3rd Quarter Market Commentary “Rate Cute. Now What?”
The much-anticipated Federal Reserve rate cut has finally arrived. The Fed cut 50-basis points, ushering in a new phase for the markets. Historically, rate cuts tend to inject optimism, with certain sectors, particularly small and mid-cap stocks, often outperforming. However, the backdrop in 2024 is more complex. Persistent inflation concerns and labor market uncertainties have made the market response less straightforward.
This delicate balance between optimism from declining inflation and the looming risk of an economic slowdown presents a unique challenge for investors. Our RiskFirst® approach remains paramount. We focus on managing drawdowns while maintaining diversified exposure across multiple asset classes. Our goal is to ensure that we are well-positioned to capture market opportunities while guarding against inevitable volatility.
Broadening Participation
The lead-up to the Federal Reserve’s first 50-basis point rate cut has played a pivotal role in reshaping market dynamics during 2024. The S&P 500 Index surged by 15.3% in the first half of the year. However, the year’s second half has so far witnessed a shift in market sentiment, with broader participation driving gains across previously lagging segments.
The S&P 500 Equal Weight Index, which gained just 5.1% in the first half, has returned an additional 9.6% so far in the second half, reflecting stronger performance across a wider array of companies. Similarly, the S&P 500 Value Index rose from 5.8% in the first half to 9.1% in the second, while small-cap stocks, represented by Russell 2000, accelerated from a modest 1.7% to 9.3%.
This broadening of market participation highlights investor optimism that the Fed’s rate cuts will help steer the economy towards a soft landing, avoiding a recession. The shift from growth centric leadership, where the S&P 500 Growth Index skyrocketed 23.6% in the first half but slowed to just 3.7% in the second, underscores the importance of diversified exposure to capture opportunities in different asset classes.
Second Half Shift
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 1/1/2024 – 9/30/2024.
Sector Sized Impact
The market’s growing dependence on large-cap tech stocks has pushed S&P 500 concentration to staggering heights. Nvidia’s 7% weighting in the S&P 500 surpasses entire individual sectors like Consumer Staples (5.8%) and Energy (3.3%) but also exceeds the combined weight of multiple sectors, such as Utilities, Real Estate, and Materials. This creates a striking imbalance, where a single stock can outweigh entire industries composed of dozens of companies.
Such dependence on a few dominant players, particularly in the tech sector, presents a heightened risk for investors. Leaning too heavily on tech giants like Nvidia or Microsoft can expose portfolios to significant volatility, especially if these key stocks experience a pullback. By diversifying beyond the tech titans, investors can create a buffer, protecting their portfolios from the sharp swings of over-concentration in a handful of heavyweights.
Single Stock vs Sectors
Source: Bloomberg, Redwood. Data as of 10/24/2024.
Jobs Drop, Stocks Pop
While the market continues to climb, there has been a significant drop in U.S. Job Openings, reflecting a critical divergence between labor market dynamics and stock market performance. These two indicators have historically moved in tandem, as rising employment signals broader economic growth.
However, recent months have shown a sharp decline in job openings, driven by the Federal Reserve’s aggressive interest rate hikes to cool economic demand. As borrowing costs rise, businesses reduce hiring in anticipation of slower growth.
Despite this, the S&P 500 has continued its upward trajectory, fueled by optimism that the Fed will successfully steer the economy away from a recession. This raises an important dilemma for investors: will the stock market eventually adjust to reflect a weaker labor market, or will economic activity rebound sufficiently to justify current stock valuations? Although economic data signals a slowdown, market sentiment often defies expectations, reminding us that markets can remain unpredictable despite mixed signals from the broader economy.
Diverging Paths
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date Range from 7/31/2002 – 8/31/2024.
Balancing Rates and Inflation
Although the Fed’s decision to cut interest rates was expected, the aggressive nature of the cut-50-basis points-caught the market by surprise. The Fed last implemented such a large initial cut in 2007. Investors embraced the move as a clear signal that the Fed is determined to balance economic growth with its efforts to cool down inflation. Encouragingly, the Consumer Price Index (CPI) has steadily declined to 2.4%, while Core CPI, which strips out volatile items like food and energy, stands at 3.3%, indicating that inflation is easing.
However, despite this improvement, the Fed’s benchmark interest rate remains at 5%, creating a significant gap between inflation and borrowing costs. This divergence continues to weigh on consumers and businesses, making it more challenging for the economy to recover fully.
The critical question now is whether this rate cut will be enough to support sustained growth or if further action will be necessary. While the market remains optimistic, the Fed must continue navigating the delicate balance between fostering economic activity and managing inflation risks.
The First Cut
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 6/30/2019 – 9/30/2024.
Fall In Borrowing Boosts Market
The lead-up to the Federal Reserve’s first rate cut has triggered a significant drop in mortgage rates, which historically serves as a positive catalyst for equity markets. When the average 30-year fixed mortgage rate declined by more than 100 basis points over a 12-month period, the S&P 500 has typically responded with an annualized return of over 12%. This past year, mortgage rates have fallen by 144 basis points, marking one of the most substantial drops since 2008.
This connection between lower borrowing costs and stock market performance highlights how reduced rates can boost economic optimism. Lower mortgage rates make housing and other investments more affordable, encouraging consumer confidence and spending.
As we head toward the end of 2024, this environment of easing rates may continue to support equity market gains, with consumers and businesses more willing to take on debt, further fueling economic momentum.
Mortgage Rates Drop Like ‘08
Source: Fred, Bloomberg, Redwood. Data as of 10/24/2024. Date range from 4/1/1971 – 9/30/2024.
Cuts Favor Smaller Players
One of the side effects of an easing rate environment is the impact across different asset classes. Historically, small-cap and mid-cap stocks tend to outperform their large-cap counterparts following rate cuts given their sensitivity to interest rate changes and greater exposure to shifts in economic momentum. This is largely due to lower borrowing costs stimulating economic activity, which in turn increases risk appetite, especially for companies that rely more on domestic borrowing.
On average, the year following a Fed rate cut has seen small-cap stocks return over 17%, and midcap stocks rise by more than 14%, compared to 9.8% for large-cap stocks. This trend is already taking shape in the current cycle, with smaller companies showing stronger performance in recent months.
Investors with diversified portfolios can capitalize on this trend by holding a mix of small, mid, and large-cap stocks. Spreading risk across these asset classes allows participation in various market drivers, making broad exposure essential to capturing gains as the effects of rate cuts continue to unfold.
Post-Cut Playout
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 1957– 2021.
First to Fall
A more direct effect is the change in cash rates. Cash and money market yields are often the first to reflect the impact of falling Federal Reserve rates. Historically, as shown by the rolling 3-month cash returns, these yields decline rapidly following the Fed’s initial rate cut. Just a few months ago, money market fund yields were around 5.4%, but as of October 25th, they have already dropped to 4.50%-4.60%, exceeding the Fed’s 50-basis-point cut. This highlights how quickly cash yields can adjust and overcompensate in a rate-cutting environment.
Unsurprisingly, high money market yields don’t last forever, prompting a reassessment of cash allocations in favor of higher-yielding or more diversified assets. With potential further rate cuts on the horizon, yields may continue their downward trend, making it critical for investors to explore alternative opportunities that provide better returns in a falling-rate environment.
Cuts Crush Cash Yield
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 12/31/1977 – 10/24/2024.
Longest Inversion Signals Caution
As short-term yields fall, the spread between short-term and long-term Treasury yields also reverses. The yield spread between the 10-Year and 2-Year Treasuries is a widely used gauge of economic health. When the 10-Year treasury pays less than the 2-Year Treasury, this is known as a yield curve inversion-an indicator often associated with looming economic concerns. Historically, these inversions have preceded recessions, as seen in 2000 and 2007, with economic slowdowns occurring after the curve un-inverts.
The most recent 10-2 yield curve inversion, which was the longest on record, has just recently un-inverted. This shift could be interpreted as a delayed signal of potential economic challenges ahead, particularly given the backdrop of high uncertainty around the Federal Reserve’s aggressive rate cuts and persistent inflationary pressures.
However, some argue that the un-inversion might also signal the worst is behind us, depending on whether the Fed can achieve a soft landing for the economy. In either case, caution remains essential as the economic landscape continues to evolve, and prioritizing risk management is crucial for navigating the uncertain times ahead.
End of the Inversion
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 9/5/1990 – 10/24/2024.
Bond Rally Fizzles Post-Cut
As the anticipation of the Fed’s aggressive rate cuts grew, traders rushed to lock in rates, sparking a 4.12% investment grade bond rally from July 11 to September 18, 2024, just before the cut. This uptick helped bonds recover some losses from their prolonged drawdown since 2020. However, with the initial rate cut behind us, much of the price action that bolstered bond performance may have already occurred.
Since the September 18, 2024 rate cut, bonds have pulled back, declining 2.4% as of 10/24. The potential for additional gains from falling rates appears limited, especially as the labor market remains resilient and inflation is seeing a modest uptick.
The diminishing expectations for further rate cuts could lead to additional bond selloffs. In this environment, maintaining a diversified approach-in terms of risk exposure and sourcing yield-may offer investors the best opportunity to navigate these evolving market conditions.
Too Late for Duration Trade?
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 8/4/2020 – 10/24/2024.
All Bark, No Bite
Beyond rate impacts, election-year concerns often surface. As the upcoming U.S. presidential election approaches, market chatter and investor anxiety often spike due to anticipated policy changes and political shifts. However, a look at historical data reveals that these fears of heightened volatility during election years are frequently overstated.
This chart demonstrates that the average annual volatility, measured by standard deviation, of the S&P 500 is nearly identical in both election and non-election years. This suggests that volatility remains consistent regardless of the political cycle.
While election headlines may create short-term noise, markets generally stay anchored in core economic fundamentals, such as interest rates, corporate earnings, and inflation trends. For investors, maintaining discipline and avoiding reactionary decisions is essential when navigating through periods of heightened media noise.
Election Year Volatility: Business as Usual
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 1/1/1929 – 12/31/2023.
Portfolio Recap
As we reflect on the market landscape this year, the enduring value of maintaining a diversified portfolio has never been clearer. While it may not always appear to be the “winning” strategy during periods of concentrated market gains-such as the first half dominance of tech giants-history has shown that diversification remains a powerful tool for managing risk.
So far, the second half has seen a reverse trend, with small, mid-cap, and value stocks taking center stage. Through both exuberant rallies and bouts of volatility, spreading exposure across asset classes provides portfolios with resilience against unforeseen downturns.
Our disciplined approach to balancing growth and risk throughout the quarter proved beneficial. Our ERB models remained fully risk-on, enabling them to participate in the market’s strong performance. However, we remain vigilant, emphasizing our RiskFirst® philosophy, which prioritizes managing downside risk while positioning portfolios to take advantage of market opportunities. Maintaining a diversified portfolio across sectors and asset classes, combined with a tactical overlay to shed risk exposure when needed, remains critical.
Dynamic Shifts in ERB
Source: Bloomberg, Redwood. Data as of 10/24/2024. Please see additional disclosures at the end of this commentary for more information.
Conclusion
Markets have responded favorably to the Federal Reserve’s confirmation that its hiking cycle has ended, and expectations of accommodative policy have fueled further optimism. The S&P 500 has notched nearly 50 record-high closes in 2024 (as of 10/24). While concern about elevated valuations persists, the price-to-earnings ratio shows the S&P 500 is 20% less than its peak since May 2021, suggesting there may still be room for gains.
However, ongoing uncertainty around inflation, interest rates, and global economic growth underscores the need to be prepared for various outcomes. By staying diversified, investors can reduce the risk of overreliance on a few dominant sectors or stocks, positioning their portfolios to both mitigate risks and capture emerging opportunities.
As always, we emphasize a disciplined, long-term approach to investing. This steadfast focus on aligning with each client’s unique risk tolerance and financial goals ensures that our portfolios are well-prepared to navigate today’s market dynamics and future uncertainties.
More Room to Go
Source: Bloomberg, Redwood. Data as of 10/24/2024. Date range from 10/19/2018 – 10/24/2024
3rd Quarter Market Commentary “Rate Cute. Now What?”
The much-anticipated Federal Reserve rate cut has finally arrived. The Fed cut 50-basis points, ushering in a new phase for the markets. Historically, rate cuts tend to inject optimism, with certain sectors, particularly small and mid-cap stocks, often outperforming. However, the backdrop in 2024 is more complex. Persistent inflation concerns and labor market uncertainties have made the market response less straightforward.
This delicate balance between optimism from declining inflation and the looming risk of an economic slowdown presents a unique challenge for investors. Our RiskFirst® approach remains paramount. We focus on managing drawdowns while maintaining diversified exposure across multiple asset classes. Our goal is to ensure that we are well-positioned to capture market opportunities while guarding against inevitable volatility.
Broadening Participation
The lead-up to the Federal Reserve’s first 50-basis point rate cut has played a pivotal role in reshaping market dynamics during 2024. The S&P 500 Index surged by 15.3% in the first half of the year. However, the year’s second half has so far witnessed a shift in market sentiment, with broader participation driving gains across previously lagging segments.
The S&P 500 Equal Weight Index, which gained just 5.1% in the first half, has returned an additional 9.6% so far in the second half, reflecting stronger performance across a wider array of companies. Similarly, the S&P 500 Value Index rose from 5.8% in the first half to 9.1% in the second, while small-cap stocks, represented by Russell 2000, accelerated from a modest 1.7% to 9.3%.
This broadening of market participation highlights investor optimism that the Fed’s rate cuts will help steer the economy towards a soft landing, avoiding a recession. The shift from growth centric leadership, where the S&P 500 Growth Index skyrocketed 23.6% in the first half but slowed to just 3.7% in the second, underscores the importance of diversified exposure to capture opportunities in different asset classes.
Second Half Shift
Sector Sized Impact
The market’s growing dependence on large-cap tech stocks has pushed S&P 500 concentration to staggering heights. Nvidia’s 7% weighting in the S&P 500 surpasses entire individual sectors like Consumer Staples (5.8%) and Energy (3.3%) but also exceeds the combined weight of multiple sectors, such as Utilities, Real Estate, and Materials. This creates a striking imbalance, where a single stock can outweigh entire industries composed of dozens of companies.
Such dependence on a few dominant players, particularly in the tech sector, presents a heightened risk for investors. Leaning too heavily on tech giants like Nvidia or Microsoft can expose portfolios to significant volatility, especially if these key stocks experience a pullback. By diversifying beyond the tech titans, investors can create a buffer, protecting their portfolios from the sharp swings of over-concentration in a handful of heavyweights.
Single Stock vs Sectors
Jobs Drop, Stocks Pop
While the market continues to climb, there has been a significant drop in U.S. Job Openings, reflecting a critical divergence between labor market dynamics and stock market performance. These two indicators have historically moved in tandem, as rising employment signals broader economic growth.
However, recent months have shown a sharp decline in job openings, driven by the Federal Reserve’s aggressive interest rate hikes to cool economic demand. As borrowing costs rise, businesses reduce hiring in anticipation of slower growth.
Despite this, the S&P 500 has continued its upward trajectory, fueled by optimism that the Fed will successfully steer the economy away from a recession. This raises an important dilemma for investors: will the stock market eventually adjust to reflect a weaker labor market, or will economic activity rebound sufficiently to justify current stock valuations? Although economic data signals a slowdown, market sentiment often defies expectations, reminding us that markets can remain unpredictable despite mixed signals from the broader economy.
Diverging Paths
Balancing Rates and Inflation
Although the Fed’s decision to cut interest rates was expected, the aggressive nature of the cut-50-basis points-caught the market by surprise. The Fed last implemented such a large initial cut in 2007. Investors embraced the move as a clear signal that the Fed is determined to balance economic growth with its efforts to cool down inflation. Encouragingly, the Consumer Price Index (CPI) has steadily declined to 2.4%, while Core CPI, which strips out volatile items like food and energy, stands at 3.3%, indicating that inflation is easing.
However, despite this improvement, the Fed’s benchmark interest rate remains at 5%, creating a significant gap between inflation and borrowing costs. This divergence continues to weigh on consumers and businesses, making it more challenging for the economy to recover fully.
The critical question now is whether this rate cut will be enough to support sustained growth or if further action will be necessary. While the market remains optimistic, the Fed must continue navigating the delicate balance between fostering economic activity and managing inflation risks.
The First Cut
Fall In Borrowing Boosts Market
The lead-up to the Federal Reserve’s first rate cut has triggered a significant drop in mortgage rates, which historically serves as a positive catalyst for equity markets. When the average 30-year fixed mortgage rate declined by more than 100 basis points over a 12-month period, the S&P 500 has typically responded with an annualized return of over 12%. This past year, mortgage rates have fallen by 144 basis points, marking one of the most substantial drops since 2008.
This connection between lower borrowing costs and stock market performance highlights how reduced rates can boost economic optimism. Lower mortgage rates make housing and other investments more affordable, encouraging consumer confidence and spending.
As we head toward the end of 2024, this environment of easing rates may continue to support equity market gains, with consumers and businesses more willing to take on debt, further fueling economic momentum.
Mortgage Rates Drop Like ‘08
Cuts Favor Smaller Players
One of the side effects of an easing rate environment is the impact across different asset classes. Historically, small-cap and mid-cap stocks tend to outperform their large-cap counterparts following rate cuts given their sensitivity to interest rate changes and greater exposure to shifts in economic momentum. This is largely due to lower borrowing costs stimulating economic activity, which in turn increases risk appetite, especially for companies that rely more on domestic borrowing.
On average, the year following a Fed rate cut has seen small-cap stocks return over 17%, and midcap stocks rise by more than 14%, compared to 9.8% for large-cap stocks. This trend is already taking shape in the current cycle, with smaller companies showing stronger performance in recent months.
Investors with diversified portfolios can capitalize on this trend by holding a mix of small, mid, and large-cap stocks. Spreading risk across these asset classes allows participation in various market drivers, making broad exposure essential to capturing gains as the effects of rate cuts continue to unfold.
Post-Cut Playout
First to Fall
A more direct effect is the change in cash rates. Cash and money market yields are often the first to reflect the impact of falling Federal Reserve rates. Historically, as shown by the rolling 3-month cash returns, these yields decline rapidly following the Fed’s initial rate cut. Just a few months ago, money market fund yields were around 5.4%, but as of October 25th, they have already dropped to 4.50%-4.60%, exceeding the Fed’s 50-basis-point cut. This highlights how quickly cash yields can adjust and overcompensate in a rate-cutting environment.
Unsurprisingly, high money market yields don’t last forever, prompting a reassessment of cash allocations in favor of higher-yielding or more diversified assets. With potential further rate cuts on the horizon, yields may continue their downward trend, making it critical for investors to explore alternative opportunities that provide better returns in a falling-rate environment.
Cuts Crush Cash Yield
Longest Inversion Signals Caution
As short-term yields fall, the spread between short-term and long-term Treasury yields also reverses. The yield spread between the 10-Year and 2-Year Treasuries is a widely used gauge of economic health. When the 10-Year treasury pays less than the 2-Year Treasury, this is known as a yield curve inversion-an indicator often associated with looming economic concerns. Historically, these inversions have preceded recessions, as seen in 2000 and 2007, with economic slowdowns occurring after the curve un-inverts.
The most recent 10-2 yield curve inversion, which was the longest on record, has just recently un-inverted. This shift could be interpreted as a delayed signal of potential economic challenges ahead, particularly given the backdrop of high uncertainty around the Federal Reserve’s aggressive rate cuts and persistent inflationary pressures.
However, some argue that the un-inversion might also signal the worst is behind us, depending on whether the Fed can achieve a soft landing for the economy. In either case, caution remains essential as the economic landscape continues to evolve, and prioritizing risk management is crucial for navigating the uncertain times ahead.
End of the Inversion
Bond Rally Fizzles Post-Cut
As the anticipation of the Fed’s aggressive rate cuts grew, traders rushed to lock in rates, sparking a 4.12% investment grade bond rally from July 11 to September 18, 2024, just before the cut. This uptick helped bonds recover some losses from their prolonged drawdown since 2020. However, with the initial rate cut behind us, much of the price action that bolstered bond performance may have already occurred.
Since the September 18, 2024 rate cut, bonds have pulled back, declining 2.4% as of 10/24. The potential for additional gains from falling rates appears limited, especially as the labor market remains resilient and inflation is seeing a modest uptick.
The diminishing expectations for further rate cuts could lead to additional bond selloffs. In this environment, maintaining a diversified approach-in terms of risk exposure and sourcing yield-may offer investors the best opportunity to navigate these evolving market conditions.
Too Late for Duration Trade?
All Bark, No Bite
Beyond rate impacts, election-year concerns often surface. As the upcoming U.S. presidential election approaches, market chatter and investor anxiety often spike due to anticipated policy changes and political shifts. However, a look at historical data reveals that these fears of heightened volatility during election years are frequently overstated.
This chart demonstrates that the average annual volatility, measured by standard deviation, of the S&P 500 is nearly identical in both election and non-election years. This suggests that volatility remains consistent regardless of the political cycle.
While election headlines may create short-term noise, markets generally stay anchored in core economic fundamentals, such as interest rates, corporate earnings, and inflation trends. For investors, maintaining discipline and avoiding reactionary decisions is essential when navigating through periods of heightened media noise.
Election Year Volatility: Business as Usual
Portfolio Recap
As we reflect on the market landscape this year, the enduring value of maintaining a diversified portfolio has never been clearer. While it may not always appear to be the “winning” strategy during periods of concentrated market gains-such as the first half dominance of tech giants-history has shown that diversification remains a powerful tool for managing risk.
So far, the second half has seen a reverse trend, with small, mid-cap, and value stocks taking center stage. Through both exuberant rallies and bouts of volatility, spreading exposure across asset classes provides portfolios with resilience against unforeseen downturns.
Our disciplined approach to balancing growth and risk throughout the quarter proved beneficial. Our ERB models remained fully risk-on, enabling them to participate in the market’s strong performance. However, we remain vigilant, emphasizing our RiskFirst® philosophy, which prioritizes managing downside risk while positioning portfolios to take advantage of market opportunities. Maintaining a diversified portfolio across sectors and asset classes, combined with a tactical overlay to shed risk exposure when needed, remains critical.
Dynamic Shifts in ERB
Conclusion
Markets have responded favorably to the Federal Reserve’s confirmation that its hiking cycle has ended, and expectations of accommodative policy have fueled further optimism. The S&P 500 has notched nearly 50 record-high closes in 2024 (as of 10/24). While concern about elevated valuations persists, the price-to-earnings ratio shows the S&P 500 is 20% less than its peak since May 2021, suggesting there may still be room for gains.
However, ongoing uncertainty around inflation, interest rates, and global economic growth underscores the need to be prepared for various outcomes. By staying diversified, investors can reduce the risk of overreliance on a few dominant sectors or stocks, positioning their portfolios to both mitigate risks and capture emerging opportunities.
As always, we emphasize a disciplined, long-term approach to investing. This steadfast focus on aligning with each client’s unique risk tolerance and financial goals ensures that our portfolios are well-prepared to navigate today’s market dynamics and future uncertainties.
More Room to Go
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