In Short

• The Fed cut its benchmark rate during the September FOMC meeting by 50bps – its first cut of the cycle.
• Although the year had been characterized by strength in growth-related sectors within U.S. equities, Q3 showed a rotation out of growth and into value.
• The start of the cutting cycle also had a major influence on fixed income asset prices with the Bloomberg U.S. Aggregate Index posting its fifth straight month of gains in September, closing out its second-best quarterly performance since 1995.
• We maintain a soft-landing outlook, suggesting that a moderate rate-cutting cycle gives rate relief to the economy’s “have-nots”—lower income consumers and smaller companies—more than its “haves.”
• Within equities, we still favor lower-beta, higher-quality names, with a preference on value versus growth while continuing to favor active management to select companies with high earnings visibility.
• Within fixed income, we currently hold at-target views on investment grade and high yield, an underweight to cash, and an overweight to emerging market debt given the current environment.

It’s About the Journey

All eyes were on the Federal Reserve (Fed) coming into September, with Chair Jerome Powell suggesting that rate cuts were all but inevitable during his Jackson Hole speech at the end of August. Powell’s remarks were a reminder that, when it comes to central bank policy, it’s better to focus on the journey rather than the destination. He reminded the audience where this all started: the COVID-19 pandemic and its shock to the system. As the economy suddenly shut down, jobs were slashed, and supply chains were disrupted. As the economy roared back following the reopening, inflationary pressures emerged.

Powell joked with those in attendance that “the good ship Transitory was a crowded one…with most mainstream analysts and advanced-economy central bankers on board” and we believe there is some truth to that. Most thought the pandemic-induced price surges would be temporary, but post-COVID conditions didn’t go according to plan. Inflation was sticky, spreading from goods to services. The Fed responded by raising interest rates 11 times in 2022 and 2023 at the fastest pace in history. While many economists predicted that these aggressive rate hikes would cause a recession, economic growth persisted, the consumer kept spending, and the labor market held steady as inflation began to cool.

Last year, the data-dependent central bank predicted that it would trim rates three times in 2024 but this schedule kept getting pushed back as inflation remained stubborn early this year. The resilience of the labor market allowed the Fed to remain patient as disinflationary trends steadily resumed and CPI moved closer to the Fed’s 2% target. However, some cracks began to show in the second half of 2024. The unemployment rate rose nearly a full percentage point to 4.3% from early 2023 through July 2024. However, it has improved in the last two months, with sequentially higher hiring numbers pushing the unemployment rate down to 4.1%. Despite this being a historically low rate of unemployment, there has been a substantial increase in the supply of workers and a slowdown in previously frantic hiring. Looking back, U.S. job openings reached about 12.2 million in early 2022 amid a hiring frenzy, meaning that there were roughly two jobs available for every one unemployed person. This metric has since declined to about eight million job openings or 1.1 jobs available for every unemployed person as of the end of August.

Considering all these factors, the Fed cut its benchmark rate during the September FOMC meeting by 50bps—its first cut of the cycle. Markets were evenly split in anticipating between 25 and 50bps points right down to the wire. One factor influencing the split was economic uncertainty. In August, the Atlanta Fed’s GDPNow estimate for 2024 GDP growth dropped from 2.9% to below 2%, and remained around that level through early September before recovering back to 3% by the end of month. Powell implied that the Fed had delivered a bigger-than-normal cut to make up for holding steady in July, but admittedly tempered the effect by coupling it with a hawkish rate projection. Looking ahead, we expect an easing cycle that delivers 25bp rate cuts at every meeting until the neutral rate settles at around 3.00 – 3.50%. That said, we acknowledge that trends within the labor market will be integral in determining the magnitude of subsequent policy decisions. Evidence of this dynamic was exhibited on the first Friday of October, as a stronger-than-expected jobs number shifted market expectations for the next Fed rate cut from 50 to 25bps. While acute labor weakness could accelerate rate cuts, a gradual normalization should lead to similarly gradual policy adjustment.

Once the uncertainty leading up to the September FOMC meeting dissipated, equity markets continued their upward trend with the S&P 500 Index steadily climbing through the end of September and hitting an all-time high on the last day of the month at 5,762. Though the first half of the year was characterized by strength in growth-related sectors within the U.S. equity market, the third quarter showed a rotation out of growth and into value. Sectors lagging the benchmark in the first half of the year such as Utilities and Real Estate were the top performers in the third quarter and the equal-weight S&P 500 Index outperformed the S&P 500 index, signaling that a rotation in the market may be underway.

Within fixed income, the confirmation of the start of a Fed cutting cycle had a major influence in asset prices. The Bloomberg U.S. Aggregate Index posted its fifth straight month of gains in September, closing out its second-best quarterly performance since 1995 with a 5.2% return. Yields for U.S. high-quality corporate bonds (as measured by the Bloomberg U.S. Corporate Investment Grade index) have retreated from their 6.1% level a year ago to 4.7% at the end of September, pushing valuations higher for this segment of the market. As a result, relative value within U.S. Investment Grade fixed income has diminished.

Historical Trends and Positioning

In the words of Jerome Powell, “The limits of our knowledge—so clearly evident during the pandemic—demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges.” This economic cycle has been anything but normal, and while investors may look to historical rate cutting cycles to predict outcomes, we believe it should be acknowledged that the lessons of the past may not fully apply to the present.

Rate-cutting cycles have tended to favor risk assets. As a result, it was gratifying for investors to see the central bank get started with a meaningful move. Beginning with equities, U.S. small caps have historically outperformed U.S. large caps in the 12 months following the first rate cut. This makes sense, in our view, as smaller companies tend to be more sensitive to interest rates than larger ones. This more domestic and cyclically oriented segment of the equity market also tends to rely on debt for financing operations, which may carry an embedded level of interest rate risk. In our view, by lowering the fed funds rate, the Fed may ease the cost of accessing credit for future expansionary plans for all companies, especially small caps. For these reasons, coupled with the view that larger companies are both fully valued and less sensitive to rate changes, the Neuberger Berman Asset Allocation Committee (AAC) has maintained its overweight stance for U.S. small caps in 2024 in anticipation of rate cuts.

As for fixed income, given the inverse relationship between price and yield, we would likely expect future returns to be positive as interest rates head lower. Among the fixed income segments, 12 months after the first rate cut, emerging markets debt (EMD) tends to be the best performer. Given where we are in the global central bank cycle, the yields on debt for some emerging economies may become more attractive relative to the U.S. as the Fed cuts rates. Today, this historical playbook for EMD also has two additional potential tailwinds: a weakening U.S. dollar relative to EM currencies that may boost returns for investors and the stimulus pivot from China that turned out to be more aggressive than expected with its pledge to ramp up fiscal and monetary measures. As is commonly recognized, China is a growth engine for the world, let alone EM economies, and the pledged stimulus may also boost economic activity for other emerging markets. Elsewhere in fixed income, as mentioned previously, while we believe valuations for U.S. investment grade are rich, the asset class has historically delivered positive returns in the 12 months following a rate cut. However, they have fallen short relative to EMD returns.

Looking ahead at the remainder of the year, October tends to be the most volatile month for U.S. equities, as measured by the VIX Index, a gauge of expected volatility. In addition to the upcoming presidential election fueling uncertainty, the rebalancing of portfolios from active managers may also play a role. October is the month with the highest number of mutual funds’ fiscal year-ends, according to Morningstar; signaling that managers may be looking to engage in tax-loss harvesting activities in their portfolios.

In general, given our soft-landing outlook, some of the soft data seen in the first few business days of the month tend to support the view that relief from rate cuts is already underway. In both the ISM Manufacturing (a more cyclical gauge) and the ISM Services surveys, Fed rate cuts were acknowledged as a positive, with the latter rising above expectations on its demand gauge for the month of September. In addition, we believe a recently announced and larger-than-expected stimulus tailwind from China is encouraging news for this view and global economies.

Portfolio Implications

Equities in the U.S. extended their gains across all market caps in September, while emerging markets outperformed the U.S. on the back of a weaker U.S. dollar and a larger-than-expected stimulus package announced from China. We maintain an at-target overall view across equities with an overweight to small caps, a sector that had priced in a hard-landing scenario, as we continue to anticipate further broadening of equity-market performance. Within equities, we still favor lower-beta, higher-quality names, with a preference on value versus growth. In this more challenging environment, we also favor employing active management to select companies with high earnings visibility.

Fixed Income was higher among all segments for the month, with longer-duration securities outperforming. We continue to favor credit markets, maintaining an overweight view on investment grade securities, reflecting a general bias towards quality. We maintain an underweight outlook on cash, preferring to lock in yields in anticipation of a decline in cash rates. We maintain an at-target view on high yield debt given the recent tightening of spreads (yield advantage over Treasuries) which has reduced the risk-adjusted return potential of the asset class.

In a challenged fundraising, exit and financing environment, we believe significant opportunities exist within Private Markets for firms and strategies that can act as liquidity and solutions providers to help close the capital supply/demand gap and support value-added transactions. This backdrop, along with Neuberger Berman’s deep relationships and unique position within the private equity ecosystem, has translated into record levels of deal flow across our platform. We continue to see potentially compelling opportunities across secondaries, co-investments, private credit and capital solutions. We are cautious on core private real estate, but this is offset by what we see as abundant market-dislocation opportunities in the value-add and opportunistic sectors and particularly in real estate secondaries.

Index Returns as of September 2024

Source: Bloomberg, total returns as of September 30, 2024. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg Ex-Energy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.