threats could help the case for a hedging asset such as gold despite higher interest rates usually being thought of as a negative for gold prices. The precious metal’s stunning +33.0% rise YTD may also have sparked “fear of missing out” (FOMO) interest from other investors, contributing to even more demand.

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