The labor market and inflation measures showed signs of easing in the third quarter allowing the Federal Reserve (Fed), to pivot and decrease its target range for the Fed funds rate by 50 basis points (bps) to 4.75% to 5.00%. This was the Fed's first rate cut since the Federal Open Market Committee began its hiking cycle in March 2022. It was a case of "seeing is believing", as discussions about potential cuts finally materialized. With the Fed cutting rates in September and forecasting additional cuts over the next two years, investors began to recalibrate to a less restrictive monetary policy environment. This shift pushed yields lower, driving strong returns for broad fixed-income assets. The yield curve steepened, with the spread between 2-year and 10-year Treasuries turning positive for the first time in more than 2 years.
While the second quarter was characterized by narrow market leadership in equities, the third quarter saw broader market participation and a rotation in sector leadership. Large-cap value stocks, along with small- and mid-cap equities, outperformed large-cap growth. At the sector level, Utilities, Real Estate, Industrials, and Financials outperformed the tech-oriented sectors that led in the first half of the year. Year-to-date, Utilities have taken top-spot, coming in just ahead of the Information Technology sector.
Inflation has moderated this year but has proven to be stubborn of late. We expect the downward path to resume next year, with inflation gradually approaching the Fed's 2% target by late 2025 or early 2026.The labor market has remained resilient, and our expectation is that, while unemployment may rise, it will likely stay anchored around 4%. This level is close to full employment, suggesting no major concerns. Economic growth is anticipated to soften but remain positive over the next few quarters, before rebounding in the second half of 2025 to around 2.5%.
In terms of monetary policy, it is clear the Fed is shifting towards a less restrictive stance. We expect rate cuts to be front-loaded, with 50 bps of reductions in each of the next three quarters. By the end of 2025, we anticipate that the Fed funds rate will be close to 3%, about 200 bps below current levels. Overall, the combination of moderating inflation, a stable labor market, and solid growth, along with a more accommodative Fed, should create a supportive environment for financial assets.
Although interest rates are expected to continue to decline, the impact of rate cuts is unlikely to be felt by consumers until late next year. Certain segments are feeling pressure from higher inflation and interest rates, reflected in the rise of both credit card usage and delinquent debt. Despite this, overall consumer spending remains healthy, as demonstrated by strong retail sales and demand for travel and entertainment. Additionally, the wealth effect has contributed positively, as significant gains in investment portfolios encourages continued spending.
As the election approaches, I want to highlight two key observations. First, over the past 30 years, heightened uncertainty has caused investors to adopt a cautious stance during Presidential election years. Flows into money market funds typically far exceed those into equity funds prior to the election. However, this dynamic reverses in the year following the election, as investors shift back towards equities and away from money market funds. This behavioral shift presents an opportunity for long-term investors. Secondly, going back to the 1930s, the average annual return for the S&P 500 has been strong, irrespective of whether there is a Democrat or Republican in the White House. Key economic drivers, such as consumer spending and business innovation, persist regardless of who is in office, while companies also learn to adapt to changing environments. Investors, especially those with a long-term horizon, should view election-related uncertainty as an opportunity to invest.
A few final thoughts for investors. TD Wealth expects interest rates to be significantly lower by the end of 2025, which could serve as a positive catalyst for both high-quality fixed income and equities. If you're currently invested in cash and short-term instruments, it's important to consider reinvestment risk, as yields are likely to decline with continued rate cuts from the Fed. Therefore, consider investing excess cash in high-quality fixed income and equities. Lastly, consider using election-related volatility and uncertainty as an opportunity to get invested.
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