Q3 Recap: Value Begins to Take Leadership

SUMMARY

• China led the way in Q3 after a huge rally in the final week.
• US Value and International outpaced US Growth.
• Weak US dollar improved developed international returns.

Quarterly Recap: Fed Rate Cut and Chinese Stimulus Take the Spotlight

The third quarter of 2024 culminated a year-long ‘pivot’ from the Federal Reserve (‘the Fed’). After quarters of speculation, the Fed surprised markets with a 50-basis point (basis point = 1/100th of a percent) cut, double what the market was expecting. As the Fed began their cutting in earnest, markets reacted with a bit of a ‘value’ rotation (as can be seen in both US Sector returns and International Returns).

This entire quarterly market recap may have been focused solely on the Fed, if not for the People's Bank of China (PBOC) announcing stimulus to help their ailing economy. In a single week, Chinese equities returned 21.2%, catapulting them, and thus emerging markets to the top of asset class returns for the quarter as shown in Table 1, below. With both Fed and PBOC stimulus, we believe it is important to look at the market’s reaction to determine where we expect things to shake out further.

US Sectors: ‘Value’ and Rate Sensitive Sectors Lead the Way

Table 2 below shows sector performance. In the first 2 quarters, ‘growth’ sectors such as Technology and Communication Services posted the top returns, but in Q3 they trailed the S&P500. At the top of the third quarter return table were the rate sensitive sectors of Utilities and Real Estate. Both of these were boosted by the by the well anticipated Fed cuts, in our view.

Joining Utilities and Real Estate this quarter on the leader board were the ‘value’ sectors of Industrials, Financials, and Materials. The strong quarter from this trio could be pointing towards the start of a ‘value’ rotation, as discussed in last month's Weekly View. Similar to Utilities and Real Estate, we believe lower rates should begin to bolster the fundamentals of these three sectors.

On the other hand, Energy posted its second consecutive negative quarter with falling oil prices applying downward pressure to the sector. We remain bullish on Energy stocks, believing that oil prices will remain above the breakeven rates for US Energy companies, allowing them to continue to produce attractive free cash flows. Furthermore, looking forward, increasing tensions in the Middle East as well as recent Chinese stimulus could provide some upside to oil prices.

International Stocks: China Rallies, Japan Lags

Moving to Table 3 below, China had far and away the highest quarterly returns of any major market. As mentioned above, the majority of these returns came in the last week of the quarter, after the announcement of their stimulus package. While this economic stimulus could be a significant tailwind for the next few months or quarters, we still have reservations regarding China’s long-term prospects. Both their domestic and global political agenda place their equity markets in a tough spot for international investors. Despite this caution, we will continue to keep an eye on the effects of the stimulus.

When looking at developed markets, the thing that sticks out is how strong currency returns were in the third quarter relative to the US dollar. This led to much higher returns for US-based investors versus local investors. While the weakening dollar boosted returns this quarter, this could create a headwind for more export driven markets in the future. For these exporters, a stronger domestic currency makes exports more expensive, and less attractive for foreigners. Specifically, we believe a strong yen and pound can often hurt the local returns of Japanese and UK equities.

While we have been underweight International relative to our policy benchmarks because we believe in diversification for times like these, our portfolios maintained an allocation to international markets. Once again, we will have to determine whether this is another short-term relative bounce or a more sustainable trend.

Looking Forward: Portfolio Positioning Remains Mostly the Same

One positioning point of note is our cyclical exposure across our portfolios. In both the short and long horizon portfolios we hold international value and large cap industrials, while the long horizon portfolios also hold small cap equities. These positions give us exposure to the burgeoning value rotation we were seeing in both returns and earnings. Additionally, we still hold positions in large cap technology across our portfolios.

We remain underweight Chinese equites in any portfolio with China exposure in the benchmark. However, as mentioned above, we will look for effects of the Chinese stimulus, specifically on company earnings, in order to determine if we need to pivot our positioning. We could do this either through direct China exposure or using Chinese-sensitive securities headquartered outside of China.

Finally, our portfolios are underweight fixed income relative to our asset allocation benchmarks. While the Fed began their cutting with a surprising 50 bps (bps = basis point) cut, we believe the rate path won’t be as clear cut as the market believes. Specifically, we believe that there is some upside to 10-year yields, and we will wait for higher long-term rates or a shift in economic and monetary fundamentals before we add duration back to our portfolios.