Stock markets around the world had a positive third quarter – the MSCI All Country World Index rose 6.6% in USD – to close September up 18.7% for 2024 so far. While the US (+6.6%) continues to grab most headlines – the S&P 500 index hit several new all-time-highs en route to returning its best year-to-date performance of the 21st century – market gains were more evenly spread in the quarter than has been the case for some time[1].
This broadening rally saw value stocks (+9.4%) outperform growth (+4.1%) over the quarter, led by strong sector performance from real estate (+16.1%), utilities (15.9%) and financial services (+9.9%), while information technology (+1.0%) and communication services (+4.0%) lagged the market. Energy (-3.1%) blotted the value copybook as oil prices fell 17% – their largest quarterly decline in a year – on fears for the global demand outlook.
Value and cyclical stocks were boosted by central banks cutting interest rates – notably in the US where the Fed trimmed the base rate by 0.5% – which also helped small-caps (+8.8%) to trump large-caps (+6.1%) over the quarter[2]. The rotation also saw developed markets (+6.4%) underperform emerging ones (+8.7%) where China was the big winner following government stimulus at the end of September. A series of fiscal and monetary measures propelled Chinese equities 21.9% higher for the quarter (+14.7% in the final week alone) and helped commodities, with copper and iron ore among the biggest beneficiaries of an expected uptick in Chinese economic growth and recovery of its ailing real estate sector.
Rotation drivers
The third quarter also saw other factors emerge that could see equity markets return to a more normal state, and with it a sustained revival of value’s supremacy over growth.
First, the AI bubble finally looks to be maturing and the companies that have led its formation now appear in need of major new technology developments to maintain their historic growth rates, just as investors are starting to doubt the size and timing of returns on the huge investments they have already made.
The Magnificent 7 (+5.4%) had their worst quarter since Q4 2022[3]. Their market concentration continues to fall towards healthier levels (31% of the S&P 500 index at the end of September from a peak of 35% earlier this year) and third quarter earnings are expected to show a narrowing of the profitability gap between them and the rest. After 15 years of unrelenting gains, are we entering a bear market for technology?
Second, the Bank of Japan hiked interest rates and loosened its yield curve control at the end of July, strengthening the currency and unwinding the multi-billion ‘carry trade’ where investors borrow cheaply in yen to invest overseas. The resulting stock market sell-off as investors scrambled to sell assets was quickly recovered but the longer-term implications for international capital flows – particularly to the US where the dollar continues to weaken – could be significant if Japanese borrowing costs continue to rise.
Overseas investors currently own around 17% of the US stock market – an all-time high – which has helped drive valuations to record premiums over markets in Europe (33% cheaper) and emerging markets (20% cheaper)[4]. Further dollar weakening, driven by a combination of Fed loosening, a rising budget deficit and US political addiction to financial sanctions, could see foreign funds flow to more attractive currencies, exchange rates and asset prices.
Chief among the beneficiaries could be China where market liquidity has returned and global investors remain underweight historic allocations after several years of outflow. Despite the recent rally, Chinese stocks also remain undervalued versus long-term average multiples of earnings and book value[5]. Any broadening of the recent stimulus to support households would likely have big ramifications for China’s unbalanced economy and drive a more structurally positive rally. This could be another important factor in returning China – and potentially emerging markets more broadly – to a more normal state.
Positive outlook but expect the unexpected
The fourth quarter is historically strong for markets and stocks have also tended to rise when the Fed cuts interest rates outside of a recession. A further 0.5% reduction is expected before the end of the year and the economic environment looks supportive for broad-based stock market returns. The latest Bank of America fund manager survey showed that 79% of respondents expect a soft landing and strong September employment data suggests that a Goldilocks scenario is on track in the US.
Further afield, earnings are expected to grow across most regions this year and next. Healthy corporate cash flows and lower borrowing costs could also trigger a wave of M&A activity, particularly where valuations are below long-term averages in areas like emerging markets, real estate and small caps.
Finally, the previous quarter demonstrated the importance of staying invested. Stock markets in July and August recorded some of their best and worst days for several years as investors grappled with recession fears and interest rate uncertainty.
With the near-term outlook clouded by the US election and rising tensions in the middle east, markets look set to remain volatile over the short-term and clients should prepare for more wild swings in the months ahead. For stock pickers like us, volatility can be positive – some of our best investments have been made during periods of market turmoil and we are ready to seize future opportunities on your behalf.
[1] US returns based on S&P 500 index.
[2] Source: MSCI. MSCI ACWI sub-indices in USD.
[3] Source: Bloomberg. Bloomberg Magnificent 7 Total Return Index
[4] Source: JP Morgan using MSCI indices. Valuations based on forward P/E (US 22x, Europe ex-US (15x) EM 18x).
[5] Source: JP Morgan using MSCI China index. Forward P/E 11x vs. 12x average, P/B 1.1x vs. 1.9x average).