Making sense of market movements

THE start of August has been a tumultuous one for markets, opening with big sell-offs followed by equally large bouncebacks. This is in contrast to the first half of 2024, where economic data was generally resilient with inflation trending down, albeit with some volatility.

Global equities were on a nice run in the first six months, rising more than 10 per cent. The US share market had its best first half-year since 1900 but has now nearly gone one full round – rising nearly 4 per cent in the first half of July, before falling more than 8 per cent by early August.

While these developments might trigger many investors to rethink getting into the market, the truth is, as with many things, the devil is in the details. If one looks underneath the hood, it is possible to find good long-term opportunities.

With five more months left of 2024, here are three things investors should be thinking about in the third quarter.

Are we likely to see interest rate cuts?

Since mid-July, there has been a general repricing in interest rate expectations. Markets are now pricing in more than four interest rate cuts in 2024, with the potential for more in 2025.

Headline inflation has surprised on the downside for consecutive months while core PCE prints are at their lowest since late 2020. Inflation is trending down towards 2 per cent levels which the US Federal Reserve is broadly targeting. Certain areas – such as the labour and housing markets, where inflation has been stubbornly high – have also shown signs of softening.

These signs bode well for the Fed’s quest to bring general price increases under control and open a window for rate cuts to prevent the US economy from slipping into an unwanted recession.

For those who have started to get accustomed to high interest rates on their deposit accounts, rate cuts signal a warning sign. Yields on cash holdings will likely fall over time, which means investors will need to start finding alternatives to put their cash to work to reduce reinvestment risks and preserve their real, inflation-adjusted income.

Is it time to deploy cash into bonds?

Cash has largely outperformed high-quality bonds since the start of the interest rate hike cycle in 2022.

Cash yields have been led higher by the aggressive interest rate cycle that began in 2022. Fed funds rates, which have a strong influence on cash and fixed deposit rates, rose from zero to 5.25 per cent in a matter of 18 months. Bonds, on the other hand, faced an opposite dynamic – rising interest rates weighed on their price returns.

However, this dynamic is looking to reverse as economic and inflationary factors are aligning, allowing the Fed to finally embark on the long-anticipated interest rate cut cycle.

Falling interest rates will inevitably decrease cash yields and drag on cash returns. On the other hand, it can boost bond prices. Furthermore, current bond yields are still high, proving an opportune window to lock in yields. Besides that, bonds serve as good diversifiers in portfolios as evidenced by their outperformance to stocks amid current volatility, since they have rallied while stocks have faced significant price pressures.

Are markets too expensive?

This is probably the most common question we receive when speaking with investors. We would argue both yes and no.

While it is true that certain parts of equity and bond markets remain expensive and very well-owned, others are trading at undemanding valuations and remain lightly held by investors. The key here is to seek out opportunities in the former.

Admittedly, headline valuations of markets are above longer-term averages. This is the case for equity and fixed-income markets. Equity markets have been very concentrated for the better part of the last two years, with investors crowding into US stocks, tech stocks and a handful of mega-cap stocks better known as the Magnificent Seven. Case in point: In 2023, less than 27 per cent of stocks beat the S&P 500. This is a far cry from the average of 45 to 50 per cent since the start of the 1990s.

However, periods of extremely low breadth don’t last forever, and there is plenty of room for the rest of the market to catch up – and a turn in interest rate cycle might be that catalyst.

Looking outside the cohort of previous period winners opens investors to several interesting opportunities.

One of them is small-mid caps. They have over the long term done well compared with large-cap stocks given faster growth rates underpinned by exciting long-term potential. However, for the better part of the last 10 to 15 years, they have underperformed large caps, to a point where valuation differentials between them have come to quite extreme levels. The eventual interest rate cut could aid small mid-cap stocks as it can lower their borrowing costs and improve bottom lines.

Another area is dividend stocks. These stocks have similarly been ignored by the market in favour of growth stocks. A rotation out of the latter can potentially benefit dividend stocks which tend to reside in defensive sectors and in markets outside of the US where investor ownership remains lighter. Their dividends will increasingly become more valuable as the interest rate falls, which adds to their appeal.

In fixed income, there are also opportunities. Where it looks expensive are credits, as spreads of corporate bonds are tighter than historical averages.

On the other hand, investment-grade bonds, especially US Treasuries, are looking attractive. Yields are at multi-period highs, thanks to the aggressive rate hike cycle. Investors can now get attractive levels of yields without taking excessive risks.

For example, an investor looking at a yield of 5 to 6 per cent would have needed to invest a large majority of their bond portfolio in high-yield bonds to achieve that in 2018. However, at present, investors would be able to achieve that level of yield with a portfolio of investment-grade bonds only. That’s a comparable level of yield with less credit risk. Besides that, when the interest rate cut cycle happens, these investment-grade bonds may also start to see some capital gains.

We entered Q3 2024 with a healthy dose of hope and optimism, and markets were favouring the usual suspects of US, Japan and technology stocks. However, as we have seen, things can change quickly, and being diversified, selective and not herding together with the crowd is crucial to investment outcomes in the short to medium term.

The writer is client portfolio strategist, Fidelity International