The markets saw more wobbles than jelly on a plate at a children’s birthday party this past quarter. But as the gelatine sets, it’s not all wibble-wobble. Explore our Q3 report to discover why cooling inflation, rate cuts, and resilient economies give us reasons to stay optimistic.
Download PDF VersionThe world’s stock markets experienced short-lived wobbles in the third quarter, plunging by 10% and more in just a few days in early August. Previously the unstoppable US technology stocks were among the hardest hit, along with Japan.
The pullback was triggered by the unexpected rate hike by the Bank of Japan (BoJ) at the end of July and fears of a US recession. The BOJ hike led to an unwinding of the yen "carry trade", which involves borrowing at a low interest rate in yen to invest in higher-yielding assets elsewhere.
A weak US jobs report prompted fears of a possible recession and concerns that the Federal Reserve (Fed) might have left it too late to cut rates. Doubts about the AI narrative were also behind the softness of some technology stocks. However, most markets recovered these losses and were approximately flat or up modestly for the quarter, helped by the US Federal Reserve's larger-than-expected 50bp rate cut, its first since 2020.
Other developed central banks joined the Fed in cutting interest rates. Inflation continued to ease, and fixed income had a good quarter as bond yields fell.
The Fed, Bank of England (BoE) and European Central Bank (ECB) will continue to lower rates, as underlying inflation is expected to carry on converging gradually with their 2% targets. If the recent cooling of the US economy turned into something more serious, the Fed would respond with larger and more rapid cuts, which gives the economy an important safety net.
Falling short-term interest rates are a fundamentally positive backdrop for both bonds and equities. Among equities, growth stocks (such as technology) are traditionally seen as the biggest beneficiaries of lower interest rates. US rate cuts could lead the trend towards a generally weaker dollar to continue. They also create a more favourable policy environment for emerging markets, which then have more scope to reduce their own interest rates.
UK and European growth has been sluggish but should benefit from lower inflation and interest rates. The Chinese economy has also been sagging, but there are hopes that the stimulus package announced in late September is finally bold enough to mark a turning point. A stronger Chinese economy would boost global growth, particularly outside of the US. At the margin it is perhaps less good news for inflation, as China's weakness has been putting downward pressure on oil and commodity prices.
Geopolitics remains an obvious risk. A serious escalation in any of the main flashpoints, particularly in the Middle East, would clearly be bad for markets. A resolution of the conflicts would be a positive surprise but does not look likely in the short term. On top of this the presidential election in the US promises to be a cliff-hanger.
The US labour market slowed in the third quarter, with job growth reducing to around 100,000 per month (about half its level over the previous 12 months) and the unemployment rate rising to 4.2%.
Could the cooler labour market be the start of a more serious slowdown?
So far the signs are that it isn't. Gross Domestic Product (GDP) growth is expected to come in at around 3% in the third quarter. Corporate profits remain strong, wages are growing faster than inflation and retail sales are growing at a respectable (if unspectacular) pace. Consumer confidence is below average, however.
The Fed's mandate requires it to target both low inflation and high employment. It therefore responded to the labour market cooling by cutting interest rates by 50bp in September. The larger-than-usual cut underlined that the Fed does not want to fall behind the curve as the economy slows and is committed to keeping the labour market robust.
The markets are pricing in around a further 50bp of cuts by the end of the year. Recent inflation data has been supportive, with headline consumer price inflation easing to 2.5% in August and the Fed's preferred inflation measure, the PCE index, to just 2.2%, only slightly above target, with core PCE at 2.7%.
A victory by Donald Trump in the presidential election has the potential to be market-moving as he has pledged some significant changes in economic policy, most notably increased tariffs and a generally growth-boosting agenda, possibly even extending to putting pressure on the Fed to lower interest rates.
So far, the market consensus is that Trump's policies would be more inflationary, but we do not know how much of the programme would be implemented in practice. Harris, by contrast, is seen as the continuity candidate.
The bull run in US tech stocks that began at the end of 2022 weakened in the third quarter of 2024, but did not end entirely. Technology was one of the worst-hit sectors during the market rout in August but recovered all of these losses, with the Nasdaq Composite index ending up 3% for the quarter.
The Magnificent Seven had mixed fortunes: four stocks fell (Alphabet, Amazon, Microsoft and Nvidia), while Apple and Meta were up over 10% and Tesla more than 30% (after weakness earlier in the year).
A reassessment of the prospects for AI was one of the drivers of the correction, along with signs of slower US economic growth. The puncturing of AI hype hit Nvidia, but the stock recovered to be nearly flat on the quarter.
Operational results remained strong in Q2, with continued robust sales and profit growth at most of the leading tech players.
As growth stocks, tech companies benefited from lower interest rates after the Fed rate cut.
The ECB followed up its first rate cut in June by cutting interest rates by a further 25bp in September. Inflation in the euro area has come in below expectations. In September headline inflation fell below the ECB's 2% target for the first time since 2021 to 1.8%, with core inflation slightly higher at 2.8%. The ECB has expressed concern about wage growth, but this has also shown signs of slowing. Further rate cuts are expected by the end of the year.
Economic growth is sluggish in the euro area at 0.6% year-on-year in Q2. The German economy has been a drag, as its large export sector has been hit by weak growth globally, particularly in China. The latest Chinese stimulus package is therefore good news for the German economy and gave European stocks a fillip towards the end of the quarter. The European economy will also benefit from the fall in inflation, as real wage growth will turn positive, which could give consumer confidence and spending a boost.
The new Labour government came to power in July and promised to make boosting economic growth its central mission. There were already signs of an improvement in the UK's economic fortunes before the election, with growth picking up to around 2.5% annualised in the first half of 2024. However, the government has come in for some criticism by seeming to prioritise austerity, as it has promised a tax-raising budget in October. The new government is more pro-European than its predecessor and will strengthen ties in some areas but has ruled out joining the single market or customs union.
The inflation picture has improved considerably. Headline inflation fell to 2.2% in August. Wage growth and services inflation, which have been a concern for the Bank of England as indicators of underlying inflation, have slowed but remain above 5%.
The Bank responded to the slowdown in inflation by cutting base rates for the first time by 25 bp in August but remains cautious. Further rate cuts are expected before the end of the year, however. This will help to boost consumer confidence and the all-important housing market. This may be offset somewhat by the announcement of tax increases in the October budget.
After three decades of pain for investors, Japan's Topix index, the broadest benchmark of the Japanese stock market, finally surpassed its record high from December 1989 in early July (the Nikkei 225 had already done so in February). But just a few weeks later Japanese stock markets slumped by around 20% after the Bank of Japan unexpectedly raised interest rates. The markets recovered but were still down for the quarter.
In recent months the Chinese economy has been stuck in a malaise, with the property sector deep in the doldrums, business confidence weak and consumer spending sagging. After previous half-hearted attempts to boost the economy, in September the authorities finally unveiled a bold stimulus package, including rate cuts, loans to the corporate sector and in effect a sizeable fiscal stimulus.
As much as the size of the package, it demonstrated that the authorities are still prioritising economic growth, which some observers had begun to doubt. Resolving the troubles on the property market will still be an uphill battle, however. It is also worth remembering that the trade war with the US may ramp up another gear if Donald Trump is elected president, as he has threatened to impose a tariff of 60% on all Chinese goods.
Furthermore, the sluggish Chinese economy and its low consumer price inflation of just 0.6% have probably given the disinflation process in the developed world a helping hand, and this effect may peter out if the Chinese economy recovers.
The narrative about interest rates shifted in the third quarter. After market expectations of rate cuts were generally revised down in the first half of the year owing to stronger-than-expected inflation data, the pendulum swung back again after more reassuring inflation numbers across the developed world and a weaker US labour market in particular. The Fed, BoE and ECB all cut interest rates and are expected to remain on this rate-cutting trajectory for the rest of the year.
Meanwhile the Bank of Japan moved in the opposite direction, raising its policy rate from 0.1% to 0.25%, citing continued progress on raising inflation sustainably to 2%.
The BoJ may also have been motivated by a desire to support the yen, which had breached the 160 to the dollar level earlier in the quarter. The market was surprised by the timing of the move, which contributed to the sharp fall in equity markets at the beginning of August. The BoJ is expected to raise rates again, but lower US interest rates will take off some of the pressure on it to move quickly.
Even after a weaker quarter for equity markets, valuation multiples remain very high, and earnings growth forecasts are still optimistic. But lower inflation gives the Fed scope to reduce interest rates and prevent the recent slowdown in the US economy from spreading. This is a supportive backdrop for equities.
Falling US interest rates and a weaker dollar are traditionally a more favourable backdrop for emerging markets, as it makes it easier for these countries to run an independent monetary policy. Other developed markets could outperform the US if global growth picks up again, otherwise US leadership may continue.
In fixed income, government bonds continue to offer value for investors, as yields are still trading well above expected inflation and short-term interest rates are falling. Corporate and high yield bonds should continue to perform well provided the economy stays out of recession.
Although it has weakened a little this year, the US dollar is still on the expensive side and has the potential to decline as the Fed lowers interest rates. A victory by Donald Trump in the presidential election could throw a spanner in the works, however.
Trump has hinted at a desire to devalue the dollar, but other policies, such as higher tariffs and possible tax cuts could work in the opposite direction. It would take some time for a newly elected Trump's economic policies to become clear.
There is no shortage of potential triggers for further market turbulence: geopolitics, the US presidential election, a possible US recession and disappointments on inflation.
However, falling interest rates are a fundamentally positive backdrop for both bonds and equities and could help to fire up relatively sluggish global growth, particularly outside of the US, especially taking the longer term into account.
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