Making Sense: October Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. Today is Tuesday, October 29th, 2024. I'm joined by Phil Neuhart, Director of Market and Economic Research, as well as Brent Ciliano, our Chief Investment Officer.

I want to welcome you to our monthly Making Sense: Market Update series. If you'd like to submit a question to be answered on this series, please visit FirstCitizens.com/MarketOutlook to submit your question. As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. This information should not be considered as tax, legal or investment advice. If you have any questions or concerns about any of the information you hear today, please reach out to your First Citizens partner. And Brent, with that, I will turn it over to you.

Brent: Great. Well, thank you, Amy. Good afternoon, everyone. Hope all of you are well. Phil, it's almost Halloween. And what's burning in my mind is what costume are you going as this year? Let me guess—Jay Powell? Greenspan? Blake Taylor? That's who you're going as.

Phil: Well, I'm kind of dressed for all three. Put a tie on. I'm ready to go.

Brent: Well, we've got a lot to cover today. So we're going to start like we normally do and give you an economic update. We're going to talk about growth. We're going to talk about the labor market. Monetary policy is on everybody's minds. And we're going to talk a little bit about residential real estate as well—and certainly talk about what's going on in equity markets and fixed-income markets across the board.

So let's get started and jump right into the economic update, Amy, and let's talk about growth. So, Phil, we had in late September pretty much an under-the-radar revision upward to US growth in a very material way. And just to give everybody a little bit of perspective, in 2022 initial growth expectations were for 1.9%. 2.5% in 2023. Those were materially revised up, you can see here on the lefthand chart, from 1.9% in 2022 up to 2.5%, and then from 2.5% in 2023 all the way up to 2.9%. So the underlying growth story in the US economy was much stronger than we all anticipated.

Phil: Yeah. And so—these are actual numbers—so we're looking back. Forget just estimates being wrong. These are actuals being revised. So when you think about inflation, some of the things we've been talking about over the last 2 years—the truth is that the economy was growing a little bit faster than was initially reported in 2022 and 2023. Some of this makes more sense, right? There was just a hotter underlying economy than we thought.

Brent: Yeah. And so let's look at the righthand side of this graph and let's look at where expectations are for this year and for 2025. Again, we started this year coming in at about 1.3%. And you can see now all the way up to 2.6%. And for 2025, again, a smaller revision up, but by and large the growth story within the United States remains resilient.

Phil: Yeah, we're often asked, you know, "How's the stock market up over 20% this year with all this wall of worry, everything we're concerned about?" And a lot of it's just that if you look at that 2024 US bar—is the bear case and even the base case just haven't played out. The bull case has played out.

Brent: That's right.

Phil: And if the US and world economies are growing faster than we expected coming this year, risk assets have to price that.

Brent: Exactly. So if we look at the next chart, Amy, and we think about that impulse for this year. Again, you can see where expectations were back, you know, in sort of the second half of 2023—all the way down to 0.9%. Pretty, pretty low expectation for growth that we would significantly moderate lower. And that certainly wasn't the case as we progressed to the end of 2023 and into much of this year. And again, as I mentioned, growth expectations continue to rise. Growth looks good, sitting at 2.6%. So again, that underlying economic impulse that's driving the fundamentals of the market remain resilient, which is great to see.

So, you know, shifting gears a little bit from growth, and we've talked about this slide, Phil, a couple of times in previous webinars. What we're looking at here—dark blue line is the upper bound of fed funds rate. The gold line is average inflation. And you can see that sort of disconnect on the far righthand side, that gold line shooting straight up, right, when everyone thought that inflation was transitory. Well, at the time, policy was out of bounds significantly. And we can see when inflation started to move up, the fed funds rate was still effectively at zero.

Phil: You can really see that—we've talked about how the Fed was late to the party in terms of hiking rates—you really see it in this chart.

Brent: Yeah, really highlights it.

Phil: It stayed flat for too long. And then when they started to hike, they had to hike very rapidly.

Brent: Exactly. And you can see—coming down after we peaked in June of 2022 from an interest rate perspective and started to fall—you can see on the way down where policy is right now at a midpoint of 4.88%. We're significantly out of bounds as it relates to coming down the other side of that mountain, where inflation has moderated lower and policy is very restrictive.

Phil: You can see that first Fed cut. I think the real question as we flip ahead is how much more do they cut? The hope—and certainly for those who like markets to go up—the hope is this is a midcycle correction from the Fed, right? A mid-cycle adjustment, maybe I should say.

So what are futures pricing? Well not that long ago, a month ago, they were pricing 10 total cuts right from the first set of cuts, which now we've had two quarter-point cuts, so eight more cuts was being priced to the end of 2025. Now it's pricing 7.5 total cuts—this is fed funds futures. When we were showing this chart and it said 10 total cuts, we were saying we did not buy that.

Brent: We took the under there.

Phil: We were taking the under. Seven-and-a-half, so let's just call it seven or eight cuts—that actually sounds more reasonable. You end up around, call it 3.5%. Well, if inflation settles in the mid-2s and you have a 0% real r-star, which is just a neutral rate, not worth digging into here, but 1% r-star, 2.5%, that's 3.5%. That's not completely out of bounds in our view, 3.5% to 4%.

Now, the one thing we know is that fed funds futures are never right. So all plans must change. Something will, of course, happen that will change the path. But it is, in our view, pretty good to see a little bit more rationality around how much the Fed was going to cut compared to where we were a month ago. But these cuts falling out, remember what we just talked about here, a couple cuts falling out of fed funds futures is being reflected in the yield curve.

Brent: I was just going to say, we're going to cover later in this presentation where the variability in fed fund futures is certainly being reflected in fixed income across the board and the yield curve.

Phil: That's right. It's driving a lot of volatility. So where might inflation settle? I mentioned, what about 2.5%? That's just a nice round number. Remember, the Fed's target is 2%, Brent. But it's pretty aspirational in the current economy to think you're going to get and stay at exactly 2.0%. Where do consumers believe?

So this is a University of Michigan consumer sentiment survey. And it's asking, "What's the share of consumers expecting prices to rise by 3% or more over the next 12 months, the next 5 years?" You'll notice over 50% believe that inflation will settle at 3% or more in the next 5 years. Now, it's close, right? There's also those who don't believe that. But it's just a reminder that when inflation gets into the water, right, and it gets into the economy—it's hard to get it out.

Brent: That's right.

Phil: Right? And that's why the Fed eventually did act very aggressively.

Brent: Recency bias is really kicking in higher gas prices, higher food prices, higher service prices.

Phil: That's right. And unfortunately, once it gets into inflation expectations, that is actually problematic because it's harder to get inflation down. So we shall see. But the idea of 2.5% to 3% trend inflation is not out of bounds, even compared to long-term history either.

Brent: For sure.

Phil: So what might all of this mean for markets as we flip ahead? You'll hear folks on financial press or the talking-head type say, "Well, if the Fed's cutting, that's bad for stocks." Well, it's really under what environment? So in the gold line, if you do not have a recession associated with that first Fed rate cut, right—and this is data since 1979—the market actually performs pretty well. Why is that? Because that is a midcycle adjustment, which is, of course, what the Fed is trying to pull off this time around.

If you do have a recession, the market sells off. That's the blue line. Not too surprising. What's interesting is that if you look out a full trading year, which a trading year is about 252 trading days, the market's flat again. We all remember 2001, the market sold down for years, right? 2008 it took years to get your money back.

But we forget that 2020—market came back very quickly. 1990 to 1991—the market came back very quickly. There are recessionary periods in which the market comes back quickly. But certainly in our base case, we do not have a recession next 12 months. It doesn't mean the probability is zero. It's just that that's not our base case.

Brent: Yeah. So we're more on the line of this gold line, which is more of a midcycle adjustment. And certainly from a fundamental perspective, data—at least we just covered from a growth perspective—would more indicate that even though we've had significantly restrictive policy, it hasn't had that long and variable-lag feedback loop to really slow the economy in a material way that would sort of cause that recessionary environment.

Phil: That's right.

Brent: So shifting gears, let's talk a little bit about the labor market. It's hard to believe it's going to be November this week, and we have Jobs Day on Friday of this week. Just to, you know, rehash where we were before for the September data, right, saw 254,000 jobs created versus consensus expectations of 150,000. So a very strong report. The previous month was revised up from 142,000 to 159,000. So decent jobs number.

And again, you can see certainly on this graph, we have been moderating lower in job creation. Expectations for October data that comes out on Friday is calling for 110,000 jobs created. Now there's certainly weather effects in there. The hurricanes that we've had—and our hearts certainly go out to everybody affected with the storms of late—but we believe that there's going to be some variability in the October data. And there's a wide range of forecasts that we have seen for the jobs data that's coming out this week. And certainly time will tell. But by and large, I think the narrative is while jobs growth has moderated lower, it's still significant enough to keep the unemployment rate from moving materially higher.

So speaking about the unemployment rate, what we're looking at here on this next slide, Amy, is the unemployment rate going all the way back to 1960. And, again, what we can see is where we are on the far righthand graph. We hit a low of 3.4% in April of 2023, which was a 50-plus-year low. Incredibly robust labor market, significant job creation, just like we showed in the previous graph. And we've seen the unemployment rate tick higher. We hit a high of 4.3% earlier this year. We've moderated back down to 4.05%, which rounds up to 4.1%. And we started to see the unemployment rate at the margin come back up a little bit.

We talked about in the last webinar, jobless claims and continuing claims—that continuing claims number's starting to move up a little bit more. We've had potentially a little bit of a weather effect, but we're going to be watching that very significantly. But by and large, robust labor market. But at the margin, it seems like the unemployment rate is starting to tick up.

So speaking of that, here's a different way of looking at the same graph. Again, dark blue line is the unemployment rate, which we just looked at—U3. And the gold line is the net share of consumers reporting jobs hard to get. So the higher the number, jobs harder to get, lower jobs, easier to get. And what you can see is there is a very high correlation between these two series, right?

And what you can see is—on the far righthand side—while the unemployment rate still sits at 4.1%, look at the gold line, and again still low, still low, but it's the directional vector that we're looking at here. And jobs hard to get is starting to creep up, which rhymes a little bit what we're seeing with continuing claims. And time will tell whether or not we see the unemployment rate move up more significantly. Consensus has the unemployment rate for next year—or sorry this year—at 4.4%, next year 4.3%. So we'll just—time will have to tell where we end up.

Phil: It's hopeful. And something else we've talked about in the past is, you know, at one point at the tightest of labor market, we had two job openings for every unemployed person. Now that's roughly one job opening for an unemployed person.

Brent: Which is more normalized.

Phil: That's normalized. So the question is—is this normalization? That's what the Fed's trying to pull off, and certainly that's what we hope. Or is this the start of something? Right now, we are in the more normalization camp, but that's why we watch the data so closely.

Brent: So let's bring that home. Why is it so important, right, when we think about this really important slide, which is consumption? Remember, 68% of US Real GDP is consumption, another 4% is housing. So as goes the consumer, as goes our economy. So obviously being gainfully employed and being able to spend money is critically important to our economy.

The gold line here is spending on goods. The dotted blue line is the spending on services. And you can see, obviously, both have moderated lower from the highs that we saw earlier in 2021. And we've talked about this. What is remarkable is how resilient services spending has been. We've printed a six handle on this data series for the last X number of quarters. And you can see spending on services sitting at 6.3%—materially above the long-term average of 4.9%. And in services spending as a percentage of total consumption is about two-thirds. So the good news is, what's growing the most year over year is the largest component of our overall aggregate spending.

Phil: Yeah, as you mentioned, it's funny, we think about big durable goods orders, like buying a car, but in the end, we spend more on services—

Brent: —experiences.

Phil: Yeah, and if you've been to an airport lately, tried to get a dinner reservation, clearly people are still out there spending on services. But is that all consumers? And what are we seeing underneath the hood? So something we hear a lot about on the road is the idea of, well, the two Americas, the two consumers, right?

So when you look at the aggregate data, data looks pretty good, but we are seeing signs of strain. So for example, we have seen credit card delinquencies rise, auto loan delinquencies rise. And when did we see credit card usage really start to increase? When inflation increased, right? Because there's a lot of Americans that are living paycheck to paycheck. So what do you access? You access your credit card. Unfortunately, rates increased at the same time. So what happens? Delinquencies go up.

So we want to look at this—we've shown data on that before—but we wanted to look at this in another way. This is a survey, and it asks consumers—this is those who report that they will likely miss a debt payment in the next 3 months, so "Will you likely miss a debt payment in the next 3 months?" And what you'll notice is—it has gone up quite a bit. Now, in some ways, it looks like normalization because we had incredible lows after all the physical stimulus after the pandemic. But still, you're getting back to levels that we haven't seen since initially the pandemic, but years even before that, the 2017 and 2016 time frame. And the directionality, I think, is something we want to watch and are watching.

So when we show aggregate data, it's not that all consumers are doing well. Inflation has taken a bite out. And when you talk about, "Okay, inflation is now 3%." Well, yeah, but that's on top of the 9%.

Brent: Yeah. The cumulative geometric effect of that is big.

Phil: We pay dollars. We don't pay inflation rate. So this is something we hear a lot about and something we wanted to be sure to highlight. To that point, the housing market, something else that's really on people's minds, something we've talked a lot about. It's been really a fascinating and disrupted housing market.

So what was the order of events? We had this very hot housing market, right? The Fed hikes rates, mortgage rates skyrocket. All of those people that refinanced or bought a home in 2020 or 2021, they're very unlikely to list their home. So what we saw was very tight inventory of homes, even as existing home sales were plummeting. You can't sell a home that's not for sale.

So if you look at just existing home sales—which we're not showing here, we've shown plenty of times—if you look at just existing home sales, it looks very recessionary. But the truth is there was just no homes to sell. What did that do? That boosted home prices. So we have this situation—talk about unintended consequences—where the Fed is hiking and home prices kept going up. When the Fed hikes, it's supposed to slow the housing market and mute home price appreciation. That's not what has happened.

So all of that is to say, what are the conditions for buying a home? If you ask consumers for that, it's incredibly low. In fact, lowest we have on record going back to the 1970s.

Brent: Truly incredible.

Phil: Why is that? Home prices continue to appreciate—they're expensive—and mortgage rates, while they've improved, are still high, at least compared to recent history. That makes it very difficult. If you look at affordability indices it shows the same thing. The potential positive is on the next slide. This is months' supply of homes available in the existing home market. So this is how many months of the current sales rate would would the supply take to work off. So higher here means more inventory. You see that we hit the absolute low in inventory a couple years ago. It has started to improve and actually is getting back to pre-pandemic levels.

Just anecdotally, we're based in Raleigh, North Carolina. Homes are on the market a little bit longer, right? We are seeing homes listed for a certain price, and the price is cut. Now, is that price still well-above where it was? Yes. That doesn't mean homes are depreciating. It means that we're seeing price cuts. So even anecdotally we're seeing this, and the data is showing it. So there are some signs of loosening. And mortgage rates—we'll see what the 10-year Treasury does—but mortgage rates at least are off their absolute highs.

So I think there is reason to think that, all else equal, the economy remains on track, 2025 might be a healthier year for the housing market in terms of just supply and demand finding better balance.

Brent: For sure. So let's shift gears Phil, and let's talk a little bit about the markets, and let's jump right in. If we look at the lefthand side, for much of this year it has been a risk-asset rally, whether it was US equities, developed international equities, emerging markets—all posting very, very robust returns. US equity markets, and—you could say this data is through Friday, October 25th—equity markets in the US well north of 20%, international markets basically double digits.

What I think is very interesting here is that we've seen sort of a little bit of a resurgence in emerging market equities. And certainly they had beaten down valuations. And we started to see that come about mostly in that second half. But what I like on the righthand side of that left graph is when we look at fixed income, the third quarter was really strong for fixed income and made up more than 100% of returns for fixed income.

So we now have fixed-income-based taxable bonds. When we look at the Bloomberg Barclays Aggregate Bond Index taxable bonds in positive territory and municipal bonds also in positive territory. So an investor's balanced portfolio is significantly positive, not only year to date but on a 1-year basis.

If we look at the chart on the right and we look at the sort of the distribution of returns within US equities and sort of look at that nine-style box between large cap, mid cap, small cap, value core and growth, you can see much more balance now here in this second half of the year.

When we showed this earlier on in the year, first quarter, even in the late spring, it was all about mega-cap growth and the Magnificent Seven. And you can see how we've seen a broadening out in US equity markets. And it's not just US equity markets, but a broadening out across other asset classes as well. If you had this display of the nine-style boxes within developed international as well, you'd see sort of that breakout as well. But it's good to see that we're seeing more breadth and more balance within equity markets.

Phil: Broadening is something we talked about in a hopeful manner for quarters on end. And seeing it to some extent has been positive. And there's actually more detail on the next slide.

Brent: Yeah. So when we look at the chart on the left, the gold line is the normal S&P 500 market-cap weighted index. The dark blue line is equal weighted. And what you can see—this data goes all the way back to the beginning of last year—and you can just see the incredible run-up that we've had in the S&P 500 over these almost 2 years now—51% cumulative return.

I remember you and I sitting here in October of 2022 answering client questions. "Well, is this now the start of a significant market downturn? Are we getting to a bear market?" Nope. And we've seen a significant bounce off of the October 2022 lows. But what I think is interesting is when you look at that equal weighted, we've seen, as I said earlier, a broadening out. And if you look at the chart on the right, this is the return starting July 1st of this year, so the second half. You can see at the top, the Magnificent Seven, decent 5% return. The cap-weighted S&P 500 that we all know and love, about 6.8%.

But as you run your eyes down, the equal weighted now in the second half of this year is outperforming the cap weighted. Mid cap basically in line with the S&P 500, small cap is still ahead of the S&P 500, developed international decent return and fixed income, again, positive return. The good news is at the margin underneath the hood, Phil, we're starting to see that rotation and a broadening out in the equity market.

Phil: It hasn't just been seven stocks, right?

Brent: Which is great to see.

Phil: Equal weighted, of course, is where every stock has the same value. And the S&P 500 is showing that we have seen some broadening. Knock on wood that that continues. Certainly something that we would like to see.

So let's talk about small caps a little bit. You know, you often hear small cap have lower profitability, et cetera. But that doesn't mean small caps can't outperform. In fact, they've outperformed recently. One of the reasons is—if you go back all the way to 2000—small caps, and here we're using price to sales, you can use many valuation metrics, but price to sales are as cheap versus the S&P 500 as they've been in two-and-a-half decades.

So valuation does matter. And it's something I know you think a lot about in terms of portfolio positioning and the team as well, that there is some value there. And eventually small caps have become attractive just on price, if nothing alone. And even given the recent outperformance, still very cheap versus large-cap stocks.

So let's talk about fundamentals. We are in the middle of an earnings season. A lot of big companies report this week, so things could change. What I'm about to say could change very quickly. But so far, it's been a pretty good earnings season. Roughly three-quarters of companies have outperformed their expectations. And the market has bounced around, always does, up and down. But still a pretty good earnings season when you look at what companies are saying out loud as well.

So what are expectations? 2024 estimated growth is 9.3%. As a reminder, that was just over double digits. So we've gone into high single digits. That's okay to us. 7.6% is the long-term average. If we settle at 9% to 10%—

Brent: —I'll take it all day long.

Phil: Sounds great. Not uncommon, by the way, during a year as earnings come out to see the high expectations at the beginning of the year come in a little bit. Speaking of which, next year, 2025 consensus expects 15.2% growth. That has been north of 15% for a while. That would be great. Usually, the smart call is to take the under, but let's say that's 12% or 10%—still really good growth.

So again, why is the market rallying? The truth is fundamentals have just remained in place and margin, which might be even more important on the right side, forward margins continue to hang around just north of 17%. We've kind of flatlined there.

Brent: Remarkably resilient.

Phil: Near the all-time highs we had after the pandemic when money was free and there was fiscal and monetary stimulus. That is really important. Can companies continue to expand margins?

Brent: $64,000 question.

Phil: That's the question. But seeing them recover and kind of flatline at these levels definitely is a support to the economy.

So let's talk markets. On the next slide. We're updating our price target as we do each quarter. We'll update it going into the new year as well. This is a 12-month price target as a reminder to everyone. We do not do year-end price targets. In our past lives, we did.

Brent: We don't like them.

Phil: Towards the end of the year, they don't make much sense. "What's the market going to do in the next 6 weeks?" doesn't resonate with us. So we try to look further into the future. Our new base case is 6,200 on the S&P 500. How do we get there? So you're looking at next-12-month earnings expectations. We're putting about 3% downward revision on that and then expecting 9%, 9.5% earnings growth the 12 months after that. So that's 13% to 24% with a relatively flat P/E multiple. That gets you to 6,200. That's up about 6.7%.

I will not go into all the math on the other scenarios, but bear case down north of 20%, bull case up about 15%. One thing I'll point out is there's asymmetry here. There's more downside to our bear case than upside to our bull case. Why is that? The market's come a long ways, right? Expecting the market to just put in 20% years, year after year is pretty unlikely. If in 12 months we're up 6.5% from here, I think that's actually a pretty good result.

Brent: For sure.

Phil: But the bear case certainly has more downside than the bull case has up. So as you think about how you think about the market, this gives you sort of a framework in terms of how we think about it.

Brent: Yeah, and I think if you take the confluence of everything that we've been talking about up until this point, you know, a robust and resilient US economic picture, right? A labor market that still is hanging in there. Consumers that have the ability to spend and are spending at a reasonable clip. And the fact that what we just covered is that on a cumulative basis from the beginning of 2023 to now a 51% cumulative return for the S&P 500. So adding another—we'll call it 7% here—to that would be great results for client portfolios.

Phil: And I'd add to that list the Fed cutting, hopefully in an adjustment way, right? I mean, rates lower, stocks like that.

Brent: That's right. And again, we're more in the camp of a midcycle adjustment versus something that's more dire. That would be, "Hey, Fed cutting, and we see the signs of a recession in the next 12 months," which we don't see.

So let's talk a little bit away from equities. Let's talk about fixed income. And what we're looking at here is the Treasury yield curve. And there's some busy-ness here. So let's talk about the three lines here.

So let's start at the top, the dark blue line was the highs for yields this year. The light blue line is the lows that we have, which was interestingly right before the Fed meeting in mid-September. And the gold line is where we are today. And I think what strikes me when I look at this is just the inherent variability in rates across the entire yield curve. And we talked about this when we were talking about fed fund futures and how much that has been repriced and how much that's changed and how much that's going to continue to change—which we think will ultimately impact the Treasury yield curve.

And we don't think that the volatility in rates is going to stop anytime soon, especially as the cycle continues through the rest of this year and into 2025. But what I think is incredibly interesting—if I look at the 2-year note, right, we're talking about a 140-basis-point spread year to date. On the 10-year, 110-basis-point spread between the highs and the lows that we've seen here. And we've sort of settled a little bit higher than the midpoint of that.

So as expectations for less Fed cuts have been priced into fed fund futures, you're seeing that directly reflected in the gold line here, where we've seen yields and that yield curve move up from that light blue line. And again, we continue to think that there's going to be more fixed-income volatility going forward.

Phil: Rates are below the highs of April but have really moved rapidly in recent weeks. A lot of that has to do with that labor market report you mentioned that surprised to the upside. If there's going to be fewer cuts, the yield curve has to price that. And it priced it incredibly quickly.

Brent: Well, and what I will say is that, you know, we've seen a very attractive yield to worst across much of fixed-income asset classes. So when I talk to clients when we're out on the road about, "Well, geez, you know, is it the right time to have maybe more fixed income in my portfolio or a certain balance of fixed income?" First of all, like we always talk about—investment policy statement, goals and objectives, financial planning should dictate where you go. But by and large, fixed income remains quite attractive on a forward basis.

So let's talk a little bit about credit, and more specifically what we wanted to talk about here is sort of, you know, the two economies between bigger companies and maybe small- to medium-sized companies. The dark blue line here is sub-investment-grade companies, so think about below investment grade. It's sometimes called, you know, junk bonds or whatnot, high yield bonds, right.

So what we're looking at here is—we're looking at the spread, right, between the 2-year Treasury and what the actual nominal yield is on those bonds. The dark blue line is high-yield corporate bond spreads. The light blue dotted line is the small business borrowing rate from the NFIB survey. And what you can see here is while high-yield spreads have moderated lower—so if I go from the highs that we saw back during the pandemic, you can draw that regression line down, and we're at pretty modest, tight spreads now at about 330 basis points for high-yield bonds.

But look at the borrowing rate for small businesses sitting nominally, right, at about 10%. So that differential, right, in that spread is still north of 6%. So again, those two economies—it's still very expensive for smaller businesses to borrow. And we think that that's going to be putting pressure on small, medium-sized businesses. We'll have to see if that's going to moderate as the Fed starts to ease policy, but it has been hard for small businesses out there to borrow.

Phil: And it's no coincidence that when rates fell sharply from April and well into September, as markets expected Fed cuts, that the Russell 2000, small-cap stocks rallied, right. Small-cap stocks are more—and businesses—are more exposed to borrowing costs, right? The largest companies in the world, do they even need to borrow, right? When you have a cash hoard, if you're a Magnificent Seven company, for example, very different for the smaller companies.

Brent: Yeah. So let's shift gears and talk about our favorite topic, which is politics. I'm just really glad that November 5th is right around the corner and we'll be done talking about this shortly, which is great. Let's look at where the current prediction markets are right now. And again, we're talking on the lefthand graph here. We're talking about betting markets right now, just polls. And the blue line is Democrat, gold line is Republican.

And you can see in the last couple of weeks, a significant change in betting markets that have swung significantly in favor of Republican victory for presidential wins, which has changed a lot. And again, potentially a lot could change in this last week here leading up until Election Day. But again, a lot of variability as people start to go to the polls and vote early. Make sure we all go out and vote however you want to do that.

When we look at the graph on the right, what we're looking at here is the probability of different types of election outcomes. That gold bar on the left is Republicans winning both the presidency as well as full Congress. And on the far righthand side is a Democratic win, Harris wins, and divided government.

That little dot that we put in there was where we were on September 1st. And what you can see is on the Republican sweep, we've seen a significant move up from just above 30% to now almost 45% probability of a Republican sweep, where when you look at sort of that dark blue bar, which is, you know, Democrats win, a complete sweep—that blue wave outcome—has fallen materially down to a little bit above 10%.

So a lot of variability here. Time will certainly tell. When we talked about this in the past, certainly what we care about at least from a market and economic perspective, I will say, is divided government, and we'll see what those outcomes look like.

Phil: Absolutely. So from a market perspective, we're often asked, you know, what mix works best for markets, right? What's interesting is the current makeup of government going all the way back to the 1800s has the highest S&P 500 return. Democratic president, Democratic Senate, Republican House. But then move your eye down—5 years of data.

Brent: Yeah, right. Not a lot.

Phil: All it takes is 1 or 2 decent years and excuse it, right. So now let's look to the right. There's all sorts of mixes and returns are actually pretty similar. Our belief is that, yes, elections can drive near-term volatility, but markets return to fundamentals. Going all the way back to the 1800s, if you look at Democrat president, the average return's around 10%, Republican president around 9%—very similar, within the margin of error.

The truth is markets return very quickly to "What's earnings growth? What's margins? Where's the business cycle?" Yes, elections matter for all of us as Americans. But the impact on markets we actually view is fairly short term. Really, markets return very quickly to the fundamentals.

Brent: Without a doubt. So, Amy, I know we got a lot of questions. So why don't I turn it over to you?

Amy: Yeah, we sure did. Brent, if Phil is going as Chair Powell, I think I'm going to get some packing tape and some bubble wrap and go as sticky inflation this year.

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So jumping into questions, Brent, both of your favorite topic is the number one question we received. There's a lot of concern around the election and seeing volatility right after the results come through. What are you telling people with those concerns?

Brent: Yeah, and look, it is true. Right around elections for a short period of time, you can absolutely see volatility, right? And we do expect to see some volatility in both equity markets and fixed-income markets. But as you said wonderfully, the markets—intermediate term, longer term—more often than not result and revert back to the underlying fundamentals: corporate earnings and profitability, net interest margins, operating margins across the board, again, a robust economic environment. And again, we believe that we're in a more of a midcycle adjustment, right? And when we saw that gold line that you highlighted, historically, the equity markets have done well.

So what I would tell clients listening—number one is make sure you have a financial plan for your family. Make sure, if you're an institution, that your investment policy statement is up to date and reflective of the goals and objectives of the organization. And make sure that you stick and formulate your investment policy and your actual portfolio in line with those longer-term goals and objectives. That is what's going to ultimately accrete wealth to either yourself and your family or your organization.

But having said that, we think that you should look through the shorter-term volatility that an election will bring and focus more on the fundamentals. And right now, Phil, I think both you and I would say that the fundamentals across the board are quite strong.

Phil: Absolutely.

Amy: Yeah, and kind of hand in hand with that, the next biggest question we're getting is around the deficit and how Congress may move forward with that. Seems to be a front burner issue for investors, less so on the Congress.

Phil: Yeah, in terms of questions we get on the road, election right now, of course, is number one. Deficit's probably number two. And in fact, whenever we're on the road, we always make sure to have deficit slides because you're going to get asked about it. Look, we have had an explosion in debt to GDP from a fiscal perspective, really started during and after the Great Financial Crisis of 2008 and then accelerated again, of course, around the pandemic. So two major accelerations in the last, what, 16 years.

And now we have debt-to-GDP of around 100%. If you go back to your—what does that mean—if you go back to your economics textbooks, you remember the term crowding out. So excess public debt crowds out private investment. That is a very fancy way of saying debt has to be financed. So the government has Treasury auctions. Money has to go to fund those auctions. So it may not be going to a more productive use of capital.

What does that do? It lowers the potential growth of the US economy, and it also can keep interest rates higher—at least put a floor under how low rates can go because of the creditworthiness of the US government, which, by the way, is still quite creditworthy.

So how does this play out? Well, no matter really who you read—left, right, middle—deficits are going to continue. It does not appear that no matter the makeup of government that we're going to see major improvement in deficits. So this is likely something we're going to be talking about for some time. A lot of, we've shown this in past webinars—the vast majority, almost three-quarters of government spending is mandatory. So think about things like entitlements. These are really hard things to change. Look at Japan. As a population ages, usually voters do not vote to lose their entitlements, right? So these are—it's not easy.

Much of the excess spending from the government that can change—yes, sure—that's only 28%. That's 28% of fiscal spending. So it actually takes hard decisions. And are Congress and the executive branch ready and willing to do that? We haven't seen that for a very long time. Hard to imagine that changes in the near term. That's uplifting, isn't it?

Brent: Yes. Yes.

Amy: Well, Phil, you mentioned the two economies and how consumers and businesses are experiencing the current economy differently. Can you talk a little bit more about that?

Phil: Sure. Again, something we hear a lot on the road is sort of two economies in terms of large businesses and small and wealthier consumers and lower-income consumers. So on the business front first, we touched on this a little bit, but businesses, smaller businesses are more exposed to higher interest rates, which has happened. Higher exposed to inflation, things like wage inflation, right? If you're a small business compared to a Magnificent Seven company and simply have tighter margins, there's less room for error.

When you look—and we showed this last month—when you look at business surveys, uncertainty among small businesses is actually on the rise. So there is a lot of uncertainty. There's tax uncertainty. So that is something we feel. For many of these businesses, revenue is pretty good. It's not that. It's that what's margin, right? What's the profit margin coming out at the bottom of their income statement? And what is the path forward? Lots of nervousness around inflation and wage inflation. We do see a separation there.

On the consumer side, same thing. I hit this pretty hard. I won't dwell on it, but there is a lot of evidence that—including what we're showing here—that people are feeling it. Even if you have a job, if inflation outpaced your wage inflation and you were living paycheck to paycheck, your options are slim, right? So what do you do? You access your credit card. And hence, consumers reporting likely to miss a debt payment the next 3 months on the rise.

So we are very aware of this. The big aggregate data is moved by big businesses and upper quintiles of earners, right? So when you look at the S&P, or you look at aggregate consumer spending data, but that doesn't mean there's not a tranche that aren't feeling it. They are, and it's something that we're very aware of.

Brent: And it's one of those things that we're certainly going to be watching. The good news is that, and we showed, inflation and the rate of change is moderating lower, right? Small, medium-sized businesses have been in this environment for a while. It's not like they just woke up yesterday and like, "Oh, hey, the environment's been bad." And the same thing with consumers.

We have seen—a good side of inflation has been wage growth for consumers. So while spending and costs have gone up, so have their wages across almost every economic strata. So again, it's looking a little bit better, right? But it's the duration that matters. It's like, how long can consumers hold on when you've been stressed for so long with higher prices? Same thing with small- and medium-sized businesses. We're just going to have to wait and see how things trend from here. But by and large, there are some stresses at the margin.

Amy: So the headline story for next week is obviously the election, but there is also a Fed meeting next week. Phil, what are your thoughts going into that meeting?

Phil: Yeah, I'll give some thoughts and happy to hear what Brent hears as well. Our view is that the Fed will cut a quarter point, right? That's what futures are pricing. What will be most interesting is that the statement's always interesting. That used to be what we partially carefully, well, it's become a lot more fun and interesting is Chair Powell's press conference.

Brent: Get your popcorn.

Phil: So that will be, what's the path? Every question is going to be trying to get to that, which is, so are you doing quarter point in December after a quarter point November? Are you doing quarterly next year? So he's going to say data dependency, et cetera. But often you can get an indication from him in terms of what they're saying. This is not a meeting that's associated with our summary of economic projections. So we do not have fresh projections from them. So in my view, it's really about the press conference. Of course, if they do something other than the quarter point, whether that's 50 or no cut, the market will react really sharply to that. Quarter point is what's expected, and that's what we're thinking as well.

Brent: Yeah. And I think what we're pretty much both in agreement with is the actual path of Fed policy will not look like this chart up here, right. We don't think we're going to see another five-and-a-half cuts before the end of 2025. We're more in that midcycle adjustment. So again, we're going to take the under as it relates to the absolute number of Fed cuts in this cycle, which is a good thing. That is a midcycle adjustment that adjusts to the rate of growth, the rate of the labor market, et cetera, et cetera—which is a good thing. We'll see how the markets react because much of this is already priced in, if not all of this is priced in.

Phil: Look at the yield curve. Look at the yield curve moving so sharply as a couple of cuts came out. All of these markets are tied. So rates have to price that, which should unfortunately have an impact on the economy. I think the Fed cutting, though, would hopefully, all else equal—an inflation scare, et cetera, is a different ballgame—but all else equal, put a ceiling on rates. That's the thing is you can start to see some certainty around, "Well, sure, long-term rates can go up, they can go down, but can they go to extremes?" That's less likely if the Fed is cutting.

Brent: Yeah, and thank you Amy for putting up this slide. I would probably argue in this cycle that this gold line where we are now likely won't go above the dark blue line, the highs that we saw back in April. Certainly, time will tell.

Phil: Knock on wood, Brent.

Brent: Knock on wood. But again, if the Fed does undercut, which we believe, you could see this gold line at the margin maybe go up a little bit. But by and large, it's just more volatility. Ultimately, the trajectory is to get to that terminal value at the end of the day. Time will tell.

Amy: Well, Brent, we have seen higher and higher highs in the S&P 500. We just updated our price target. What are your thoughts going into the end of the year and into 2025?

Brent: Yeah, I think certainly the momentum in equity markets is strong. It's starting, as we said earlier, starting to broaden out, Amy, which we like to see a lot. It's no longer just seven stocks driving equity markets higher and higher. It's more balanced, which we believe reflects an underlying healthiness in the markets. And it's good to see that rotation.

Again, we see, as Phil highlighted nicely, the next 12 months, you know, pretty decent single-digit returns. You combine that geometrically with the 51% that we've seen since January of 2023. That's really healthy equity returns. We see that the underlying fundamentals, Amy, are supporting equity market prices. And again, we certainly have to see corporate earnings and profitability continue to come in. Gross operating margins, net operating margins still need to remain robust. But by and large, we think that equities can move higher in the portfolio, but we are starting to broaden out our allocation beyond just large-cap stock. We've always been global multi-asset portfolio diversified.

But by and large, where we're seeing some of the moves more tactically and more structurally in our portfolio construction is down in cap and diversified a little bit more into international now. We've been significantly underweight in international for quite a while. That's paid off in portfolios, but we're just starting to reflect a little bit more breadth in portfolios, which we think is healthy and great to see, Amy. So a little bit stronger from here, not only through year to date but through the next 12 months.

Amy: I'll take it. That sounds great. Phil, Brent, thank you both so much for going into that deep analysis of the economy and markets and for answering questions. Lots to consider as we near the end of the year. I hope you both have a great Halloween and look forward to seeing everyone next month.

Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Director of Market & Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

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