Introduction
While investors experienced a bumpy ride through late July and early August, equities and fixed income recovered to resume their climb toward the end of Q3, resulting in new all-time highs for the S&P 500. The stock market has continued to climb on a confluence of factors – easing monetary policy from the Federal Reserve, continued disinflation in the economy, slowing (but not slow) economic growth, resilient corporate earnings, and a strong labor market. We expect these factors to continue into year-end as the Fed continues its rate-cutting campaign. The most significant market overhang this year remains the election in November, after which the market will see a clearer picture of regulatory and fiscal influence in the coming years. In this edition of our market view, we address the following:
- Federal Rate Cuts and the Impact of Easier Monetary Policy
- The Impending Exit from Cash and Money Market Funds
- Election 2024 and Relevant Policy Proposals
- The Housing Market Conundrum
- Investing in Assets for any Administration
Rate Cuts are Upon Us
For the first time in over a year, the Federal Reserve has officially changed its target interest rate level – reducing the federal funds target range from 5.25-5.5% to 4.75-5%. Wall Street has been myopically focused on the Fed since rate hikes began in 2022, and speculation on Fed action has been high for over two years now. At first, the market was concerned with how high rates would go, then on how long they would be held at an elevated level, and as we are finally entering the final innings of this rate cycle, focusing on how quickly the Fed will bring rates back to a neutral level.
What do rate cuts mean for the Economy and for Markets?
This interest rate cycle is certainly atypical. We’ve seen interest rates move from essentially 0%, when the Federal Reserve attempted to stimulate the economy during the pandemic, to a level not seen since before the Global Financial Crisis. All the stimulus generated during Covid led to rampant inflation, which spurred the Fed to hike interest rates. Now that the economy has cooled significantly and inflation has abated, the Fed is now comfortable bringing rates down to a level that is not stimulative (hot) and not restrictive (cold) – “Goldilocks” as many market strategists like to say.
Rate cuts will be a positive for the economy and markets as long as economic activity remains robust and the labor market holds strong. Typically, the Federal Reserve cuts rates in response to a recession or fragile economic environment. This time that is not the case. The Federal Reserve may have won the fight against inflation without bringing the economy into recession, and the decline in rates to a healthy level will be welcomed by many. Lower rates facilitate greater economic money flow and help corporations borrow at more attractive levels. Just as many homebuyers locked in mortgages at low rates during the pandemic, many corporations extended debt at low interest rates, too. These loans become largely due from 2025 onward, so the faster rates decline, the more likely corporations are to avoid being unduly hurt by higher borrowing costs. Easier monetary policy helps money flow more freely, and more money flow aids all areas of the economy.
Declining Rates will Force Investors out of Cash
The decline in interest rates will increase the relative attractiveness of many asset classes – cash in money market funds has generated over a 5% return for over a year now, and many investors were hesitant to extend risk with this as an option. Now, money market returns are set to drop immediately as the Fed cuts rates. The Fidelity Government Money Market Fund (FDRXX) has already dropped to a 4.75% yield. This decline will continue as the Federal Reserve continues to reduce its interest rate target.
As cash yields continue to decline, investors will look to other areas of the market for returns. There are currently over $6.5 Trillion (yes, with a T!) in money market funds, and a significant portion of this balance will flow into new investments. Equity, fixed income, real estate, and other asset classes will see inflows as investors search for higher returns. We view this as a net positive for our portfolios as we position portfolios to benefit from declining rates. We expect a significant percentage of dollars currently deployed in money market funds to exit over the next two years as rates fall. If money market balances return to pre-Covid levels, around $2.5 Trillion or more will flow into other areas of the economy.
Election 2024
Heading into the 4th quarter of the year, we would be remiss if we did not mention the election and its impact on markets. As of the time of writing, polling shows this race as a toss-up between former President Donald Trump and Vice President Kamala Harris. Each candidate has outlined their economic policy to some extent at this point, so we have begun preparing two versions of our portfolio – one for a Trump administration and one for a Harris administration. Some sectors and companies are likely to perform well under only one of the administrations, while many should perform well under either. We like to have portfolios prepared under any scenario and have been working to ensure our investments will perform under any combination of government. As we consistently say: money always flows to where it’s treated best.
Differing Tax Proposals
Perhaps the most significant differentiating factor between the Trump and Harris campaigns is the approach toward taxes. The largest piece of legislation we know is slated to change is the Tax Cuts and Jobs Act (TCJA), passed under the Trump administration in 2017. Several of the TCJA provisions will sunset in 2025 if not renewed. The following are some of the most notable tax policy differences:
Reduction of top individual tax bracket from 39.6% to 37% – Under Republican control, the 37% top tax bracket will likely be maintained per the TCJA. VP Harris has expressed a desire to return to the 39.6% top tax bracket.
Estate Tax Exemption of $13.6 million – After being doubled under TCJA, the Trump admin aims to extend this exemption. The Harris admin plans to let this sunset as currently outlined under TCJA and has proposed the elimination of stepped-up cost basis on property at death.
Child Tax Credits – Both candidates have expressed a desire to increase the child tax credit.
Corporate Tax Rates – The Trump campaign aims to reduce the corporate rate to 20% (possibly 15%). The Harris campaign seeks to increase the corporate rate to 28%.
Corporate Alternative Minimum Tax (Eliminated under TCJA) – The Trump admin aims to maintain no AMT. The Harris campaign aims to re-institute and raise corporate AMT to 21%.
Of course, all these tax proposals require acts of Congress, which will encounter headwinds under a mixed government scenario, which is looking likely. While a Trump administration would seek a generally lower tax situation for individuals and corporations, tax revenue would likely fall, at least in the short term, as tax policy takes time to stimulate economic growth. The Harris administration’s policies would work to increase immediate tax revenue, but they may inhibit long-term economic growth.
Fiscal Spending
Wall Street has a renewed interest in the U.S. government deficit, as post-COVID era spending levels have remained elevated, and high interest rates have pushed debt servicing costs even higher. As forecasted, U.S. Federal net debt is expected to surpass 100% of GDP in 2025 for the first time since WWII.
Source: J.P. Morgan Asset Management
While both political parties have acknowledged the spending issue, cutting government budgets has never been a good way to gain votes, and this election cycle has seen far more spending promises than cutting initiatives.
The current situation is unique because the U.S. government is spending at record levels despite having low unemployment and strong economic growth. Fiscal spending is typically used to stimulate a struggling economy, and this has been at odds with the Fed’s rate hiking cycle of the past two years, which is geared at reducing inflation by slowing the broader economy.
The problem with such high debt levels is that they prevent the U.S. government from discretionary spending. Debt servicing costs are so high that the category represents almost half of our total annual borrowing and has nearly eclipsed the entire non-defense discretionary budget.
Source: J.P. Morgan Asset Management
Eventually, the U.S. will run out of borrowing power and need to find a solution to its spending problem, leading to concern that non-discretionary items, such as Social Security, will get cut. No political party wants to touch Social Security or Medicare/Medicaid entitlements, but without any changes or reductions, funding is expected to run out by 2037.
This is an important dynamic to watch over the coming years, as a reduction in government spending may decrease GDP and potentially create a material change in the retirement plans for many Americans age 50 and younger.
Energy Policy
Energy policy is always contentious heading into an election. Traditionally, Republicans tout policies that will increase oil drilling activity and boost fossil fuel production, while Democrats tend to focus more on clean energy production methods like solar and wind. This race is not much different from recent history. Trump continues to promote drilling and the oil & gas industry, and while Harris has stated her administration will not ban fracking, it is likely traditional fossil fuels will be put under pressure and that many of the clean energy subsidies put in place by the Biden administration will be kept or increased under a Harris administration.
Trade and Tariffs
Trade policy has become more bipartisan in recent years. Trump instituted significant tariffs against China during his administration, which Biden largely kept (and even expanded in some cases). Trump promises to push broader tariffs in a second term to drive a fairer trading environment with current partners. At the same time, Harris would likely avoid additional tariffs beyond the current “tough on China” approach. A Trump administration would likely see increased pressure on geopolitical rivals via tariffs and economic sanctions, while a Harris administration would largely avoid additional conflict.
Regardless of the next administration, U.S.-China relations are likely to remain tense, and trading activity will further shift toward near-shoring partners like Mexico and Canada as well as friend-shoring partners like India and Latin American countries.
The Bottom Line for Markets
The majority of Trump’s economic proposals aim to promote economic growth through traditional trickle-down economics by removing burdens on corporations and businesses. As noted, however, spending is an issue and these policies may reduce short-term tax revenues without a substantial budget overhaul. We expect Trump’s policies would be better for markets in the near term, but Wall Street will focus more on the national debt as the administration develops its policy and spending priorities. On the other hand, Harris has pledged more support for the middle class and higher taxes on corporations. Her economic policy hasn’t been sufficiently outlined, so it is harder to anticipate what a Harris economy would look like beyond the policies implemented by the Biden administration over the past 3 ½ years. We will likely see some form of mixed government over the next two years, with what looks likely to be a Republican Senate and some combination of Democrat Presidency or House control. The market has typically favored mixed government scenarios as regulatory overhaul is less likely and uncertainty is removed via legislative gridlock.
The Housing Market Conundrum
With the much-anticipated reduction in the Federal Funds target rate, many questions have arisen about its impact on the relatively anemic housing market of late. Since the Fed began raising interest rates in early 2022, housing supply and the number of homes sold have fallen. Supply has been chronically low since 2008, and the “golden handcuffs” of low-rate existing mortgages have kept homeowners from selling. In recent months, demand has dried up due to elevated mortgage rates and high prices, keeping first-time homebuyers on the sidelines while renting remains more affordable than owning.
As interest rates drop, so will mortgage rates. The 30-year mortgage is already down to 6.13% from 7.9% at the recent peak. This will likely spur housing market activity and allow the market to normalize. In our view, this normalization will take time and occur in stages:
Short-Term Outlook: In the short term, there is an opportunity for home prices to increase as the most price-insensitive buyers enter the market. Many homeowners have accumulated large amounts of equity in their homes as prices have increased, and they’ve been stuck waiting for lower mortgage rates. Those well-capitalized buyers with some urgency and the ability to stomach a 6% mortgage may be the first back into the market, helping to push up prices. First-time homebuyers may be well served by trying to move quickly before competition heats up, so long as they can afford a higher mortgage in the short term before refinancing. The adage “date the rate but marry the house” is very relevant in the current market conditions, as a mortgage can be refinanced, but a home (and its purchase price) isn’t going to change.
Medium-Term Outlook: Over the medium term, as mortgage rates drop into the mid/low 5% range, more and more homeowners will be able to justify giving up their 3% mortgages, bringing even more housing market activity. At this point, home prices will likely begin to moderate as increased market activity brings supply and demand into better balance. Homebuilders will likely continue to build at an elevated pace for the next few years, adding much-needed supply to the market.
Long-Term Outlook: The long-term outlook is much more challenging to forecast. Many moving pieces, such as renting vs. buying trends and land availability, obfuscate the market. Still, one thing is clear: more housing will be needed for a rapidly growing population.
The U.S. is estimated to need seven million new houses to alleviate shortages despite only building at a rate of about 850,000 per year. Without new supply, homes will continue to appreciate beyond the reach of many first-time homebuyers.
Both political candidates have made housing affordability part of their platform, and according to the National Association of Homebuilders, regulatory costs, such as permitting and zoning issues, account for almost $100,000 of additional cost to the average new home. Even a slight improvement in streamlining regulations could result in more cost savings than many proposed direct government subsidies.
We don’t anticipate mortgage rates will return to 3% anytime soon, but we still expect a strong housing market with rates in the high 4 or low-to-mid 5 percent range.
Assets for a Variety of Market Environments
We always work hard to set up our portfolios in pursuit of success, and with this effort comes the introduction of many assets we believe will perform well in various economic and market environments. Given the current uncertainty of the Federal Reserve’s rate path, geopolitical tensions on the rise, the advent of a new political administration, and the ongoing turbulence of the stock market, we believe it is prudent to implement a variety of conservative investments that may offer lower volatility while maintaining upside potential. A few investments we are implementing include:
Structured Notes – Structured notes have been a staple in our portfolios for over a year now, and we believe they continue to provide attractive upside while avoiding significant loss in the case of a downturn. We structure our notes according to factors we believe give us the best possible chance of success, utilizing a combination of downside protection and upside potential to generate returns even in volatile market environments.
Preferred Shares – Preferred shares are currently offering attractive yields, typically in the high single-digit range. These securities exist higher in a company’s capital stack than traditional stocks, and we believe they offer attractive income generation while remaining a conservative portion of the portfolio.
Private Investments – Private (or Alternative) investments are another asset class we continue to implement in our portfolios. These include private credit, private equity, and private real estate. These positions are not marked-to-market daily like public securities, so they limit volatility within portfolios while offering what we believe is very attractive upside. We utilize private investments to gain access to areas of the market that are not traditionally available via public investment.
Defined Parameter Investments – Similar to structured notes, we believe defined parameter investments offer a good combination of upside potential while offering a buffer in the case of a market downturn. Utilizing this asset class allows us to participate in market upside (up to a limit) while helping to protect against significant losses in the case of a market pullback. Often, we will invest in these tactically to create what we believe is the greatest likelihood of success for our clients.
By implementing the investments above, we believe we can bolster portfolios and create exposure that will help manage portfolio volatility. Many of these investments have upside potential that can generate returns uncorrelated with public markets. With the uncertainty of the current market environment, we believe it is prudent to continue seeking investment options like these that we believe may experience less volatility compared to traditional public market asset classes.
Conclusion
As we head into year-end, we remain confident that the combination of interest rate cuts, a strong labor market, resilient corporate earnings, and stable economic growth will present an attractive investment environment. However, as always, we remain cautious and concentrated on market fluctuations to create the best likelihood of success for our clients. The only constant in investing (and life!) is change, but by taking a prudent approach to portfolio construction, we believe we are set up for success in the months ahead. Thank you for reading our Q4 market view, and we wish the best to you and your family as we head into this new year!
Disclosures