‘Potpourri’ for $1000, Alex

While many emphasize the three dissenting votes for this meeting (one voting member wanted a deeper interest rate cut while two others preferred no change), the ultimate 0.25% reduction in the fed funds target rate was in line with market expectations. The largest takeaway is the divergence among the 19 Federal Open Market Committee (FOMC) participants regarding where interest rates should be in future years.  

Every other scheduled meeting, the FOMC releases its “Summary of Economic Projections,” which reflects members’ point-in-time views of growth, inflation, unemployment — and of course the target interest rate — for the next three calendar years and for the longer run. Ironically, the committee’s expectations for most (but not all) years converged relative to their September projections on unemployment, GDP growth and inflation, yet the distribution of future interest rate expectations remained wide. Perhaps most importantly — and while subject to change — participants continue to nudge their longer-run interest rate expectations. Since thinking through a multi-year investment horizon underpins our investment philosophy, a steadily increasing long-term interest rate baseline is a key consideration for financing rates, asset price valuation and broad portfolio construction factors.    

Separating facts from narratives is a core investment principle. In his book, Thinking Fast and Slow, Nobel Prize-winning psychologist Daniel Kahneman highlights how human decision-making can be impaired by biases and heuristics prevalent in fast thinking, but logic emerges from more careful considerations.

The current interest-rate narrative is that the Fed will continue to cut, and this will drive down borrowing costs for consumers and businesses: The bond market, small-cap stocks and other interest-rate-sensitive assets may be prime beneficiaries in this scenario, especially if the much-discussed incoming Fed chair retains a lower interest-rate bias. That could play out, but one fact we reflect on is that the bond market is comprised of maturity dates across time — and while the Fed retains influence over very short-maturity interest rates, longer-maturity bonds do not always follow Fed and other central bank dictums. This week represents this reality. At time of writing, U.S. government bonds with less than three-year maturities are higher in price and lower in yield than they were a week ago, but bonds with greater than three-year maturities are lower in price and higher in yield. That trend can reverse, but since bonds with longer maturities are subject to more risks than those with shorter maturities, investors may demand more yield compensation for more time risk.

A parallel fact we reflect on is that the U.S. 10-year Treasury bond, arguably the cornerstone of global finance, has not sported a yield above 5% since July of 2007 — over 18 years ago. In other words, investors, borrowers, lenders and the aggregate economy have grown used to a low-interest-rate world, and challenges to U.S. fiscal health, trade relationships, embedded inflation considerations and other factors could ultimately test that 5% ceiling. Since we want bonds to “act like bonds,” we will continue to gauge the interplay between Fed projections, bond market activity and how business and consumer lending dynamics drive asset pricing for this core category. Decisions around portfolio duration, bond issuer credit quality and market structure remain key focal points for us. 

Domestically, the question is whether the S&P 500 and other indices can draw on broad sector participation to drive earnings growth. One encouraging sign discussed at our internal investment committee meetings this week was that the third quarter represented the lowest overall contribution that the “Magnificent Seven” (Alphabet, Amazon, Apple, Microsoft, Meta, NVIDIA and Tesla) have had on S&P 500 earnings growth since 2023.

The S&P 500 has gained over 15% this year. If we look at the 11 major sectors that constitute the index, only three sectors have outperformed the broad index (Communication Services, Information Technology and Industrials) while the eight other sectors are below that watermark. However, only one sector (Real Estate, which has a very small weight) has a negative total return year-to-date. Within domestic small caps, we see a similar, more narrow performance, led by Technology and Industrials, but five sectors are in negative territory year-to-date.

Looking forward, consensus estimates are for the S&P 500 to grow earnings by 13% in 2026 and 13.5% in 2027. If we look at global earnings ex-U.S., expectations are for 12% and 11% for 2026 and 2027, respectively. One factor we covered at length was the concept of valuation, meaning that if we do see a broadening-out of industry earnings — for example, if Financials or Health Care begin to deliver better earnings growth at the expense of Technology — will investors pay a lower multiple of earnings for that growth relative to what they have become accustomed to, given strong Technology earnings over the past three years? This is a worthy question, particularly if Tech overspend concerns, like what we have seen with individual companies this week, become more prevalent. 

During our investment committee discussions, we covered valuation across several cuts. Let’s start with framing; valuation is not always a catalyst for price change, and valuation interpretations are opinions. We may view an asset class or security as expensive relative to history or a reasonable comparable, but markets are the ultimate adjudicator. Using conventional valuation metrics, we would group most global equity indices at the country level as priced toward the higher percentiles (i.e., more expensive) within their 20-year histories. Government bonds and broader bond indices of higher-quality, government and government agency bonds are more in the middle-to-cheaper valuation percentiles, while corporate bonds (both investment grade and high yield) are on the more expensive side. Real assets in the form of publicly listed infrastructure, natural resource and real estate-related equity interests are more in median- and average-valuation ranges.

One variable we explored earlier that adds some complexity to valuation considerations is the forward path of interest rates. While interest rates inextricably impact bonds (yields move in the opposite direction of prices and vice versa), when we evaluate future cash flows in the form of dividends, interest payments, royalties, distributions from private assets or other cash and cash-like flows, interest rates play a central role in determining what the potential future streams may be worth relative to other choices. For us, short-term interest rate moves driven by Fed meetings are eye-catching, but, for our time horizon, interest rate stability and structure are more important than the near-term direction. While we acknowledge that valuations across many asset classes sit on the higher side of historical levels, we are encouraged by productivity enhancements, corporate adaptation and versatility, which can all help drive innovation, and we will continue to evaluate interest rates to frame our valuation perspectives.