Making Sense: September Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. Today is Friday, September 20th, and I'm joined by Phil Neuhart, our Director of Market and Economic Research, as well as Brent Ciliano, our Chief Investment Officer. And we want to welcome you to our Making Sense: Market Update series.

We received a number of questions for the team on FirstCitizens.com/Market-Outlook, and we will answer as many as possible during today's recording. If we're not able to answer your question, please reach out to your First Citizens partner.

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 or legal advice.

And Brent, with that, we are ready to go. So I'll turn it over to you.

Brent: Great, Amy. Thank you so much. And good afternoon, everybody. Phil, I cannot believe September is basically over. Where did this year go? Where did it go?

Phil: It flew by.

Brent: So as we head into the fourth quarter, investors are going to squarely, Phil, change their focus away from the drivers of growth in markets in 2024 to 2025. Phil and I are going to give you an update on what those drivers are for 2025. We'll cover the labor market. We'll cover monetary policy. We'll cover economic growth broadly and as well as corporate earnings and profitability. We'll talk about your favorite topic and mine. We have an election coming up here in, geez, almost feels like a little bit more than a month. We'll talk a little bit about what that looks like and the impact of that on growth in the markets in 2025.

So let's jump in, Amy, and let's talk about the economy. So we've covered this slide, Phil, an awful lot. We've talked about where economic growth is this year and where it has been. Economists' expectations of growth have risen basically all year from a low of 0.9% all the way up to 2.5%. So we've seen growth materially increase as it relates to expectations, but also many of the growth drivers as it relates to the durability of the labor market, manufacturing—more specifically services—have been robust. And we're sitting here at 2.5%. And if we were to end the year here at 2.5%, that would be back-to-back years of 2.5% growth. So the broader economy remains very resilient overall.

Phil: Yeah, we're often asked, why is the stock market up so much this year and late last year? Well, part of it is simply that the probability of the bear case fell.

Brent: That's right.

Phil: Look how low expectations were middle of last year. We've really seen outperformance in the US economy in 2024.

Brent: So let's talk about—we're going to give you guys a little bit of a preview, early preview of what some of those catalysts and fundamental drivers we believe for 2025 will likely be.

The first one on the next slide, Amy, is squarely Fed monetary policy. We had probably one of the most eagerly anticipated meetings this week on September 18th. What we wanted to highlight here is how restrictive monetary policy was coming into that meeting that we had this week. And you can see the gold line here is inflation. The blue line is the upper bound of Fed funds. Historically, Phil, going all the way back to 2000 and even before, usually monetary policy—the level of fed funds—is plus or minus where inflation usually ends up being.

And again, as far as kind of driving monetary policy, obviously the dual mandate of the Fed is price stability and full employment. And what you can see on the far right, how fundamentally restrictive and how big a gap there was between the fed funds rate and inflation. And if I look at the Fed's primary gauge, looking at core PCE of 2.6%, core CPI at 3.2% and where fed funds was at a midpoint of almost 5.4%, more than 200 basis points of restrictiveness of Fed policy rate relative to where core inflation is. So, again, there was certainly an impetus for the Fed doing something material, and they did.

Phil: Right, and in this chart, you can see there's room for potential further cutting. And as we flip ahead, Amy, that is what markets expect. You can see where we were. We had a range of 5.25, 5.5%. This is sort of the median point. Where we are today, right, the Fed cut 50 basis points. If you look all the way to the end of 2025, the expectation is another 2% worth of cuts, meaning 2.5% worth of cuts. Ten quarter-point cuts is what gets you there.

We will take the under on 10 quarter-point cuts because the truth is the Fed's neutral rate could be around the mid-3s. So more like 8 total cuts, two have already happened because the Fed cut 50 basis points. We think the Fed's going to be cutting for sure, but we aren't so sure it's going to be as aggressive as markets are pricing, which was kind of the case coming into this year as well. We have seen that before.

So something you'll hear, as we flip ahead is, "Well, the market underperforms when the Fed is cutting." Well, the truth is it really depends under what economic environment. So in the gold line, if you have no economic recession following the first rate cut, which is our base case, it's not that there aren't risks, we will talk about those risks. The market can perform pretty well.

When the market sells off is because the Fed is cutting due to economic recession. Think 2020, think 2008, think 2001. That, of course, the market tends to underperform. That's the dark line here. What is interesting, though, is if you go out a full year, on average, the market has recovered those losses.

Brent: It's basically flat.

Phil: Yeah, there’s exceptions to that. Some of those exceptions are recent, like the financial crisis. But then, of course, you think 2020, market came back very quickly. So it's not necessarily the market stays down, but the fundamentals do matter in terms of why the Fed is cutting. Our hope is and what the Fed is trying to pull off is this is an adjustment cut, right, mid-cycle, not an end of cycle we're cutting because there's a recession.

Brent: Absolutely. And if we think about—in our opinion, again, we've said this time and time again—it's about the labor market, it's about the consumer over and over. And as we get to this next slide, Amy, and we think about the labor market, we believe that the labor market and the underlying resiliency and durability of the labor market is going to be one of the additional key drivers of economic growth or lack thereof, as well as the markets, as we head into 2025. What we're looking at here is a 3-month moving average of job creation. You can see from the highs that we saw back in the summer of 2021, incredibly robust job creation post the COVID pandemic.

Phil: Great bounce back from the pandemic.

Brent: Exactly. But you can clearly see if you drew a line from this—or through this data set—you would see that we're moderating lower as it relates to the overall level of job creation. If we look at the most recent August payrolls data, 146,000 jobs created, still good. Below expectations of 165,000 jobs. I think it was interesting that we saw a revision downwards in the July data to 89,000 jobs from about 114,000. So, again, job creation is moderating for sure.

Phil: It's slowing, absolutely.

Brent: And as we flip on to the next slide, Amy, and we think about job openings broadly. Again, when we go back to 2022, you can see how tight the labor market was. We had two open jobs for every unemployed person. And you can see we've certainly, again, moderated lower as it relates to the number of unemployed workers per job opening down to almost one-for-one. Which again, we haven't materially fallen below the long-term average, we're just moderating more towards a more normalized environment as it relates to that ratio between job openings and unemployed.

Phil: Yeah. When the labor market was that tight, when we had two openings for every unemployed, what we were hearing from our clients was, "I can't find workers." And by the way, it's still difficult, particularly skilled labor. But it is certainly not the extremes we saw. Not that it's easy, but that was really a pretty extreme scenario in terms of finding labor.

Brent: Absolutely. And on this next slide, which, you know, Blake Taylor put together—it's one of my favorite slides because we hit a cycle-low in U3 unemployment back in April of 2023 at 3.4%. We moved all the way up to 4.3% in July, came back down a little bit. We've seen almost a full percent move up.

And the question is, again, analysts' expectations are basically a slight move up from here, but more of a flat or sideways move in the U3 unemployment rate over the next couple of years. And I think, again, we would push back against that because when you look at all of these cycle-lows going all the way back to 1960, you've had these cycle-lows. You've seen a material move-up in the unemployment rate, either back towards the long-term unemployment rate of about 5.9% or something greater.

You know, we certainly don't think that we're going to see a double-digit unemployment rate here anytime soon, but again, maybe like the cycles that we saw in the late-60s, early-70s, or what we saw in the early 2000s where you hit that cycle-low, and it moved back more towards the long-term average.

Phil: And the truth is because it was so low if we were to get to the average we might be talking recession, right? So what the Fed is trying to pull off is very difficult here, something that we don't normally see. It's interesting. We've yet to see that explosion in layoffs or initial jobless claims. So it does appear that the demand for new labor has softened the touch, but we've yet to see the true deterioration that you might see in a recession.

Brent: Absolutely.

Phil: So something we're going to be watching very carefully every Thursday morning at 8:30, initial jobless claims. That's still very low. If those were to increase on trend, there could be some volatility, but increase on trend, definitely worth watching in terms of true deterioration in the labor market.

Brent: 100%.

Phil: So as we flip ahead, generally in America, if we have jobs, we spend our excess money. And there's certainly multiple consumers. Right? And we acknowledge that there is—lower-income consumers have really struggled with inflation, looking at credit card delinquencies, et cetera. But when you look at the data overall, right, in sum, you are still seeing some pretty good spending. Above average spending on services. Goods spending is positive, but below the long-term average. But roughly, what, 70% of spending, personal consumption, is on services. So if you're going to cheer for one, you're cheering for services.

And the truth is, as we've talked about before, a lot of goods spending was pulled forward into the pandemic. People moved into new homes, re-did their homes. That is something that was pulled forward. Now it's more about services. I've been traveling a lot lately. If you're in an airport, it does not look recessionary, right? You're trying to get a dinner reservation. It does not look recessionary. People are spending. One thing we've noted before, a lot of that excess savings from the pandemic is now spent, so it's not that the consumer feels wonderful, but the truth is they still have jobs, and when the consumer has jobs they do spend. This is what supports the US economy.

Brent: Well and we've got to hope that this moderation-lower in inflation maybe supports that case for a softer landing if we can get the confluence of lower aggregate costs, whether that's what you were just talking about, whether that's travel, whether that's food away from home, groceries. Gasoline prices have moderated lower. In the second half, we've seen almost a 20% drop in West Texas Intermediate. So we're starting to see some relief from some of those inflationary pressures. Maybe that will continue to buoy spending. Time will tell.

Phil: And couple that with what's been pretty decent wage inflation. If price inflation can remain low, that's a positive.

So let's—you sort of start looking backwards in terms of expectations for 2024 in the US—let's widen that out to the globe, and let's talk 2024. But also let's look ahead to 2025. So first you can see world, US, et cetera, on the first column.

The 2024 estimate, we're showing as of beginning of this year, end of last year, December 2023, and then where we are today. And you'll notice that it's not just a story in the US, which we covered before. World growth has been revised up higher. Europe is growing very slowly. That is something that the European banks talked a lot about, but has actually been revised up. Same in UK. Japan has actually been revised down, interestingly, and there's a lot going on towards the Bank of Japan and fresh inflation, et cetera. And China fairly flat and certainly having some issues.

So let's look ahead to next year and just focus more on the US for our purposes here. Next year, 1.7% growth. Now what's interesting is that's higher than the growth was expected for this year, last December.

Brent: That's right.

Phil: So it doesn't—it's a reminder that just because consensus expects 1.7% does not mean it's going to be that.

Brent: That's right.

Phil: But the real question, Brent, I'm interested in your perspective is, you know, can we outperform again? We outperformed in 2023 from a growth perspective. We did in 2024. Remember, in 2022 consensus was that we're going to have a recession, which we did not have. You know, the question is can we keep this up? What are your thoughts there?

Brent: Yeah, I mean, to your point, I mean, analysts over the last couple years have fundamentally underestimated the durability of the US consumer, of growth. And remember, the reason why we focus so much on that previous slide is that 68% of real GDP is consumption. Another 4% is housing. So about 72% is the consumer.

And so as goes the consumer, as goes our economy. And to your point, came into 2023 expecting 0.4%, ended up with 2.5%. Came into this year at about 0.9 to 1.3%, ended up at 2.5%. Here we are at 1.7%. Is the third time going to be a charm? Are they finally going to get it right? We see a moderation lower. But what I will say is that the starting point for estimate for going into 2025 is much higher on a relative basis differential than where we were in 2022 and 2023.

Which lends to the point where I believe that we're going to potentially—again knocking on wood—of potentially more of a softer landing than maybe the hard landing scenario that many had forecast some quarters ago. Time will tell.

Phil: And a lot of it's going to depend on Fed policy. Why do we and other market pundits spend so much time talking about the Fed? Because it matters for markets.

Brent: That's right.

Phil: It's not because it only matters for the economy. It matters for markets as well. So speaking of markets, let's flip ahead, Amy, into the market section. So the first slide here, we show this each month, and it's something that's very intentional because we want for clients to have a reference point when you're thinking about markets.

First, US equities, of course, have outperformed. Outperformed international, but you have seen some performance outside of the US as well. And year to date, fixed income is up, a lot of that has been in the recent drawdowns. And yields, remember, yields down, price up. We'll talk about that more in a moment.

Looking within the US on the right side, you'll notice large-cap growth is the leader. But what is interesting is not that long ago, a number of these, think small cap, small-cap value, were flat or down. So what we have seen is a broadening. Yes, the Magnificent Seven has pulled us higher last year and this year. The truth is you're starting to see broader returns in mid and small and value, which is excellent to see.

Brent: Yeah, and it's incredibly important to see the broadening out, which we'll cover a little bit more in a minute. That lends itself to the overall health and potential durability of this incredible rally and bull market that we've seen in US equities.

Phil: If you think back to periods where we were discussing how narrow the rally was, we were hoping for and wishing for it. I say predicting, but we wanted it—broadening—because that, of course, is good for markets. For the market as a whole, as we flip ahead, just a reminder of how far we've come. We mentioned that in 2022 there was some real concerns, valid concerns that we could have a recession. Since that bottom, we've rallied nearly 60% of the S&P 500. So that is what it looks like when fundamentals outperform the bear case. Just since last October—remember, it's easy to forget, but there was a sell down last year. Since last October, up 36% as of yesterday, trading a fresh all-time high on the S&P 500.

Brent: I think it is interesting as we get into October—2022, October drawdown, 2023, October drawdown. Let's hope that we avoid it and we don't do a repeat on drawdown. But again, remember the path. Remember what's going on. I think we'll talk about some of the fundamental underpinnings of this equity market as we get to corporate earnings and profitability and gross and net operating margins in just a second. But again, it's been a very robust run supported by fundamentals.

Phil: So, Brent, we talked about the breadth of the market. Why don't we get in there?

Brent: So if you look at the chart on the left, what I find interesting is the gold line there is the cap-weighted. The normal S&P 500 that we all know and love is in the gold line, going all the way back to January of 2023. The darker line is the equal-weighted S&P 500. Equal weighting, each one of the constituents of the S&P 500. Again, both nominally positive, both up pretty materially if I were to sort of a geometric average over those 2 years.

But think about this. Over 21 months, the S&P 500 is cumulatively up about 50%, which by itself is pretty incredible. When you look at the right, we started to see that rotation in that fundamental shift. So in the second half, let's kind of go top to bottom. The Magnificent Seven, the stocks that were driving the cap-weighted equity market, the S&P 500, were actually negative in the second half of the year by almost a percent.

And as you run your eyes down, cap-weighted up about 3%, equal-weighted up 7%. It's not just equal-weighted versus cap-weighted. Let's think about broader diversification, mid-cap, small-cap, developed international, even broad US aggregate bonds. All of those asset classes are outperforming the S&P 500 in the second half. So that is highlighting, at least to us, a very, very healthy rotation within the equity market and the constituents within US large-cap, but also down in cap across mid- and small- and international, as well as bonds. That diversification is starting to really benefit investors.

Phil: It's something that makes us very happy to see a broadening. And also the context that it's an up market, the S&P, that cap-weighted market—that's the S&P that's reported broadly—up 3%. It didn't take that Magnificent Seven to lead us there. So this perception that "We just go as the Magnificent Seven goes," the third quarter shows an example that's just not the case. You can have broadening and you do have 493 other stocks in the S&P 500, not to mention mid and small. So this is something that—certainly for market participants—seems like a positive.

Brent: Yeah. And I think one of the things that we always center ourselves on, especially when we're building portfolios, is the fundamental valuation of the equity market on this next slide here. Thank you, Amy. And what we're looking at is the next-12-months P/E ratio. In essence, in English, this is what investors are willing to pay for a dollar of earnings over the next 12 months.

And what you can see, we're sitting at about, you know, 22.2 times, which puts us in the fifth quintile of valuation. So first least expensive, fifth most expensive and going all the way back to, you know, the late 80s. We are in the most expensive quintile, rather, of valuation. So stocks are not cheap. And again, we're talking about the S&P 500 capitalization-weighted and in aggregate. So, again, stocks are not cheap relative to history.

But if we kind of dissect that a little bit on the next slide, Amy, and we break it down between the gold line, which is the top 10 stocks within the top 500 stocks, or the darker line, which is that residual 400 stocks, you can see a very, very different story. And you can see the top 10 stocks are trading a little bit more than 30 times forward earnings.

Again, looking at long term history, the average has been about 19.7 times. So we're trading pretty expensive relative to history going all the way back to 2000 for the top 10 stocks. But looking at the residual and maybe why we have some of this rotation is—we're only trading at about 20 times forward earnings on the residual 400 stocks.

Historically, that's been about between 16.6 and 17.2 times forward. So we're more trading on sort of an average basis, a realm of average for the residual stock. So, again, overall, in aggregate, the equity market is expensive. US equities are expensive. But when I look at the residual 400 stocks of the top 500, a little bit more like average valuations than expensive.

Phil: And we've shown this chart before. And the reason we want to show it again is when we showed this, when the market was very narrow, we were saying this is an argument for broadening, right? There is room for broadening. It's there in the title. So seeing some broadening, there is a valuation argument for it. Another data point is that 25% of companies, the largest 3,000 companies in the US have gross margins over 60%.

Brent: It's incredible.

Phil: 25%. So it's not that there are seven good companies in the US. That is not the case. There are a lot of good companies in the US. So let's talk about the fundamental earnings on this next slide here.

Earnings just keep chugging along. 2024 estimated earnings at 10.2%. 2025, 15.4%. That number is rising. It's been rising, which, by the way, normally around this time of year, you start to see the out-year analysts sharpen their pencils and lower. Remember, this is bottom-up company analysts who are summing that up.

So earnings growth remains pretty robust. Look at that versus the long-term average. We do have an earnings season coming up in October. That is always an important earnings season because it starts to give us real perspective what companies are thinking as they look to 2025. So we will learn a lot. I think it's one of the reasons October is often a volatile month, to be honest.

But the other thing that's really important, and as we often say when we're speaking to folks is, if there's one chart that explains why has the market rebounded so strongly since 2022, it's the right side. Expected operating margins have just simply improved. We had all-time highs during the pandemic and post. Why? Money was free. That predictably fell back to normal. And now we're rising back towards those levels. Companies in the US are dynamic. They adjust to things like inflation faster than I think we give them credit.

Brent: Yeah. And one of the things on this slide that I would say—a lot of positive here, make no mistake—one cautionary tale might be the bar is very high. 15.4% next year is baked into the S&P 500 today. 17.4% next-12-month operating margins baked into the current S&P 500 levels. So we have to make sure that earnings come through as we start to head into earnings season, and earnings season to 2025. The bar is a little bit high, which we are not concerned about, but I think it will introduce potentially some volatility along the way.

Phil: And as we flip ahead, Amy, that bar is likely to come down as one of the drivers, including election and other factors. But we probably see some volatility this fall. It's not that we don't remain constructive. We do. But volatility, I don't think is a stretch. Our peak-to-trough selldown so far this year is what, 8%? On average, that's 15% going back to 1990 peak-to-trough entry year drawdown. So we've had a very resilient market. I don't think any of us should be surprised if we see it bounce around because that's what equities do.

Brent: That's right.

Phil: That's the norm, not the exception.

Brent: Never a straight line.

Phil: Our base case remains at 5,900. This is for 12 months. That's 5% up from September 18th close. So that is up. Is that a max-up number? Not really. And the reason is that we could see it bounce around, but we do remain constructive. If the Fed pulls off a true soft landing, earnings expectations are proven true, it's more like the bull case, most likely. If the Fed does not pull off a soft landing, and we have a recessionary type scenario or a true slowdown, that probably looks more like the bear case.

So Brent, why don't we talk a little bit about fixed income and the yield curve, which has been a pretty fascinating year.

Brent: When I go back through the 30-plus years that I've been doing this, I would say that the last year and change has been the most volatile that I've seen on the rate side of things. Whether we're looking at charts like this, which looks at, you know, sort of months and quarters, but on a day-to-day basis, you know, we're watching it every single day. The degree of daily rate volatility is exceptional. It's pretty incredible.

So what we're looking at here is—the dark purple line is where we started the year, right, sort of that middle line there. You can see where we were across the board, and we were steeply inverted when we look sort of look at shorter rates, higher-than-longer rates. That's what inversion means. As we got a little bit of volatility and expectations were the economy was going to slow and maybe the Fed wasn't going to move as fast as they ultimately did—that lighter blue line, we saw yields rise pretty significantly. And it started to get more towards a flattening of the yield curve across the board.

Phil: You had a 2-year Treasury was at 5%.

Brent: Yeah, it's pretty incredible. I mean, a 10-year went from 3.9% to 4.7%. I mean, you had an, you know, an 80-basis-point move in a very, very short period of time. We're talking about beginning of the year to April 25th. But then as the economic data started to come in, as we started to see that moderation in the jobs market and as fed fund futures were pricing in, a higher probability of not only the Fed moving, which they ultimately did, and moving maybe more significantly than what we had thought earlier in the year.

You can see, look at that precipitous drop in yields. And to remind everybody on this call, as yields fall, what happens to bond prices? They go up. So you can see across the board and more specifically, we'll call it that belly of the yield curve. So look at 2-year notes all the way out to 10-year fell precipitously from April 25th down to where we are today. We still see shorter rates higher-than-longer term rates. But we are now on the path to a more normalized monetary policy environment, which usually then portends normalization in the bond market.

Phil: Yeah, when you look 2 to 10s, they are pricing these Fed cuts. The very front end of the curve is going to move with the fed funds rate. You're thinking about the 1 month, for example. So it's waiting. It's waiting for the Fed to move. But we're starting to see normalization. But a lot's been priced in, much like the stock market. We look at something like the 10-year at 3.7%. The fed funds rate still is pushing 5%. There's quite a spread there.

Brent: And that's a great dovetail into this next slide here, which talks about yields across the board for various fixed-income markets and sectors. Across the board, I think when you kind of look at where we were in that very first column, sort of the highs across the board, and as you run your eyes down, like you just mentioned, 5% on the 2-year, 4% for the 10-year.

But think about the broad US aggregate bond index, which many investors have as they baluster the core of their portfolios for qualified assets, you can see a starting yield-to-worst of 5.3%. And as we've covered in many other WebExes is a pretty good indicator of forward returns over the duration horizon for that.

5.3% was a pretty good starting point, even in investment-grade corporate bonds, almost 6%. And you can see where we are now. Yields have come down, and you can see that difference there. They've come down across the board, almost a percent across many categories. Does that mean that fixed income is no longer attractive? Absolutely not. Fixed income today remains very attractive.

When I look at aggregate bonds at about 4.2%. Corporate bonds still about 4.7%, almost 5%. Municipal bonds at 3.3% for investors in a higher tax bracket. Still very, very attractive entry point. And I think at this point, as the Fed starts to normalize policy and rates start to fall—which will bring the short end of the curve down—it might make sense to be talking to your advisor, talking to your portfolio strategist about extending duration in your portfolio.

We've been talking about that for quite a while. We think that capturing yield while it's available and extending that carry and maturity over a longer horizon, shifting out of maybe shorter-term Treasuries and money market funds to a broader, more diversified part of your portfolio might be the right thing to consider. Obviously, taking into consideration your investment policy statement, your goals and objectives—might be a good conversation point.

Phil: Yeah, there's still opportunity for yield.

Brent: Absolutely.

Phil: So let's take a hard turn to the election. As everyone on the phone is—

Brent: I was trying to stay on markets and avoid the election conversation.

Phil: As everyone's well aware, it is an election year. I'm reminded every Sunday as I'm watching football when ads come up, living in a swing state. So what is the state of play, as we turn to the first slide?

Our preference is to lean towards prediction odds versus polls. Now, it's not that predictive markets have gotten it right always, either. It's all a distribution of outcomes. Just because one thing is favored over there doesn't mean it happens. It's just like fed funds futures, it doesn't mean they're right, but it tells you where people are mentally. And I think that that is important for markets.

As we point out many times, every election year, you would think when we're on the road, the only thing that matters for markets is elections. Which is not the case. But we do want to talk a little bit about it. So if you look on the left side, what's the probability of winning the presidential election? It has swung about.

You, of course, had the transition from Biden to Harris, right? Right now you see Harris favored, but you are not all that far from that purple line. We are a 50/50 nation. Calling it a coin flip from now to November is somewhat fair. We'll see if the prediction markets move, but you can see there's points where they converge to that 50% chance. In other words, coin flip. And then they widen out.

Lately you've seen Harris favored, but you still have some time, of course, for the election. We shall see. What about the breakdown? Because so much as Brent will cover around policy really has to do—is the government divided or not? If government is divided, of course, not quite as much gets done. And politicians have to do this thing I've heard of, it's called negotiation.

Brent: Bipartisanship?

Phil: And they might have to talk to each other. So you can see the various odds. First is Republican win President and Congress, so under a Trump scenario that's the higher probability. Trump wins divided government a little bit lower probability, so on a Trump side you'd expect a higher chance of united government.

Democrat win, slightly higher probability of divided government, as you can see on the right side, actually more than slightly. That is definitely the higher probability, whereas the dark bar is Democrat wins Presidency and Congress a little bit lower. So favored towards Democrats at this moment, but certainly—and this data is as of September 18th, if anyone's curious—but divided more likely with Harris.

Brent: Yeah, and one thing that we are certain of is more variability in these bars and this information, and certainly for markets. And I would also say, as we'll get into a moment, economic policy, as you highlighted, divided government is probably best for that. I think it's going to be interesting this year when you have, you know, 23 seats up for reelection for the Democrats in the Senate, only eleven. We might see some volatility there in the Senate. So we'll have to see as time progresses what that actually looks like. But again, divided government might be best for both markets as well as policy.

Phil: So how are people feeling, as we flip ahead? This is the misery index.

Brent: It's a great index name.

Phil: Which really is one of my favorite index names. It's inflation plus the unemployment rate. So if you look at the early 80s, for those who were working during that period, you'll remember—for those who weren't, you've heard about it. Not a time of happiness, the 70s and 80s. People were angry. And why was that? You had very high unemployment and high inflation.

What's interesting is if you look at the pandemic and just after the pandemic, you had the highest levels in the misery index that we had seen in a long time—since the Great Financial Crisis. So very unhappy. What has happened is inflation has come down. Is it negative? No. Are prices still going up? Yes, but it's come down. And the unemployment rate, while it's risen, is still very low by historic standards. So you are in a place where the misery index—is it at the levels it was before the pandemic? Very low? No. Is it a lot lower than it was recently? It is.

Brent: Yeah. And I think it's going to be interesting to see the relationship between how voters feel when we actually go to the polls and what the turnout actually looks like. And as you said, we are a 50-50 nation. Turnout is going to drive the results of the election. It'll be interesting to see how people feel and whether or not they get out of their house and go actually vote and make change, which we all should do.

Phil: Are they motivated? Exactly. So let's talk our favorite thing, which is policy.

Brent: Yeah, let's talk about economic policy. We don't have enough time in the day to go through all of the economic policy proposals that either Vice President Harris or Former President Trump are laying out and espousing.

I will tell you, there's a lot of variability in what they're saying on the campaign trail, and we believe that that's going to continue. But we're kind of highlighting some of the major points here. On the Harris side—and I think what you'll see, not only in economic policy, Phil, but as we get into tax policy—much of it is focused on tax policy, even when we look at economic policy.

And as you can see here on the left, under the Vice President Harris side, again, no tax hikes on incomes below $400,000, potentially higher capital gains rates and taxes on higher-income taxpayers. Hasn't been fully defined and laid out what that might actually look like. There's certainly been talk on the Harris side as far as raising taxes from 21% to 28% for corporations. Certainly, a lot of talk about, you know, child tax credits and child care both, I would say, on the Democrat and Republican side. J.D. Vance has been talking an awful lot about child tax credits and childcare across the board. And you can see that list continues down a lot of other things that she is talking about.

On the right side, former President Trump talking about potentially extending the 2017 Tax Cuts and Jobs Act, which is a major component of his discussions, the potential lowering of corporate tax rates from 21% to that 15 to 20%. And certainly we've been talking about and we're going to show a slide—you're going to cover nicely—tariffs and what that might mean across the board. And we certainly have tariffs in place today and a continuation of the Trump policy through with Biden. But potentially more unilateral increases on tariffs across the board under a President Trump scenario. So a lot to talk about, and a lot is going to change, and it's going to be interesting to watch.

Phil: And as you mentioned, as the campaign trail heats up, some of these are changing as we speak.

Brent: We've seen a lot of flip-flopping already on both sides, and we'll see what they actually do.

Phil: For participants, none of this is in stone. It's just what we have at this moment.

Brent: Say, more cocktail napkin than chiseled on the stone. So when we shift gear to tax policy, which I think a lot of our listeners are absolutely focused on, and if we take the top part of this graphic, that's individuals. The bottom part is corporations. And what I think is most important to highlight—and there's a lot to cover, and obviously this presentation is available that you can look through after this—but I think what is important is that, we think that more would get done when you talk about full party control scenarios than divided government.

As you covered nicely, there's right now a higher probability of divided government. So how much ultimately, as far as tax policy, sees the light of day is an unknown at this point. But by and large you can see on the individual side under Trump, certainly what's in focus is the extension of the 2017 Tax Cuts and Jobs Act, a lot there. Under Harris, as we talked about, a return to the marginal tax rate from 37% to 39.6% is there. And additional potential surcharges on income above certain levels, still not totally defined.

I think what's interesting, though, is the likely outcome of divided government is the expiration of the 2017 Tax Cuts and Jobs Act, which automatically sees the highest tax bracket going marginal tax bracket going from 37% to 39.6%, which is a not-unrealistic scenario.

On the corporate side, you can see, and we've talked a little bit about under a Trump and Harris situation, but divided government, which is, again, the most likely scenario, sees basically that 21% tax rate for corporations kind of stay where they are. There's no expiration of the current 21%. Again, under divided government scenario, not much change on the corporate side of the table.

Phil: Right. So let's turn to tariffs, another hot button—really something that's been talked about a lot over the last 8 years. And we're sort of showing here the amount of US imports from the world subject to tariffs. This is not tariff revenue it's just how much is subject—and by the way a lot of this looking forward is estimates because when you put a tariff in, the imports might fall, right? So we're estimating here, but the baseline pre-2017, of course, you could see that tariffs were very low—you added the China tariffs under Former President Trump's administration. President Biden extended those tariffs. He's kept them, so you can think of "tough on China" from a tariff policy as being a bipartisan thing.

Brent: That's right.

Phil: It's really not a Republican or Democrat at this point. We had a Republican institute it, a Democrat continue it. Under various scenarios, I will not go through these in detail, but you can see various scenarios—whether you have China tariffs just at a higher rate, but the same amount. You add some autos, new tariffs on all imports. You can see that under two of the scenarios under Former President Trump, it's pretty much the same, the amount of US imports that have tariffs. It doesn't mean the revenue isn't different because it would be, but the amount.

The new tariff on all imports, that is the scenario that is dramatic, right? And that's where you see a lot more imports that have tariffs on them. Does that happen? We don't know, right? I mean, a lot of this is a negotiating stance. And we'll see how that plays out. But that's something that certainly you could see drive some distortion.

Harris, not a lot of detail there, but under potential Harris administration, the Vice President, the current Vice President may keep the China tariffs. We don't know if there's additional. This remains very much in flux. As a reminder, a lot of this, some of it may involve Congress, but a lot of it does not. So it's one of those things that divided government may not keep from changing.

Brent: Yeah, I think one of the big takeaways, if we kind of pull all this together—economic policy, tax policy, tariffs—I think it's pretty clear when you talk and you read bipartisan economists' views on both. Make no mistake, both Democrats and Republicans will see an increase in deficit spending in the trillions of dollars over the next decade.

Time will tell what that looks like. The makeup and composition will likely change. And the $64,000 question is, "What are we going to do on the revenue side to sort of offset that deficit spending?" Time will tell. But on either scenario, it looks like an increase in the deficit, as the CBO has already projected, not a reduction in the deficit under either scenario, Democrat or Republican.

Phil: Absolutely. So the question we often get, and we've shown this before, but it's in high demand during election season is, "Well, how does the market perform under various makeups of the executive and legislative branch?" as we flip ahead, Amy.

So here we're showing data going all the way back to 1872. And we have various breakouts, right—President, Senate, House. What's interesting is the current scenario: Democratic President, Democratic Senate, House Republican is the highest return. But look at the sample size. It's 5 years. We don't invest on 5 years of data. But then you move to the right, and you see all sorts of mixes: Democrat Presidents, Republican, Republican united, divided government.

They're all very similar until you get to the very far right. And some have small, some size small, some have large. The answer is—the market returns to fundamentals pretty quickly. If you're going back to the 1800s on a Democratic President, on average, the market returns 11%. Under Republican, it averages 9%, which is basically within the error term. In other words, it's very equivalent.

The market goes back to "What is going on in productivity in the US economy? Where are we in the cycle? What's happening with margins?" Can policies change some of that on the margin? Yes, but usually not all that dramatically unless you make a major shift in terms of policy. So our emphasis remains and where we guide clients, rather, is don't try to trade elections, right.

Focus on the fundamentals. Focus on your plan, whether you're an institutional client or a personal client. A lot of this is noise. And as this year is a reminder, there can be a lot of political noise and the market can do well. That's been the story of this year, why the market is watching things like GDP growth surprises the upside, earnings surprises the upside and margins expanding.

Brent: And that is why we started this webinar the way that we did. Fundamentals, the drivers to 2025, as you nicely just said, is whether or not monetary policy will do what it does. Whether or not we continue to see durability and stability in the labor market, even though it's moderating. And to your point, corporate earnings and profitability—that is the underpinning of the catalyst for 2025. This is just something that we go through every 4 years. And by and large, as you highlighted, more likely divided government than other scenarios. So time will tell.

Phil: So, Amy, why don't we address some of our content and the questions we might have received?

Amy: Yep. Thank you both so much for going into great detail with the economy and the markets and especially that election section. I think that's going to help a lot of people that are asking questions around that.

Just a reminder to everyone, we do have several publications throughout the month, including a weekly video from Phil around what's happening on the economic calendar for the week ahead. Also this week, we released a note following the Federal Reserve's rate cut. If you're one of our subscribers, you should have gotten that in your email. So if those types of things are what you're looking for, I highly recommend that you subscribe to our content. You can hit the QR code on the page or visit FirstCitizens.com/MarketOutlook.

So let's jump into questions. No surprise on the first one that is listed—will the Federal Reserve make more larger rate cuts in that 50%—sorry—0.50% range?

Phil: Yeah, so it's a great question. In fact, right before we got on, we were looking at fed funds futures for the next meeting in November, and it's close to a coin flip. Something, I believe is a 40% chance, 50 basis point, 60% chance of a 25. So you certainly can't say there's no chance. But I think the Fed started with 50. They wanted to start with a bang.

We felt that they should have considered July as a cut.

Brent: We were saying that for a long time.

Phil: We said that, and so in some ways there's a little bit of a catch-up. I don't think you can just assume they're going to stay at 50. Quarter-point I think should be the base case, and then we'll see how the data moves. We're getting a lot of data between now and November. What happens in the labor market? What happens in initial jobless claims? Not to mention inflation.

So I think that 50 is a possibility in any meeting, but quarter is kind of our base case. To the point that we made earlier, the 10 total cut that is priced in, right. So when I say cuts to 25 five basis points, we've had two 25 basis point cuts because they did 50. We will take the under on that. I think it's more likely that they cut, yes, each meeting this year, but maybe they move to a quarterly beat next year. Just because there's a meeting doesn't mean they have to cut.

Policy is too restrictive now. They need to cut the meetings this year. But as we move to next year, I don't think there's some responsibility to move each meeting. And also it's not a responsibility of the Fed to tell us exactly what they're going to do 6 months from now, because the truth is this, the data can change. They will be watching that.

Brent: And Fed President Jerome Powell said that in his press conference. He told listeners that we might go faster, we might go slower, we might pause, and we are going to be fundamentally data-dependent on their path towards hopefully engineering a soft landing, which again, to your point, if we see 10 cuts, it feels a little bit more recessionary, at least to us, than maybe a softer landing.

So that's why we're sort of taking the under. And because we do have a not-zero probability of a soft landing. And we'll have to see what that looks like. But again, monetary policy and the path from where we are today to the normalization and terminal value of fed funds is that journey that's going to affect the economic picture and landscape for 2025, for sure.

Amy: And I think it's safe to say a lot of the anticipation around this week's Fed rate cut was to do with the housing market and potential impact there. Phil, do you want to talk about what your thoughts are there?

Phil: Yeah. So if we flip to page 21, the yield curve. I think this really exemplifies something that we think is really important. And that question we receive on the road, every meeting we do, is mortgage rates. Remember, mortgage rates track things like the 10-year Treasury and the 30-year Treasury more closely than the fed funds rate. Alan Greenspan referred to this as a great conundrum. The Fed does not control mortgage rates or long-term bonds. It controls the overnight rate.

So a lot—we've seen mortgage rates fall. And the reason is what we've seen from the April line to the September line, from the purple line to the gold line—a lot of this news has already been priced in. So just because the Fed is cutting does not mean mortgage rates shift parallel with the Fed because a lot of it's come in.

Now the good news is that a lot of it's come in, right? And that brings mortgage rates down because they're going to track things like the 10- and 30-year in the Treasury curve. There is a world, and I don't think it's an unlikely world, where the Fed is cutting—longer term rates? Maybe they move modestly lower, but they stay sort of where they are because so much has been priced in even as the Fed's cutting. What it does do, though, in my mind—outside of something unexpected happening—keeps a cap on rates moving dramatically higher if we're still in a Fed-cutting scenario, right? Longer-term rates, I should say.

So mortgage rates, the truth is they've already moved down. Thinking that they moved down just because the Fed cuts on the day. It doesn't work that way. The truth is a lot of it's already been priced in, and mortgage rates have become more attractive. We have seen mortgage applications go up as rates have fallen. So consumers are paying attention. And when you see rates fall on mortgages, applications go up and we have seen that.

Brent: And I think you always cover this super well. The two other legs of the stool in that discussion is—home prices and supply. So it's not just mortgage rates. It's mortgage rates, overall affordability, home prices that affects affordability, and supply and demand dynamics affect that overall landscape. So it's a much more complex situation than just mortgage rates.

Phil: And we showed housing affordability, I believe that was last month, is very low. Why is that? A lot of that's because price appreciation continues. So it's not that the housing market is healthy. In fact, it's quite distorted still. We need more supply. Mortgage rates coming down could improve that supply picture, though. Doesn't mean there's not plenty of demand—there is—but it could improve it.

Amy: So, Brent, we are on the eve or about a stone's throw away from earnings season in Q4. The S&P is at record highs. What are you seeing for markets going forward?

Brent: Yeah, look, as Phil and I covered on the earnings slide, the bar is high for corporations, right? So a high number for this year at 10.2%. And for earnings in 2025, 15.4%. Next-12-months operating margins at 17.4%. That's a high bar. The equity markets have already priced in those lofty expectations. We have—to the point that you made—not seen analysts from a bottom-up perspective really sharpen that pencil yet.

And who knows? Maybe they won't. Maybe it'll continue to be robust.

Phil: I think we'll know a lot more during the October earnings.

Brent: That's right. And one of the reasons why October might be volatile is we'll have to see what earnings actually looks like in the third quarter, which will be a preview for market participants as we head into 2025 when we start to see fourth quarter 2024 earnings and beyond. So again—

Phil: Management teams are going to be asked in their earnings calls in October, "What are you seeing going into next year?"

Brent: Absolutely.

Phil: So that's why that earnings season is one of the more important seasons of the year because you're starting to look at that next year.

Brent: Correct. And that's why when we think about it from a base case, you don't see our base case being 6,500 or 7,000 is because we've already—as we covered in the slides—we are up almost 50% on the S&P 500 from January of 2023 to now over those 21 months. We've seen significant movement in equity markets as equity market returns go up, forward expected returns fall. That's not a prediction, that's math.

So at the end of the day, when we think about what's going on—our expectations for the equity markets are still positive. But it's not ridiculously positive, and as we already started to see in the rotation and the broader breadth across things like equal-weighted, mid-cap, small-cap, developed international, aggregate bond. We are seeing a rotation in asset classes, which bodes well for diversification. But I would say more modest returns overall, which is still an okay thing at this part of the cycle.

Phil: Yeah.

Amy: Well, Brent, Phil, thank you both for answering questions. And to our listeners, thank you, as always, for trusting us to bring you this information. We will be back again next month and look forward to seeing you then. Thanks, everyone.

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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