Q4 2024 Market Commentary: Volatility Strikes Back

This information is meant to be a commentary regarding Consilio Wealth Advisors’ views on the relative attractiveness of different areas of the market, contrasted with our current asset allocation strategy for the near term, 12-18 months.

These views are always made in the context of a well-diversified portfolio and are not meant to be a recommendation to buy into or sell out of a particular area of the market. These views can and will change as new information becomes available, and we will periodically update this brief to keep you informed of changes.

Volatility

The stock market performance over the last 20 months has been abnormally calm. The last quarter experienced bouts of volatility caused by several factors, all somewhat influenced by interest rates.

The Yen carry trade: Money managers previously borrowed in Yen and converted that money to US dollars to invest in US assets, whether stocks or bonds. Why go through a complicated transaction? The Bank of Japan held rates at 0% so anyone borrowing in Yen would pay very low interest rates. Assuming they can take those borrowed Yen and earn more interest after converting to US dollars, you have what’s called a carry trade. It all sounds nice in theory, but exchange rate fluctuations can wreck those plans. When you borrow in Yen, you need to pay back your loan in Yen. If the exchange rate suddenly swings against you and it takes more US dollars to convert back your borrowed Yen, your gains could suddenly swing to losses. There were enough hedge funds converting their dollars back to Yen as they rushed to the exits. First, they needed to sell their US based assets, whether stocks or bonds, and then convert those dollars back to Yen.

Job market cooling: There was a string of jobs reports that came in below expectations. Job seekers are finding their services aren’t in as high demand as 2022 or 2023. Suddenly, the market is worried that the Fed will keep financial conditions too tight or has kept rates too high. Many view the Fed accomplished its goals in late 2023 so what are they waiting for when they finally cut rates? The job market is still healthy at 4.1% unemployment rate and the data shows that new entrants to the job market is what’s causing increased unemployment, not job losses. That’s a key distinction between a healthy job market compared to one we should worry about.

AI investment scrutiny: AI related companies were under pressure as the market started asking when these investments will start to pay off. Big tech CEOs justify their costly build outs by saying the risk of under investing is greater than over investing. The companies selling generative AI products aren’t generating much revenue from subscribers. However, there are successful companies that have integrated AI in retail to improve their inventory management and sales. Healthcare companies use it to identify buying patterns and discover new compounds. During the AI run up, few questions were asked about profitability because the future was so exciting. The biggest companies had so much cash, no one questioned the massive spending. Even after heavy investment, these companies still boast large cash piles.

S&P500 nearly touches correction territory: The Nasdaq was down 13% and the S&P500 was down 9%. The Nasdaq experienced more downside because the sell-off was mainly targeted towards the Magnificent 7 stocks, which were collectively down 15%. A correction is 10% down and we’d expect to get at least one correction each year.

The sell off was a gift: Whenever the market sells off, an optimist would see lower prices and the pessimist sees the end of civilization. I am only kidding, pessimists, go be negative somewhere else. For the rest of us, when the market gives a 9% or 10% discount, it should be viewed as an opportunity for long term investors. We know we can’t time the bottom at the right moment but buying assets cheaper tends to yield good results.

As September closes, the S&P500 has recovered its losses, up 1% for a net of 10% recovery. The Nasdaq is down 3% after recovering 10%. The Magnificent 7 is down 6%, recovering 9%. All performance figures are as of September 30th.

Fed Rate Cuts

We finally got a rate cut(s)! The Fed cut rates twice in September, lowering rates by 0.50% which is making up for the blown chance to lower rates earlier in the year. The comments accompanying the lowered rates have shifted from battling inflation to focusing on stabilizing the job market. Or at least trying to stem the slowdown of the job market before it becomes an issue. Unemployment is currently 4.1%, which is well below the Fed target of 5%. The job market could quickly erode past the 5% unemployment rate because rate changes work on a lag. The economy likely won’t feel the impact of September’s cut for another 18 months.

That makes timing more important when the Fed had the chance to lower rates earlier in the year. The inflation trend had been persistent since mid-2023 so a pattern had already emerged and was consistent all 2024. Meanwhile, the unemployment rate started to rise as available job openings growth slowed and able-bodied workers entered the workforce.

If the Fed was premature in lowering rates, they run the risk of reigniting inflation. Inflation measures the rate of price growth. Though the chart says inflation is now 2.53%, prices are still higher than they were in 2019. They’re just not moving much higher from here.

If trends continue, the Fed is forecasting year end rates to be 4.4% and rates in 2025 to be 3.4%. The rates we’re quoting here are essentially 1-day rates and have the greatest impact on savings and money market yields. Anyone parking cash is going to immediately start earning less interest. Earning 5% on cash was fun while it lasted.

The Election

Polling and prediction markets have the election as a coin flip. Run 10 elections, Trump wins 5, Harris wins 5. Now that you know what a coin flip is, let’s breakdown some of the policy promises from both candidates. We expect volatility to remain higher as uncertainty persists. The market doesn’t care who wins, it just wants to know who wins. Once the election is done, we expect volatility to go down.

If anything, try to keep a level head regardless of the results. Republican and Democratic presidents have both been good to the stock market. Allowing our emotions to get the better of us just leads to suboptimal results. Investors who jump in an out of the market based on who’s president could potentially sit out for eight years. Staying invested allows for compounding and the result is much better than being invested only half the time.

Tax Cuts and Jobs Act: Trump would likely work to extend the Tax Cuts and Jobs Act which would increase the deficit by a forecasted range of $4.1 trillion to $5.8 trillion. The estimated lower range does account for economic growth potential, so even if lowered taxes spur more growth, there will still be an expected shortfall.

Harris will likely allow the Tax Cuts and Jobs Act to lapse and would increase taxes for most payers. State and local tax caps would be removed so there would be some offsetting from residents in expensive states. Still, there would be an expected shortfall in the range of $1.2 trillion to $2.3 trillion.

JP Morgan charted the Congressional Budget Office (CBO) projections if the Tax Cuts and Jobs Act were extended. Cutting tax revenue without corresponding spending cuts will continue to grow the debt.

Both major political parties have little interest in proposing meaningful cuts. Cuts to the top spending categories would be especially painful.

The obvious category to cut is Net Interest, which is the interest payments on the debt we carry. The problem is you can’t reduce debt without bringing in more tax revenue and spending less in other categories. Any candidate proposing cuts to social security would never be elected even though that may be a sacrifice the US needs to make. Same goes for Medicare proposals.

Candidates have tried to cut education and other less costly categories, but those cuts barely move the needle. If a candidate was able to eliminate the bottom six categories, they’d save $1.6 trillion and still have an $800 billion shortfall with Harris and a $4.1 trillion shortfall with Trump. Bottom line, there’s no easy way out of this and pain for generations to come is likely.

No taxes on tips: Both candidates are proposing no taxes on tipped wages. This could impact ~2.5% of all workers. This is playing politics to appeal to Clark County Nevada, which is home to Las Vegas. Candidates who win Clark County generally win the state. If this becomes policy, we would expect businesses looking to increase tipped wages and ask the consumer to subsidize employee wages. Oh wait, that’s already happening! While tipped workers support this, consequences extend beyond lowered tax revenue. There is fear that businesses will recategorize wages as tipped, reducing taxes on themselves and employees.

Tariffs: Trump wants to impose at least 10% tariffs on imported goods. This will increase price levels and price inflation will register temporarily higher. Inflation measures the rate of price increases so if prices remain stable after tariffs, inflation will read as 0% but the price level is going to be 10% higher. The US has a net deficit when it comes to import/export, meaning we import ~$900bn more per year than we export every year. Tariffs would make the deficit worse if we don’t export more. Any country hit with tariffs would likely respond with tariffs on US goods. No one wins in a tariff war.

Capital gains tax: Harris is proposing a long-term capital gains tax increase of 28% for earners of $1 million or more per year. The current rate for this level of income is 20%. The impact could be an increased lock in effect where owners of long-term assets will simply hold them longer. Generally, good planning tends to minimize the current 20% rate.

Trump/Harris trades: There are traders in the market who are positioning themselves for a potential Trump or Harris win. The assumption is Trump will be energy friendly so therefore buy energy stocks. Harris is clean energy friendly so therefore buy solar stocks. Both trades are stupid. Ignore any tips or forecasts about what president will help which industry. Here’s a chart with a clean energy ETF versus the regular energy sector ETF during Trump’s first term in office. If we didn’t know any better, we’d assume he’s very clean energy friendly. It just shows these assumptions are asinine and shouldn’t be followed.

A divided government: Our most probable outcome is a split government. At least that’s the hope. Government spending is out of control and when one party is in power, the spending ratchets up. Tax cuts without a reduction in spending is still an expenditure and only adds to the debt. Government spending that outpaces tax revenue adds to the debt. Both parties are proposing just that, increasing debt, they’re just finding different ways to get to the same place.

Looking Ahead

The Fed has officially started its rate cutting cycle. While we may have some idea where lower rates might settle, there’s no guarantee that rates won’t drop faster or lower than we expect.

Anyone with safe money was happy earning 5%+ in money market funds. The party is ending, someone is turning down the music and turning on the lights. That doesn’t mean savers should panic. 4% through the year end is still respectable. We’ve encouraged exploring locking in rates through CDs or certain bonds because it’s likely the Fed will keep cutting rates until around their 3% 2025 target.

As rates fall, the stock market beyond the Magnificent 7 could stand to benefit. It’s already been happening over the past three months. The Equal Weight S&P500 has more than doubled the pace of the S&P500. The equal weight ETF reduces the weights of Nvidia, Apple, Microsoft, Meta, Google, Amazon, and Tesla. The outperformance of the equal weight suggests that mid and small sized companies have performed better than their larger counterparts.

Smaller companies tend to be more sensitive to rates than the big companies. Find me a smaller company that has as much cash than Microsoft. I’ll wait. The point is the smaller companies are more sensitive to rates because they tend to borrow more. When the cost of borrowing goes down, it becomes cheaper to operate.

Same thing with real estate companies. They tend to have a higher sensitivity to interest rates because they are leveraged operations. The real estate sector is up nearly 18% over the last three months. While we don’t recommend limiting investments to a single industry without the support of a diversified portfolio, we’re highlighting an industry that is already benefiting from lower rates.

Didn’t you just say that the Fed just lowered rates on September 18th? Why did the market react to the rate cuts as early as July? I’m glad you asked. The market doesn’t wait for the Fed to act. Everything I’m able to show in charts already happened. While the short-term trend could continue, we’ve always been in the camp of holding a well-diversified portfolio to take advantage of unexpected outcomes.

Traders trying to time the Fed would’ve needed to get their trades in by July or earlier. Waiting until the official announcement could mean they’re too late to act. Everyone knew the Fed was going to cut rates in September, the Fed said so itself. There was no reason to wait when the next move was already known.

DISCLOSURES:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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