The third quarter of the year saw heightened volatility for markets, driven by weakening labor market data, underwhelming profit growth linked to artificial intelligence, and anticipation of the Federal Reserve’s first interest rate cut since the early days of the pandemic. Still, the S&P 500 closed at a record high by quarter-end with a total return of 5.9% for Q3. The gain was driven by a rotation into more rate-sensitive areas of the economy, including Utilities, Real Estate, Industrials, and Financials. Notably, only three members of the “Magnificent Seven” posted a positive return during the quarter, which resulted in the Information Technology and Communication Services sectors underperforming the broader market. The rotation spread across asset categories as well, with mid-cap, small-cap, and international stocks all outperforming the S&P 500 as investors sought returns away from mega-cap technology stocks.
While expectations for the Fed to cut interest rates were already high, debate about the size of the initial cut became front and center as the September meeting approached. With greater confidence that inflation is heading toward its 2% target, and risks to the labor market growing, the Fed opted to cut by a larger-than-expected 50 basis points. After over two years focusing on bringing inflation down to a normal level, attention has now turned toward preserving the strength of the labor market. Whether the Fed chooses to cut rates by 25 or 50 basis points – or not at all – at future meetings remains uncertain and will depend on how the economy performs in the months ahead. However, the expectation is for interest rates to continue to fall through 2025 now that the Fed has officially begun its easing cycle.
The fixed income market staged an impressive rally throughout most of the quarter leading up to the rate cut, with the Bloomberg U.S. Aggregate Bond Index gaining 5.2%. Bond yields declined across the treasury curve, with short-term rates falling more sharply than long-term rates. This shift ended the longest period of inversion between 2-year and 10-year treasury yields in history. Often viewed as an indicator of an oncoming recession, the inversion had persisted since July 2022 before normalizing in August.
Corporate earnings have continued to exceed expectations during the first half of the year. The latest quarterly reports from the tech giants underwhelmed investors looking for meaningful profits from heavy spending on artificial intelligence, which have yet to materialize. Disappointing profit growth related to AI, and uncertainty around future growth, was a primary driver of the volatility seen in mega-cap technology stocks during the quarter, putting downward pressure on market indexes overall. Also notable were comments from executives in the consumer sector suggesting that people are becoming more discerning in their purchases after years of price hikes and higher interest rates. Lower overall inflation and declining interest rates should offer some relief heading into 2025.
As we look toward the remainder of the year, several key developments will remain in focus, including the Federal Reserve’s approach to lowering interest rates, the upcoming U.S. presidential election, escalating foreign conflicts, and rising geopolitical tensions. While investor optimism remains high heading into the fourth quarter, each has the potential to shift sentiment in the short term. We’ll be monitoring them closely.
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