By Ellen Hazen, CFA®, Chief Market Strategist

November Takeaways:

• The US election early in the month resulted in a clear win. Investors had been jittery that a close election might be contested in the courts, increasing uncertainty. When the race was called early and decisively, markets rallied. The following day alone, the S&P 500 Index returned over 2.5%
• In the month, small- and mid-sized companies outperformed large companies as investors embraced risk. As measured by the S&P Small-Cap 600 Index and the S&P Mid-Cap 400 Index, small- and mid-sized stocks materially outperformed the large-cap S&P 500 Index, returning 10.9% (small-cap) and 8.9% (mid-cap) as compared to 5.9% (large-cap). Growth stocks edged out Value stocks at 6.5% vs 6.4%
• Another 0.25% rate cut. At its November 6-7 meeting, the Federal Reserve (Fed) cut its benchmark interest rate by another 0.25% to a range of 4.50%-4.75%. This widely expected move was followed by mixed messages from Fed officials regarding whether they are likely to cut the Fed Funds rate by another 0.25% at the Dec 17-18 meeting or pause rate cuts until inflation gets closer to the Fed’s 2% goal
• Inflation has remained stubbornly above the Fed’s 2% target for some months, with the most recent Consumer Price Index (CPI) reported at +2.6% Y/Y, while the most recent Personal Consumption Expenditure (PCE) was +2.8%. These were both a touch higher than previous months and may support a pause in rate cuts at the December meeting
• Interest rates declined during the month (but by less than the 0.25% rate cut). Between the end of October and the end of November, both short-term and long-term rates declined by about 0.10%. This suggests that the market is skeptical that a full 0.25% cut will occur in December. Indeed, markets are currently pricing in only a 75% chance of a cut in December
• Bonds had a solid month. The Bloomberg Intermediate US Government/Credit Index appreciated by 0.6%. Like the risk-on dynamic we observed in equity markets, the higher-risk Bloomberg US High Yield Index performed twice as well as the investment grade index, appreciating by 1.2%
• Other economic data was solid. Retail Sales grew by 0.3% month over month, well ahead of expectations of 0.1%, while new nonfarm payrolls for November of 227,000 rebounded from October’s hurricane-impacted levels
• US companies finished reporting Q3 results. The average earnings surprise was nearly 7%, in line with the last two years. Revenue growth of 5% and earnings growth of 8% reflect a continued strong economy
• International stocks declined. Developed markets stocks declined by 0.5% in the month, while the MSCI Emerging Markets Index declined by 3.6%. This may reflect increased anxiety that the incoming US administration will increase tariffs, thereby dampening GDP and corporate profit growth in other countries

What We Are Watching In December:

• Fed meeting December 17-18. Based on recent speeches, Fed officials are split on whether they should reduce the benchmark rate again, or wait until inflation gets closer to the 2% target before reducing rates
• Inflation. CPI will be reported December 11 and PCE will be reported December 20. The market is expecting inflation to be broadly similar to recent months, in the 2.5% – 3.0% range

As a result of the recent US elections, we note potential shifts in a number of underlying economic fundamentals, including tariffs, immigration, inflation, taxes, deficits, and interest rates. At the same time, the core forces driving the economy remain unchanged: corporate profitability, the labor market, and a strong services sector. We review both new shifts and the consistent drivers below:

Tariffs. President-elect Donald Trump has promised higher tariffs on goods imported from other countries, including mention of as much as a 60% tariff on Chinese goods, 25% on imports from Canada and Mexico, and 10% for other countries. We expect that these tariffs will increase the price of goods as importing companies are likely to pass the cost increases on to consumers. This is likely to both increase US inflation and decrease US economic growth, all else equal. The reduction to US GDP is likely to be modest – perhaps 0.25%. Of course, these tariffs may not be enacted as advertised but may instead prove to be a starting point for negotiating, in which case the impact would be smaller. Industries particularly sensitive to tariffs include technology hardware, retailers, and steel manufacturers. To the extent that tariffs reduce US purchases from other countries, GDP growth in countries outside the US would be pressured. We note that countries with a higher percentage of GDP from services rather than goods would be relatively less impacted, while those primarily manufacturing-based would be more impacted.

Immigration. The US is already structurally short of labor supply due in part to baby boomer retirements; the most recent unemployment rate of 4.1% is quite low relative to history. Certain industries, such as construction, leisure and hospitality, agriculture, meatpacking, and food processing employ a higher-than-average proportion of undocumented immigrants. If these industries find it necessary to raise wages to hire new workers, and pass along those higher costs to consumers, this may increase inflation. Conversely, if those industries absorb higher wage costs, they would instead report lower profitability.

Inflation. Inflation has been trending down since the June 2022 peak but has not yet reached the Fed’s 2% target. The closest that the CPI has gotten since the pandemic is 2.4% in September 2024. Given the likelihood of higher prices due to both tariffs and increased wages, inflation could be higher for longer. This may mean that the Fed does not cut interest rates as soon as investors expect.

Taxes. We expect that the incoming administration will remove the expiration on the 2017 Tax Cuts and Jobs Act, thereby keeping tax rates at current levels. If taxes are eliminated on tips and on social security, we expect that the federal deficit will increase.

Deficit. Currently, the 2025 fiscal deficit is expected to be 6.7% of GDP. This is higher than the last two years, although lower than the pandemic years and lower than the post Global Financial Crisis years. Most economists believe that higher deficits will lead to higher long-term interest rates and higher inflation. Because of lower taxes, the deficit may continue at high levels of GDP. On the other hand, the incoming administration may cut federal spending and thereby reduce the deficit.

Interest rates. If longer-term interest rates are higher, we expect that consumer durables that are typically purchased with borrowing, such as autos and housing, will be the most negatively impacted.

Lighter regulation. We expect that the incoming administration will lighten federal regulation, which will benefit a host of industries. Some of these include conventional energy, manufacturing, and banks (particularly if capital requirements are loosened). Investment banks would further benefit if antitrust scrutiny were reduced, leading to higher approval rates for mergers and acquisitions.

Less focus on clean energy. Clean energy may be negatively impacted by the incoming administration, as environmental regulation could be rolled back, higher interest rates negatively impact project economics, and tariffs increase clean energy component costs. Portions of the Inflation Reduction Act could also be rolled back. We believe EV purchase credits and wind incentives are most at risk of being rolled back.

Medicare / Medicaid. On healthcare, the first Trump administration supported the private Medicare Advantage program. If this recurs, insurance companies that offer Medicare Advantage plans could benefit. On the other hand, Washington may find it desirable to reduce Medicaid funding (perhaps by encouraging states to increase eligibility requirements) as one method to reduce the deficit.

What hasn’t changed

Corporate profitability has remained remarkably resilient over the past four years, with operating margins for the S&P500 rising from the 13.5%-15.5% range pre-Covid to a range of 14.5% to 17% post Covid. The largest increases have been generated by industrials, where margins have increased from just over 10% to nearly 15% over the same timeframe. Currently, analysts expect corporate profits to grow by 11-13% over each of the next two years. Over the medium- and long-term, equity prices follow (or sometimes lead) corporate earnings. As long as profits are healthy and growing, this is a positive signal for equity markets.

The labor market has remained very strong throughout the entire post-pandemic period. Although new jobs created have decelerated from the peak in 2020 (when the paycheck protection program enabled businesses to rehire workers only recently let go), they remain in a healthy 150,000-200,000 range. This is equivalent to 1.0% to 1.5% of the entire labor force of new jobs each year. Unemployment at 4.1% is lower than 85% of the time since 1970.

Services are healthy. The US ISM Services Index has generally remained solidly above the neutral 50 level for most of the past several years. The most recent reading of 56 was the highest since the middle of 2022. This dovetails with the stronger labor market.

Inflation is still sticky. Inflation has been above 2% since February of 2021, peaking at 9.2% (CPI) in mid-2022 before declining to 2.6% today. However, recent readings have been steady in the 2.4%-2.6% range; the decline may have stalled out. The Conference Board estimates that consumers still expect inflation to be 4.9%. The largest contributors to the high CPI are shelter costs and auto insurance. Without a rate decline, it’s hard to see housing costs coming down. Auto insurance rates have been driven higher by medical costs, repair costs, and higher accident rates – these could decline. Overall, though, we expect the higher inflation to continue for some time, complicating the path for Fed rate cuts.

Positioning largely unchanged. So, despite some tweaks due to the results of the election, our view of 2025 and beyond is not materially different than it was before November 5. We are positioned for a continued strong economy, albeit one with higher inflation and higher interest rates.

We believe equities are a more attractive asset class than fixed income, because equities are a natural inflation hedge: companies typically increase prices to at least keep up with inflation. Other inflation hedges include real assets (e.g., infrastructure or real estate) and Treasury Inflation Protected Securities (TIPS). Corporate profit health bodes well for equity markets, although the US large-cap equity market is vulnerable to negative news, as the forward price-to-earnings multiple is 2 standard deviations above its 35-year average, an unusual occurrence. We are not believers in the recent small-cap rally, given that earnings estimates for small cap indices are still declining. We look forward to detailing our thoughts more thoroughly in our upcoming Market Outlook newsletter. Until then, we hope you all have a wonderful holiday season.

Disclosures