Understanding capital markets

Investors were reminded in August 2024 that capital markets can act unpredictably in the short term when volatility flared. U.S. stocks declined sharply in early August as investors focused on economic concerns. A key labor market report showed slower-than-expected job growth and the continuing trend of rising unemployment.¹ Stocks experienced a significant, two-day selloff on August 2 and 5. This resulted in the NASDAQ Composite Index entering a correction phase (representing a decline of 10% or more from its peak level), and the S&P 500 falling 8.5% from its mid-July peak.

Yet the setback was short-lived. Markets quickly bounced back, and after August 19th trading closed, the S&P 500 was within 1% of its mid-July all-time high, and the NASDAQ Composite was only about 4% below its previous record.

“There was a sell-off, people reassessed and came back to a focus on the fundamentals of corporate America and the economy,” says Tom Hainlin, senior investment strategist at U.S. Bank Wealth Management. “Once we did so, we saw investors come back into the equity market.”

Bond markets rallied during the initial market downturn, with yields on the benchmark 10-year Treasury falling below 4% for the first time since early January. Yields remain below the 4% threshold into mid-August. As bond yields dropped, bond prices rose.

“The fundamentals of the underlying economy are still positive, at least for now,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The market’s sudden negative reaction showed that investors were temporarily in a different mindset.”

The U.S. stock market, as measured by the S&P 500, is up more than 18% year-to-date, following up on gains of more than 26% in 2023. As of mid-August 2024, the S&P 500 has trended up every month except April.

The bond market has followed a different path this year. The yield on the benchmark 10-year U.S. Treasury, which ended 2023 at 3.88%, jumped to as high as 4.70% by late April 2024, then retreated. 10-year Treasury yields are now back below 4%.³ As interest rates decline, bonds already on the market gain value. Year-to-date through August 20, 2024, the Bloomberg Aggregate Bond Index gained 3.37% on a total return basis, bouncing back from a negative start to the year.⁴

Haworth says the combination of reasonable economic growth and still elevated inflation favors equities.

Current capital market drivers

Despite the market’s recent sentiment that economic headwinds could be in the offing, the U.S. economy is coming off of a second quarter than generated annualized Gross Domestic Product (GDP) growth of 2.8%, double the pace of first quarter growth.⁵ Inflation, which emerged as a challenging issue in 2021, has declined to 2.9% for the 12 months ending in July. It marks the lowest inflation level since March 2021.⁶ The Federal Reserve (Fed) fought inflation by significantly raising interest rates. What should investors expect now?

In today’s environment, Haworth says investors should pay particular attention to three primary factors:

• Fed rate cuts. In late 2023, the inflation Fed put the possibility of rate cuts on the table, but delayed cutting rates due to persistent inflation concerns. Markets fully expect that to change at the Fed’s mid-September 2024 meeting, with a high likelihood of at least a 0.25% rate cut at that time. “We’re not seeing signs of inflation resurging, and the Fed is putting increasing focus now on its mandate related to keeping the labor market strong,” says Haworth. “The Fed will make interest rate decisions based on what it sees in the overall data, not on one point in the cycle like the recent disappointing jobs report.”
• The state of the economy. The economy continued to grow despite headwinds created by Fed monetary policy, driven primarily by healthy consumer spending. “How strong and resilient will consumers continue to be in 2024 and beyond? That’s an open question,” says Haworth. “The biggest question today is whether the labor market has changed enough to alter consumer spending.” A recent favorable sign was a very strong retail sales report in July,⁷ indicating consumer spending was alive and well.

• The direction of corporate earnings. Earnings, or a company's profits, are typically one of the biggest drivers of capital market performance. “S&P 500 earnings have grown for four straight quarters,” says Haworth. “In contrast to an earnings contraction that was underway in the first half of 2023.” Haworth notes that the earnings outlook for the rest of 2024 remains positive, and markets are even more optimistic about earnings prospects for 2025. “But it’s a stock-by-stock story, and not every company is on the same earnings growth track.” Earnings growth is critical as it helps lay the groundwork for rising stock prices. If anticipated earnings growth fails to materialize, Haworth says equity investors could face a more challenging environment.

While these factors are likely to have the greatest impact on equity and fixed income markets, investors need to be aware that other events can temporarily impact the markets and potentially contribute to investor uncertainty. Read more about our capital market perspective in our quarterly investment outlook.

Capital markets explained

Here are answers to some fundamental questions that may help you better understand capital markets and how they work.

What are capital markets?

Capital markets are a way to bring together individuals or institutions with money (also known as capital) they wish to invest, and various entities that seek money to underwrite costs to meet specific purposes. Capital markets also facilitate the issuance of securities on an exchange, where stocks and bonds are offered by those seeking capital, to be purchased by investors seeking to put capital to work.

For example, government entities regularly issue debt securities (bonds) to meet costs for major capital projects or, in the case of the federal government, finance day-to-day expenditures. Investors, in effect, lend money to the government entity by purchasing a bond. The borrower is required to pay interest on a timely basis and repay principal when the bond matures.

What are types of capital markets?

Capital markets are most commonly made up of stock and bond markets.

• Stock (equities) is issued by a corporation, providing an ownership stake in the firm. Individuals and institutions can purchase stock in the firm, obtain voting rights as a shareholder, and be a recipient of dividends paid out by the corporation from its earnings (profits). Stock values can rise and fall, and investors can re-sell shares through an exchange on the secondary market, which is where bonds or shares of stock are bought and sold after their initial public offering.
• A variety of entities issue bonds, such as governments, school districts and corporations. By purchasing a bond, the investor becomes a lender and is due interest and principal payments. Bondholders always take priority over stockholders when it comes to repayment, should the entity that issued the security face financial difficulty, such as bankruptcy.

How do capital markets work?

A key to capital markets is the issuance of securities. Entities seeking to raise capital will issue debt or equity securities that are exchanged with investors. A corporation, for example, may issue new shares of stock, at a set price. However, once on the open market, the price of a security is generally always changing, reflecting demand in the market.

When raising capital, companies or entities may issue new shares of a stock or bonds, with proceeds from investors going directly to the issuer to meet its current financial purposes. Original issues of stocks and bonds are not always accessible to individual investors, such as in an initial public offering (IPO) of stock. Most individuals purchase stocks on the secondary market, where those who previously purchased stocks or bonds can re-sell the securities they hold.

How do capital markets differ from financial markets?

There are similarities between the two; however, capital markets typically refer to the issuance of new securities to raise capital, while financial markets can refer to all forms of securities trading.

Financial markets encompass a wide variety of exchanges involving traditional securities like stocks and bonds, as well as other types of assets and contracts. Most individuals trade securities on the secondary market.

Talk to your financial professional

As you assess your own financial goals, understanding the current and anticipated performance of capital markets may help you more effectively position your assets to achieve your objectives. Discuss your circumstances with your wealth professional to help determine the best approach for you.

Our investment strategies are designed to weather all types of market cycles. Learn about our investment management approach.