Explore This Report With These Links
- U.S. Economy Rebounds In Q2
- Federal Reserve Initiates Recalibration Of Monetary Policy
- Labor Market Shows Signs Of Softening
- More Progress On Inflation
- Tracking The Consumer
- Mortgage Rates Hit A Two-Year Low
- Debt Ceiling Looms Again
- Manufacturing Sends Mixed Results
- Global Growth Is Mixed
- Market Commentary
- Potential Tax Law Changes On The Horizon
Executive Summary
The U.S. economy expanded at a healthy 3% annual pace in the second quarter of the year, boosted by strong consumer spending and business investment. Recent economic data indicate that inflation is steadily declining towards the Federal Reserve’s 2% goal. The labor market has also cooled, with the unemployment rate rising to 4.2% in August from 3.7% at the end of last year. Monthly payroll growth has slowed to 116,000 for the three months through August, down from 212,000 in December 2023.
Considering these factors, the Federal Reserve lowered rates in September for the first time since 2020. The long-anticipated pivot followed an aggressive two-year campaign against inflation. While not yet declaring victory, the Federal Reserve is encouraged by the progress on inflation even with the relative strength of the economy.
Market volatility was elevated in the quarter as investors grappled with a potential labor market slowdown and uncertainty about the timing of the Fed’s easing cycle. Large cap stocks advanced but were outpaced by small cap, emerging markets, and developed international. Bond markets rallied as rates declined, marking the best quarterly returns since the second quarter of 2020.
U.S. Economy Rebounds In Q2
Annualized gross domestic product (GDP) growth in the second quarter rebounded to 3%, well above the first quarter’s 1.6%. Growth of consumer spending has remained resilient, rising in the second quarter by 2.8%, driven by a bounce-back in spending on goods. Fixed investment slowed from Q1, but equipment spending was robust, rising by a seasonally adjusted annual rate of 9.8%. After two negative quarters, inventories rebounded, contributing 1.05% to economic growth. In terms of value added by industry, private goods-producing industries led, increasing 6.9%, private services-producing added 2.4%, and government increased 0.8%.
Meanwhile, the Bureau of Economic Analysis published the regular annual update and revisions of the National Economic Accounts. The U.S. economy grew 1.6% in Q1 2024, higher than 1.4% initially reported. In 2023, GDP growth was revised up to 2.9% from 2.5%, and for 2022, the GDP expanded 2.5%, 0.6% stronger than previously estimated.
Despite some evidence that economic growth is slowing, the Atlanta Fed’s GDPNow, a running estimate of real GDP growth based on available economic data, is tracking the economy through the third quarter at a growth rate just above the 3% we saw in the second quarter.
Federal Reserve Initiates Recalibration Of Monetary Policy
In September, the Federal Reserve enacted its first interest rate cut since the early days of the COVID-19 pandemic, reducing the benchmark rate by 0.5% to counter a potential labor market slowdown. With the labor market softening and inflation nearing target levels, the Federal Open Market Committee (FOMC) lowered its key overnight borrowing rate by half a percentage point. This marks the first such cut outside of emergency measures since the 2008 financial crisis. Eleven of 12 Fed voting members backed the cut, which brings the new federal funds rate to a range of 4.75% - 5%, impacting short-term borrowing costs for banks and spilling over into consumer products like mortgages, auto loans, and credit cards. The post-meeting statement indicated that the Committee has gained greater confidence that inflation is moving sustainably toward 2%, and judges that the risks to achieving its employment and inflation goals are roughly in balance. Chair Powell repeatedly described the move as policy “recalibration,” suggesting that the Fed is proactively managing economic risk. It was reiterated, as has been the case with each meeting, that decisions will be made on a meeting-by-meeting basis and based on data at the time. Quarterly projections released in September show a narrow majority of officials penciled in cuts that would lower rates by at least a quarter-point each at meetings in November and December. Bond markets are pricing in additional cuts totaling 75 basis points through the end of this year.
The ultimate goal of the Federal Reserve strategy was to engineer an economic slowdown to curb inflation without significantly harming the labor market or causing a recession — in other words, to create a soft landing. In 1995, the Federal Reserve steered the economy to a soft landing, setting the stage for the subsequent economic boom that continued until 2001. Can this success be replicated? With a significant rate cut in September, the Fed could be on the right track. Back in 1994, the Fed aggressively raised rates to combat inflation. By 1995, the labor market was cooling, and, like today, there were no clear signs of an impending recession. However, a negative jobs report in May 1995 prompted the Fed to initiate the first of three cuts in the following month. Today’s economy is arguably stronger than the environment in 1995. Chairman Powell stated that the markets should view the 50-basis-point cut as a sign of commitment to achieving their dual mandate of price stability without undue pain in the labor market.
Other major central banks have initiated easing measures. The Bank of Canada was the first, cutting its benchmark interest rate in three consecutive meetings starting in June. Despite not yet reaching the 2% inflation target, the Canadian central bank noted solid progress on inflation and a general softening of the economy. The European Central Bank, which set rates for the 20 countries that use the euro currency, followed suit by cutting rates by 0.25% in June for the first time in five years, from an all-time high of 4%. In September, the rate was reduced again by 0.25%, bringing the new target to 3.5%. In August, the Bank of England made its first interest rate cut in over four years, reducing the target rate to 5%. At the September meeting, they opted to maintain the current rate, citing concerns about the still-rapid rise in services prices and wages.
Labor Market Shows Signs Of Softening
The August jobs report showed job gains of 142,000, bringing the three-month moving average down to 116,000. In addition, June and July were revised lower by 86,000 jobs. The unemployment rate ticked lower to 4.2%, providing some relief after the recent increase. Lastly, wages grew 3.8% year over year, providing a real wage increase after inflation. Looking at the labor market overall, the participation rate for workers in their prime working years remains high, job openings have declined but remain above pre-pandemic levels, and the number of “quits” are steady and lower by 338,000 from a year ago. Average monthly layoff and discharges are modestly lower than in 2023. Overall, the labor market is in solid condition and the Fed’s goal is to keep it there.
Every year, the Bureau of Labor Statistics (BLS) conducts a revision to the data from its monthly survey of businesses’ payrolls, then benchmarks the March employment level to those measured by the Quarterly Census of Employment and Wages program. In August, we learned that the preliminary revision of -818,000 jobs marks the largest downward revision since 2009 and shows that the labor market wasn’t quite as hot as initially thought. When spread through the prior year, the average monthly job gain from April 2024 through March 2024 was 174,000 net new jobs per month versus 242,000. The negative revisions provide additional evidence that the labor market is softening. However, the revised 174,000 monthly job growth is still solid by historical standards.
More Progress On Inflation
Recent inflation reports confirm that overall pricing pressures have retreated from the peak in 2022, but challenges remain. According to the latest Consumer Price Index (CPI) report, the overall inflation rate in August was 2.5%, the lowest level since February of 2021. Energy prices contributed to the modest inflation reading, falling by 0.8% month over month. Increases in food prices were modest, rising only 0.1%. Two categories keeping the inflation rate elevated are shelter (+5.2% year over year) and transportation services (+7.9% year over year). These elements of the index have stickier prices that don’t typically fall quickly.
The Producer Price Index (PPI), which measures price trends at the manufacturing level, increased 1.7% year on year in August, the lowest in six months. Producer Prices change averaged 3.1% from 1950 until 2024, reaching an all-time high of 19.6% in November of 1974 and a record low of - 6.9% in July of 2009.
Despite the overall decrease in inflation, many prices remain elevated. Experts suggest that persistently high food and shelter prices contribute to why many Americans feel pessimistic about the economy, despite low unemployment, rising wages, and steady economic growth. Lower-income households are disproportionately affected due to their higher percentage of income spent on necessities, limited financial buffers, and the essential nature of these goods, which makes it difficult to cut back on consumption even when prices rise. These households spend a larger share of their income on essential items such as food, housing, and utilities. Since January 2020, food prices, as measured by the CPI, increased by nearly 28% through August. Food, a basic necessity, has inelastic demand, meaning higher interest rates cannot control its pricing forces. Various other factors influencing food prices include weather, fertilizer, tariffs, labor costs, energy prices, and animal diseases.
The Personal Consumption Expenditure (PCE) Index, the Federal Reserve’s preferred gauge for inflation, increased 2.2% year over year in August, which is the lowest rate since February 2021. The progress in August came despite continued pressure from housing-related costs, which increased 0.5% on the month for the largest move since January. Services prices overall increased 0.2% while goods declined by 0.2%.
Dockworkers at ports from Maine to Texas walked off the job September 30, potentially initiating one of the most disruptive strikes in decades. The strike could stop the flow of a wide variety of goods through nearly all cargo ports on the East and Gulf Coasts, affecting items such as bananas, European wine and liquor, clothing, toys, household goods, and European autos. Additionally, parts essential for keeping U.S. factories operational and American workers employed could be impacted. Depending on its duration, a strike might lead to shortages of consumer and industrial goods, possibly driving up prices again. This could adversely affect an economy that is finally recovering from a pandemic-induced inflation spike.
Tracking The Consumer
Recent data suggests that the consumer is still relatively strong. U.S. retail sales rose 0.1% month over month in August, following an upwardly revised surge of 1.1% in July. Data from the Federal Reserve of New York shows that total consumer debt rose in the U.S. by $109 billion in the second quarter to a fresh high of $17.8 trillion. The use of consumer credit is on the rise, surging $25.4 billion in July. This marked the largest credit growth since November 2022, driven by substantial increases in both revolving and non-revolving debt. Revolving credit, which includes credit card balances, climbed by $10.6 billion, the biggest jump in five months. Meanwhile, non-revolving credit, covering loans for vehicles and education, surged by $14.8 billion. Household debt-service ratio, which is a measure of debt payments as a percent of disposable income, is up to 11.5%. Although higher than during the pandemic, this rate is in the range that we have seen since 2012. This sharp rise in consumer borrowing signals strong demand for credit despite ongoing economic uncertainties. Workers have seen a real increase in wages, net of inflation, of 1.3% year over year as of August.
Before the pandemic, the University of Michigan Consumer Sentiment index was at 101. However, as inflation soared to over 9% in mid-2022, the index plummeted to a low of 50. While sentiment rose close to 80 in March as inflation declined, it retreated to 66.4 in July. Conventional wisdom attributes this decline to rising inflation. Although the 21.3% increase in the CPI from January 2020 to August 2024 was certainly painful, its impact was largely offset by a more substantial 23.8% rise in average hourly earnings during the same period. This wage growth helped mitigate the effects of inflation on consumers’ purchasing power.
Mortgage Rates Hit A Two-Year Low
The residential housing sector entered a recession in 2022 and has since struggled to recover. Residential housing construction contracted by 24% in the last half of 2022. However, since housing constitutes only 4% of GDP, its impact on the overall economy was limited. At the core of the housing problem is a supply and demand imbalance. There are more people ready to buy than there are houses for sale. That was true even before the pandemic drove demand through the roof. The housing market became nearly inaccessible as mortgage rates soared from record lows in 2020 to generational highs in 2023.
A steady decline in mortgage rates to two-year lows has current homeowners rushing to take advantage of potential savings. The average interest rate for conventional 30-year fixed-rate mortgages reached a two-year low of 6.08% toward the end of September, well below the peak of 7.8% in October of last year. The drop has caused a 20% surge in refinancing activity.
Meanwhile, the inventory of homes for sale is improving. There were 1.35 million units for sale at the end of August — up 22.7% from a year ago. However, this is still just a 4.2-month supply. A six-month supply is considered balanced between buyer and seller. Tight supply is keeping the pressure on prices. The median price of an existing home sold in August was $416,700, up 3.1% from the same month in 2023. First-time buyers made up just 26% of August sales, matching the all-time low from November 2021. As mortgage rates continue to decline, we should expect a recovery in U.S. housing market activity led by improvements in home affordability.
Debt Ceiling Looms Again
The federal government is borrowing at levels not seen since World War II, the 2008 financial crisis, and the COVID-19 pandemic. This year’s budget deficit is on track to top $1.9 trillion, or more than 6% of economic output, a threshold reached only around World War II, the 2008 financial crisis, and the COVID-19 pandemic. Publicly held federal debt, which is the accumulation of all past deficits, has now surpassed $28 trillion, nearly 100% of GDP.
The annual budget outlines the nation's spending plans, which for many years have surpassed its tax revenues. Since 1970, the federal government has run a deficit except the four years between 1998 to 2001. The shortfall is funded by the issuance of debt up to a limit set by Congress. The 2023 debt-ceiling agreement removed the limit through the end of 2024, re-establishing it to the debt level that will exist on January 2, 2025. Assuming typical collections and expenditures, it is estimated that the nation can sustain itself into mid-2025. Beyond that, a new agreement will be necessary, coinciding with significant negotiations over the sunset of the Tax Cuts and Jobs Act (TCJA).
Long-term fiscal policy is challenging for several reasons. Mandatory payments for Social Security, medical programs, and interest account for almost 60% of the federal budget in 2024. Defense spending consumes another 14%. A diminishing percentage of our budget goes through the appropriations process, which only addresses the discretionary portion of the budget. A meaningful solution will likely include a mix of spending cuts, tax increases, and policy reforms aimed at stabilizing and eventually reducing the national debt. These measures, including austerity and revenue increases, are unpopular at any time, and especially during an election year. However, as debates continue over continuing resolutions and the debt ceiling, the national debt keeps rising. Currently, the debt exceeds 100% of our GDP, and forecasts indicate a significant rise in the coming decades.
U.S. taxes are relatively low compared to other advanced economies. The corporate income tax rate of 21% is below the global average of approximately 24%. The top personal income tax rate of 37% is also among the lowest in the developed world. In contrast, the average top personal income tax rate in major European countries is around 43%. The U.S. tax revenue to GDP ratio is 26%, the lowest among high-income economies.
Manufacturing Sends Mixed Results
The S&P Global U.S. Manufacturing Purchasing Managers' Index (PMI) fell to 47 in September of 2024 from 47.9 in the previous month, marking the third consecutive month of contraction in the U.S. factory activity at the sharpest pace in over one year. The sharpest declines in new orders for goods since December of 2022 caused the drop, underscoring the pessimistic momentum for U.S. goods producers and driving production to fall for a second straight month. At the same time, new orders for manufactured durable goods in the U.S. were loosely unchanged from the prior month in August of 2024, compared to the revised 9.8% surge in July — the highest in four years.
Global Growth Is Mixed
Recent business surveys indicate that the eurozone economy had slowed sharply as the third quarter ended. The surge in energy prices following Russia’s invasion of Ukraine curtailed the eurozone’s post-pandemic recovery, though the EU managed to avoid a recession. Policymakers at the European Central Bank aimed to control inflation without triggering an economic contraction, but signs of weakening activity have emerged as borrowing costs remain high. An aggregate measure of business and consumer confidence in the EU remained stable in September, with industry confidence modestly lower and consumer confidence slightly improved.
Despite a robust job market with record-low unemployment rates, the surveys suggest a turning point, with businesses shedding workers at the fastest rate since the end of 2020. Weaker demand also helped ease price pressures. The services sector, a key driver of inflation in the eurozone, reported the smallest rise in input costs in three-and-a-half years, while those costs fell for manufacturers. Consequently, the prices that businesses charged their customers rose at their slowest rate since the Russia-Ukraine conflict sparked a lengthy cost-of-living crisis early in 2022.
Services activity, which had been buoyed by the Olympic Games in Paris in August, slowed sharply, with the index deteriorating to 50.5 from 52.9, marking the weakest rate of growth in seven months.
Manufacturing activity continued to decline across the eurozone, with little sign of a rebound for the struggling factory sector. Germany, Europe’s industrial powerhouse, saw a further slowdown in manufacturing, the surveys showed, with the measure of activity reaching its lowest point in a year.
China’s GDP grew by an estimated 4.9% year over year in the third quarter, marking a slowdown compared to previous quarters and highlighting ongoing economic challenges. The manufacturing sector contracted for the fifth consecutive month, with the official purchasing managers’ index indicating weakened export orders and continued caution among firms regarding hiring. Additionally, a parallel measure of activity in the services sector slipped into contraction in September, reflecting declining consumer sentiment.
In response, Chinese officials unveiled a flurry of significant policy measures to bolster the economy, housing market, and stock market. These measures include cuts to the policy rate and reserve requirement ratio (RRR), as well as injecting billions of yuan into the stock market. The government also announced initiatives to revive the housing market, including lower down payments for second homes and allowing existing homeowners to refinance their mortgages at lower interest rates – a common practice in the U.S. but more challenging in China. Despite these measures, estimates are that China will not meet its 5% annual growth target in 2024.
Market Commentary
After relatively low levels of volatility in the first half of the year, the S&P 500 index declined by more than 1% in seven trading sessions and increased by more than 1% in 13. Overall, movements of plus or minus 1% occurred in over 30% of the quarters trading sessions. Large-cap markets experienced some leadership rotation during the quarter. Falling interest rates provided a boost to more interest-sensitive sectors like utilities, real estate, industrials, and financials. Utilities, one of the smallest sectors in the S&P 500 index, posted a 19% return for the quarter and is up more than 30% for the year. Real estate recovered from a negative year-to-date return through June to a 14% gain after the third quarter. Industrials and financials posted double-digit gains in the quarter. Technology and communications lagged in the quarter, both up around 1%.
The small-cap Russell 2000 index posted the best quarterly result, gaining 9.3%. It was followed closely by the emerging markets (MSCI EM) and developed international (MSCI EAFE) indices. up 8.7% and 7.3%, respectively. The S&P 500 rose 5.9%. The globally diversified MSCA All-Cap World Index (ACWI) was up 6.9%. The tech-heavy Nasdaq trailed, rising only 2.76% for the quarter. The “Magnificent 7” (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla) lagged during the quarter with five of the seven generating negative returns.
The S&P 500 and the Nasdaq continue to dominate year to date, up 22.1% and 21.9%, respectively. Emerging markets and developed international are up 16.8% and 13%, respectively. The Russell 2000, which came on strong in the third quarter, is up 11.2% to date. The globally diversified MSCI All-Cap World index is up 17.8% for the year to date.
S&P 500 earnings are expected to grow 18% in 2024, with a 14% increase excluding the Magnificent 7 companies. However, these projections should be considered in light of the 2022 earnings recession. As of the second quarter of 2024, earnings in all sectors except financials remained below their previous peaks. Technology and Magnificent 7 companies have recently shown strong growth, but they also experienced the most significant declines in 2022. The technology sector saw maximum peak-to-trough earnings drop of 17%, only fully recovering by the fourth quarter of 2023. The Magnificent 7's earnings fell even more dramatically, declining 40% from the fourth quarter of 2021 to the second quarter of 2022, and didn't rebound until late 2023.In the most recent earnings season, the S&P 500 (excluding the Magnificent 7) reported positive earnings per share (EPS) growth for the first time in five quarters, with gains in eight out of 11 sectors. If the economy achieves a soft landing, it could create a favorable environment for a wider range of companies to thrive.
Interest rates declined significantly during the quarter as the Federal Reserve initiated its easing cycle. This chart illustrates where U.S. Treasury yields were as of the end of September compared to the end of June. October 18, 2023, which is the recent peak in rates, is shown for comparison purposes. This decline is particularly prominent on the short end of the yield curve, where the rate on a 1-year Treasury fell by 1.1% since the end of June and is 1.5% lower than a year ago. The 10-year Treasury rate has decreased by 0.5% from June 30 and is down over 1% from a year ago. This decline in rates drove prices higher, generating total returns in the 3 to 5% range – bringing most major bond indices back into positive territory year-to-date.
The inverted yield curve has been a prominent discussion topic over the last 26 months. An inverted yield curve is when short-term yields on U.S. Treasurys exceed long-term yields. Historically, an inverted yield curve meant that the U.S. economy was likely to slip into recession in the coming months. The yield curve has accurately predicted almost every recession since 1955. However, there was a lone exception in 1966, when the curve inverted, and a recession did not materialize.
In July 2022, against a backdrop of rising inflation, the yield curve began a prolonged period of inversion remaining “upside down” until late of August 2024. At times, the rate differential exceeded 1%. Historically, the range in lag between inversion and recession has spanned 5 to 23 months. Since 1978, the longest delay between an inversion and the start of a recession was 23 months, which occurred in 2006. Given the lack of signs of an imminent recession, this current inversion may join 1966 as another exception.
Potential Tax Law Changes On The Horizon
We are continually monitoring changes that will impact our clients. One potential change is the “sunset” of the TCJA, which was enacted in 2017, and brought significant modifications to the United States tax code. However, many of its provisions were temporary and are set to expire at the end of 2025, impacting individuals and businesses across the nation. These kinds of “cliffs” have become more common in recent decades, as major fiscal bills passed under a reconciliation procedure cannot increase the deficit beyond a ten-year window. The TCJA reduced individual tax rates across most income brackets, nearly doubled the standard deduction to $12,000 for single filers and $24,000 for married couples, eliminated personal exemptions but expanded the Child Tax Credit. The law capped state and local tax deductions (SALT) at $10,000. It limited mortgage interest deductions and eliminated several itemized deductions. These changes were designed to simplify tax filing for many Americans. The increased standard deduction and elimination of some deductions meant that fewer taxpayers itemized.
For businesses, the TCJA lowered the corporate tax rate from 35% to 21% and introduced a new 20% deduction for qualified business income for pass-through entities. The act allowed 100% bonus depreciation for qualified property. This lets you deduct the full cost of eligible assets in the year they are placed in service.
The TCJA introduced numerous tax changes set to expire after 2025, some of which will likely be addressed by Congress prior to expiration. Several key elements that may impact individuals and businesses are:
- Individual tax rates would return to pre-TCJA levels, with the top rate increasing from 37% to 39.6%.
- The standard deduction would decrease, potentially affecting your itemized deductions strategy.
- Personal exemptions and SALT would be reinstated.
- The estate tax exemption would be reduced, impacting estate planning for high-net-worth individuals.
Planning ahead can help you navigate these changes effectively. Your Private Wealth team can help.
