By Ellen Hazen, CFA®, Chief Market Strategist
What We Are Watching in January and in 2025:
As we look to 2025, we see a continuation of many of the trends we observed in 2024. Economic indicators have generally remained strong, and we expect this to continue in 2025. Corporate profits are on track for another year of solid growth.
Where we see a bit of a difference in 2025 vs. 2024 is in market-based indicators. Some market-based indicators (particularly equity and fixed income valuations) have become quite optimistic, which could crimp asset price returns for the year. Thus, despite a similar economic backdrop, we would not be surprised to see asset price volatility in 2025. This is because we view further multiple expansion (equities) or spread compression (fixed) as unlikely.
In this context, we believe the best opportunities are high-quality. In equity, we favor large-cap stocks over small-cap stocks and US stocks over international stocks. In fixed income, we favor short duration, investment-grade corporate bonds, and inflation-protected securities. Details follow.
December Takeaways:
- December 0.25% rate cut, but bearish commentary led to a bearish market response. As expected, the Federal Reserve (Fed) cut its benchmark Federal Funds rate by another 0.25% in mid-December, to a range of 4.25% – 4.50%. In his remarks, chair Jerome Powell acknowledged that any additional rate cuts would require more progress on inflation. US equities declined by 3% and longer-dated bonds declined as investors absorbed Powell’s hawkish message
- Inflation stalled out. Inflation remained stubbornly above the Fed’s 2% target again in November, with the Consumer Price Index (CPI) reported at +2.7% Y/Y, and Core Personal Consumption Expenditure (PCE) at +2.8%
- Yield curve is closer to normal. During December, the short end of the curve declined by about a quarter of a point (in line with the Fed rate cut), while yields on Treasurys with maturities greater than one year rose by as much as 38 basis points (0.38%). Thus, the curve is clearly back to a normal shape, with long rates higher than short rates
- GDP stronger. In mid-December, Q3 2024 GDP was revised upward from the previous estimate of 2.8% to 3.1%, a very solid growth rate
- Jobs were a bit stronger than anticipated, at 227,000 new nonfarm payrolls created in November, compared to 220,000 expected
- Bond values declined. During December, both investment grade and high yield indices modestly declined, with the Bloomberg Intermediate Government/Credit Index declining by 0.62%, and the Bloomberg High Yield Index declining by 0.43%. For the year however, bonds posted respectable returns – the investment grade index appreciated by 3.0% and the high yield index appreciated by 8.2%
- Domestic stocks declined. In the month of December, most US equity indices declined, with the flagship S&P 500 Index down 2.4%. However, indices had strong returns for calendar year 2024, with the S&P Index 500 +25%, the S&P Midcap 400 Index +13.6%, and the S&P Small Cap 600 Index +8.6%
- International stocks declined. Both developed equity markets (-2.3%) and emerging equity markets (-1.7%) declined in December, capping off another year of underperformance vs. the S&P 500 Index. Developed market equities appreciated by only 4.4% in 2024, while emerging market equities appreciated by 6.5%
Economic indicators have been strong, while market indicators reflect stretched valuations |
Jobs. The US labor market remains healthy, even as unemployment has crept up from the post-pandemic low of 3.4% (a 50-year low) to 4.2% more recently. We expect that new nonfarm payrolls will continue in the 150,000 – 225,000 range over the coming months, which will continue to support full employment.
GDP. Estimates for both 2024 and 2025 have steadily risen in recent months, as economists incorporate strong corporate profit growth and business spending. Currently, both 2025 and 2026 look to be approximately 2.0% real growth (or mid-single digits in nominal terms).
Inflation. Whether measured by CPI, PCE, Core CPI, or Core PCE, inflation seems to have entered a new, higher regime as compared to the pre-pandemic era. After spending most of the 21st century bouncing between 1% and 3%, both core CPI and core PCE have bounced between 2.5% and 3.5% after declining from the highs of 2022. Given this, we expect interest rates to remain higher for longer, which has implications for both equity and fixed income positioning. Within both, we seek to shift toward sub-asset classes that are less sensitive to higher rates.
Interest rates. The Federal Reserve (Fed) will debate at its late January meeting whether to continue the recent string of Federal Funds Rate cuts or hold the rate steady at its current 4.25% to 4.50% level. We believe that the higher recent inflation readings will drive the Fed to keep rates steady.
Corporate earnings growth. We expect corporate earnings growth to broaden in 2025, driving broader equity market performance within the large-cap universe. Small-cap earnings may stabilize, but at present estimates are still declining.
Generally, stock performance is correlated with earnings growth: in 2024, the fastest earnings growth sectors in the S&P 500 were Communications Services, Technology, and Healthcare, while the best-performing sectors were Communications Services, Technology, and Financials (aided by Fed rate cuts). In 2025, analysts currently expect the sectors with the highest earnings growth rates to be Technology, Healthcare, and Industrials. Technology is not a surprise. Earnings growth in Healthcare is attributable to pharma and biotech acceleration, while Industrials earnings growth is attributable to both strong economic growth and to government infrastructure spending. The broader earnings growth in 2025 may drive a broadening of the large-cap equity market.
US small-cap stocks made three attempts to outperform large-cap stocks in 2024: in May, in July, and in November, the S&P 600 Small Cap Index did, in fact, outperform the S&P 500 Index. However, in each case, small cap stocks underperformed in subsequent months, leading to yet another year of small cap underperformance. Small cap stocks have underperformed large cap stocks in eight of the last nine years, as the benefits of technology in general and artificial intelligence in particular are seen to be most accruing to the largest companies.
Equity market multiples are high. The S&P 500 forward earnings multiple is nearly two standard deviations above its 35-year average. The only times in the past 35 years that it has been higher were during the 1999-2000 internet era and in the early Covid months, when large declines in earnings estimates meant the calculated multiple increased. Yes, the economic backdrop is very favorable – but markets seem to already reflect this.
Credit spreads are tight. Bonds returned roughly their coupons in 2024, as rising rates precluded capital appreciation. We have consistently focused on shorter duration investments in the face of rising interest rates and expect that to continue. Like equity investors, fixed income investors appear excessively optimistic, as evidenced by credit spreads. Investment grade credit spreads are notably tighter than their 40-year median (dotted line), and are approaching the lows of the mid-1990s.
So, should we sell stocks and bonds? No, we should not. As long as economic fundamentals are solid, valuations can remain stretched. They may not further expand but could certainly hold current values as underlying economic and corporate profit growth drive further equity and fixed income returns. That said, were the economic environment to begin to markedly weaken or if interest rates spiked for some reason, valuations would certainly be at risk. Thus, we are carefully monitoring all aspects of the economy, with particular focus on corporate earnings growth and inflation. Our base case is that the economy will remain strong, driven by solid corporate and household balance sheets, strong profit growth, and growing wages. We will take advantage of any volatility – when assets can often become temporarily mispriced – to further increase portfolio quality.