News and Commentary

We take a closer look at economic activity in China, the potential changes to tax exemptions and what that might mean for munis, and how earnings expectations drive stock prices.

A look at labor conditions and what they signal for the path ahead, how low interest rates will go, and if September’s FOMC meeting will bring more volatility.

In This Month's Issue:Portfolio Positioning for an Election OutcomeMark Luschini, Chief Investment StrategistOften, before a presidential election, sample portfolios get trotted out to reflect a sponsor’s view on what is likely to perform better or worse under each potential administration. While it is an interesting parlor game, we have advocated taking a longer-term view that coincides with the bespoke objectives of the investor as a method to mitigate the risk of various sectors or the market at large not reacting as anticipated. After all, much in the financial markets depends on the prevailing economic climate, credit availability, interest rates, the Federal Reserve’s monetary setting, congressional composition, and geopolitical influences.In the case of this upcoming election, as it stands today, we know the nominee of the Republican Party and the presumptive candidate for president from the Democratic Party. Plus, we have a record under each regime that we can reflect on to see whether front-running the candidate with portfolio positioning, which was thought to do well, was successful in practice. However, since President Biden is not running for re-election, and it is not yet clear for a lot of reasons how the Democratic candidate for president will govern, we will primarily focus on what we know occurred during the previous Trump administration, which can serve as a template supporting our thesis.Dating back to 2016, many investors thought that they had a script for how to position for a Trump presidency. The question to be answered is whether it actually worked. In preview, there are numerous examples of sectors or asset classes that were thought to do well under one party or the other and instead did poorly. This piece demonstrates the shortcomings of trying to guess what areas of the market, or even stocks and bonds in general, will outperform.The prospects of Donald Trump returning to the White House have pundits thinking there will be less regulation, more tariffs, and lower taxes. If true, and from an economic perspective, these Trumpian policies could boost growth and likely inflation. To be sure, the makeup of Congress will be key to policy implementation. While the executive branch has sway over regulations, tariffs, and immigration, congressional support will be needed for a large policy overhaul.What we do know is that over the entire course of Trump’s term from 2017-2021, Technology and Consumer Discretionary were the best-performing sectors. Meanwhile, Energy, Real Estate, Consumer Staples, Utilities, and Industrials were the biggest underperformers. Low interest rates, less regulation, and tax cuts that resulted in the repatriation of previously untaxed overseas profits proved most beneficial for the tech-dominated sectors. However, it wasn’t all policy driven. Concurrently, the widespread adoption of cloud computing supported earnings, helping to drive investor enthusiasm for these same companies, which had more to do with the network effect produced by a new technology than a political impulse. On the other side of the spectrum, sectors thought to do well, such as Industrials, Energy, and Banks, underperformed their tech brethren.Under President Biden, it is easy to see where policy is just one driver of leadership trends as other factors frequently overwhelm policy initiatives. Consider that despite Biden championing green energy investment, clean energy stocks have been crushed, while they thrived under former President Trump, as low interest rates led to a surge by the group. Conversely, traditional Energy was the worst performer under Trump and has been the best-performing sector under President Biden.To be sure, one big fiscal change helped the stock market under President Trump as the top rate on corporate tax was lowered from 35% to 21% by the Tax Cuts and Jobs Act of 2017. At the same time, while some might expect the stocks of small, domestic-facing companies to have done well under the Trump Administration, small caps actually underperformed the big cap dominated S&P 500 index.The lesson here is that there are often other forces at work that override presidential preferences and policies and even congressional party composition. Investors may be better served focusing on the macroeconomic environment that underpins a president’s term as much or more so than attempting to trade the prospective beneficiaries of the president-elect. Indeed, over many years, the asset mix selected to achieve one’s long-term goals prudently matters more than who is occupying that historic structure located at 1600 Pennsylvania Avenue for a four-year term or two.Floating Rate Bonds-In ReverseGuy LeBas, Chief Fixed Income StrategistSeveral times in recent years (2015, 2021, and again in 2022), we have advocated for the inclusion of floating rate bonds in portfolios as a tool to reduce interest rate risk into a period of Federal Reserve (Fed) rate hikes. Today, by contrast, the Fed is on the verge of executing rate cuts, most likely starting in September 2024. Accordingly, it is time to reduce the portion of floating rate and other short-term bonds in fixed income portfolios, as the yields of those bonds will quickly decrease as the Fed cuts overnight interest rates.Floating rate bonds pay a coupon determined by adding a spread to some benchmark interest rate. Historically, the most common benchmark interest rate for floating rate bonds has been the three-month LIBOR, but most new bonds reference an alternative rate called SOFR, the Secured Overnight Financing Rate. SOFR is a short-term benchmark that roughly tracks the Federal Reserve’s overnight target interest rate. When the Fed cuts its target for interest rates, overnight rates fall immediately, SOFR follows suit, and the coupons on floating rate bonds will decline as well. For example, a U.S. bank might issue $1 billion of five-year floating rate bonds that pay an annual interest rate of SOFR + 1.00%, which would mean that if SOFR in Year 1 averaged 5.50%, the bonds would pay 5.25% + 1.00% = 6.25%. If SOFR fell to 3.00% in Year 2, the bonds would pay 3.00% + 1.00% = 4.00%.Since floating-rate bonds pay investors more when rates rise and less when interest rates fall, their interest rates change, but their market values tend to be stable. By contrast, traditional bonds have fixed interest rates and market values that change more over time. It does not take a big logical leap to build a strategy around floating rate bonds: if we know with certainty that the Fed will hike interest rates, the income produced by floating rate bonds will increase, and they should outperform fixed rate bonds. If we know with certainty that the Fed will cut, the opposite should be true and fixed rate bonds should outperform.There are two problems with this approach: one, we never know with certainty what the Fed will do, and two, the markets often function on Fed expectations, not just on Fed actions. As we sit today, it seems likely (though never certain!) that the Fed will cut rates shortly and by 0.75% - 1.00% over the next few quarters. But that view is very much within the bond market’s consensus. Since markets already expect these rate cuts, the interest rate on a fixed rate bond today already incorporates some of that effect.Here is a concrete example using today’s interest rate outlook. An unnamed North American bank has a number of fixed rate and floating rate bonds outstanding, including a recently issued two-year floating rate bond yielding SOFR + 0.70% and a two-year fixed rate bond yielding 4.93%. At present, SOFR is 5.33%. For the floating rate bond to pay as much as the fixed rate bond, SOFR would have to fall roughly 1% to 4.23% (4.93% - 0.70% = 4.23%). If the Fed cuts rates four times—which is fewer than market expectations— SOFR will fall about 1%, and a bond investor should be indifferent between the floating and fixed rate bond.Chart 1: Markets Expect SOFR to Fall Below 4% by Mid-2025When the economic cycle has an “upside skew,” meaning the odds of stronger growth and inflation are higher than weaker, holding floating rate bonds will often make sense. Today, however, that is not the case. We anticipate at least three rate cuts in the next few quarters, assuming everything goes right with the economy. However, if we are wrong, the skew is to the downside. There is a decent chance that economic conditions deteriorate, the Fed cuts more than four times, and the floating rate bond underperforms. For that reason, we anticipate fixed rate bonds will outperform floating rate bonds through the coming rate cut cycle, a noted contrast from the post-pandemic experience thus far.Beach, Golf, and EarningsGregory M. Drahuschak, Market StrategistA sharp change in emphasis was the main market story in July. An 18-month widening performance gap favoring the cap-weighted S&P 500 versus an equally-weighted version turned suddenly as the gap narrowed more than 50% in July alone. The cap-weighted S&P 500 had to scramble to end with a gain of 1.13% versus its 1.24% average.The precedent-setting performance gap between the two S&P 500 versions was poised to narrow due to the stretched valuations for the top S&P 500 stocks, while everything else was relatively inexpensive and, in some cases, notably undervalued. Although the performance gap widened modestly on the final day of July, the narrowing process is probably not complete.Earnings were not a problem. As July ended, roughly half of S&P 500 firms had reported second-quarter results that produced a blended earnings growth rate of 9.8% and a revenue growth rate of 5.0%, with 78% of reporting firms topping consensus earnings expectations. As a result, the 2025 S&P 500 earnings estimate reached a new high.Various financial metrics are used to determine the stock market’s valuation. The most common of these is the price-earnings ratio (P/E). Over time, the rising equity market has allowed the market P/E to rise to a level that, based on the current 2025 S&P 500 earnings estimate, puts the market P/E at 20, which is on the high end of normal. There are some extremely preliminary estimates for 2026 that put the P/E based on these estimates at a fraction below 18. Some market analysts argue that a 20 P/E on earnings more than a year out is excessive. We do not, as long as the earnings path continues on the upward trajectory it has been on.The volatility in July created interesting technical possibilities.The rush higher early in July pushed the S&P 500 to a significantly overbought level, which set it up for a pullback. Should the market succumb to additional weakness, however, technical support should help to contain pullbacks.The Investment Strategy Group Mid-Year Outlook reads: “The job market remains reasonably strong, underpinning consumption and business activity remains expansive. Corporate earnings estimates, which once appeared optimistic for 2024 and 2025, are far more plausible. Bond yields are benign, given fewer spike-inducing variables. Stocks advance on rising animal spirits and maintain a 20x forward multiple looking out to 2025 estimates.”The 5,600 S&P 500 target mentioned in the Mid-Year report was surpassed on July 16 when the S&P 500 touched an intraday high at 5669.67. Despite topping 5,600, the ingredients that led the S&P 500 to that level are still in place, which, in our view, can drive the S&P 500 beyond the July 16 high. However, the market needs to negotiate the seasonally weak months of August and September.Chart 2: Number of Positive S&P 500 Results—Final Five Months of Election Years: 1952-2020It is natural to think the presidential election would influence the equity market. However, this usually does not have a great bearing on the market in August. In the 18 presidential election years of 1952 through 2020, the S&P 500 ended August with a gain in 11 years. Three of the best Augusts were in election years, while none of the five worst were in election years. The election might not exert significant influence, but we believe the increased market volatility that is common in August probably will. August historically sees the largest outflows from equity funds.The information herein is for informative purposes only and in no event should be construed as a representation by us or as an offer to sell, or solicitation of an offer to buy any securities. The factual information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Charts and graphs are provided for illustrative purposes. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors.The concepts illustrated here have legal, accounting, and tax implications. Neither Janney Montgomery Scott LLC nor its Financial Advisors give tax, legal, or accounting advice. Please consult with the appropriate professional for advice concerning your particular circumstances. Past performance is not an indication or guarantee of future results. There are no guarantees that any investment or investment strategy will meet its objectives or that an investment can avoid losses. It is not possible to invest directly in an index. Exposure to an asset class represented by an index is available through investable instruments based on that index. A client’s investment results are reduced by advisory fees and transaction costs and other expenses.Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. From time to time, Janney Montgomery Scott LLC and/or one or more of its employees may have a position in the securities discussed herein.