Newsletter - 4th Quarter 2024

The U.S. markets exhibited robust performance in 2024, with major equity indices delivering double-digit returns. Large-cap growth stocks, particularly those within the Technology, Communication Services, and Consumer Discretionary sectors, drove the S&P 500 and Russell 3000 indices to outperform mid- and small-cap peers. The Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) accounted for over two-thirds of the S&P 500’s annual gains, bolstered by enthusiasm for artificial intelligence and deregulation prospects following Donald Trump’s election victory. However, market valuations appeared stretched, with the S&P 500 trading at a forward P/E ratio of 22, well above its historical average of 17.

International equities underperformed due to U.S. dollar strength, which erased gains from non-dollar-denominated investments. Meanwhile, the bond market was volatile, with long-term bonds suffering losses amid interest rate fluctuations. The Fed’s December meeting and concerns over inflation curbed broader fixed-income performance, leaving the U.S. Aggregate Bond Index with minimal gains for the year.

The Federal Reserve cut interest rates twice during Q4, bringing the Fed Funds target range to 4.25%-4.50%, totaling a 1.00% reduction in 2024. Despite progress in reducing inflation toward the 2% target, Core PCE inflation remained elevated at 2.6%-2.8%. Concerns over inflation, coupled with potential policies under the Trump administration, prompted the Fed to lower its 2025 rate cut projections from four to two. This recalibration contributed to market volatility late in the quarter.

Economic indicators highlighted continued growth, with U.S. GDP expanding at an annualized rate of 3.1% in Q3 and 2.7% in Q4. Consumer spending and business confidence surged, driven by the anticipation of pro-growth policies. However, rising credit card debt and delinquencies, alongside potential labor market pressures, raised concerns about sustainability. The economy’s robustness suggests the Fed may adopt a cautious approach to further rate cuts.

Looking ahead, the U.S. economy is poised for real GDP growth of 2.0%-2.5% in 2025, supported by favorable credit conditions and strong employment levels. U.S. equities are expected to benefit from lower inflation and projected earnings growth of 13%. However, policy uncertainty under the Trump administration, including potential tariffs and tax reforms, could increase market volatility. U.S. 10-year Treasury bond yields are forecasted to range between 4.00%-5.25%, with the Fed anticipated to cut rates by an additional 0.50%, creating opportunities for intermediate-term bond investors. While inflationary risks persist, the economic backdrop supports cautious optimism for balanced market performance in the year ahead.

FEDERAL RESERVE POLICY

The Federal Reserve cut interest rates twice during the quarter, lowering their target Fed Funds rate to a range of 4.25% - 4.50%. In total, the Fed has cut interest rates by effectively 1.00% during 2024 as they navigate taming inflation while maintaining full employment for the U.S. economy.

At the December 17-18 FOMC rate and policy meeting, Fed Chair Jerome Powell noted that inflation has made progress toward their 2% objective but noted that inflation “still remains somewhat elevated.” While inflation has fallen noticeably since 2022, progress slowed during the quarter, with the Fed’s Core PCE (Personal Consumption Expenditure) inflation gauge stuck in a 2.6% - 2.8% range. Aside from this trend, the Fed also became worried that President-Elect Donald Trump’s policies could further increase inflationary pressures. A potential trade war using tariffs could send consumer prices higher in the near term. Any curb to illegal immigration could result in a tighter labor market, which could lead to wage inflation. Additional tax cuts tend to boost consumer demand for goods and services, which could increase prices. As a result of their concern on the path of inflation, the Fed lowered their December Dot Plot projection down from four rate cuts to just two rate cuts in 2025. This recalibration of interest rate expectations was the primary catalyst for market volatility in the last two weeks of the quarter.

The rate of inflation will need to start falling again materially for the Fed to resume cutting rates. If inflation remains elevated or falls at a slower-than-expected pace, there is a risk that the Fed could pause rate cuts further. 

US ECONOMY

The primary reason inflation remains elevated is due to the U.S. economy’s resilience. During the quarter, many economic metrics advanced, indicating that economic growth accelerated, albeit marginally.  

For the year, U.S. GDP expanded at its fastest pace so far, growing at an annualized pace of 3.1% during the third quarter versus 3% for the prior quarter. Although fourth quarter GDP growth fell to 2.7%, this is right in line with the quarter’s starting expectations. Consumer spending also accelerated during the same period, with Retail and Food Services Sales growing by over 3.5%. The rate of unemployment held steady for the quarter at 4.1% after rising for the majority of 2023 as well as in the first half of 2024. The ISM Manufacturing New Orders Index jumped from a reading of 47.1 to 50.4 in the quarter, hinting at manufacturing growth for the first time in over 8 months.

Business confidence also increased at a rapid pace in anticipation of the new administration’s pro-growth policies, with small business capital expenditure plans increasing by nearly 15% on a quarter-over-quarter basis. Although small business capital spending plans have not yet fully signaled a firm expansion in business sentiment, this is the first time since 2023 that we have witnessed such a move.

Even though most of the economic indicators are pointing toward continued economic strength, there are a few areas that continue to give us pause. In particular, the rising balance of U.S. credit card debt which now stands at nearly $1.2 trillion, which is an all-time high. The drastic uptick in both credit card and auto delinquencies is also concerning especially if the rate of unemployment begins to rise.

For the time being, the balance of economic conditions continues to support economic strength, and with that, a Fed that is in no rush to cut rates. When the Fed initiated a jumbo-sized 0.50% rate cut in September, the health of the labor market was in question. But if the labor market can manage to stay resilient, the Fed can stay focused on alleviating inflation. This suggests that the economy is healthy enough to manage a higher interest rate environment. During the height of the Fed’s rate hike cycle in 2022, many economists were projecting a recession in 2023. This was mostly because economists did not believe that the economy could manage low unemployment and higher output growth, with interest rates being over 5%. However, the current level of economic activity brings confidence to the notion interest rates are not necessarily an issue and that we could be in a new higher interest rate regime.

US EQUITIES

 2024 was certainly a good year for U.S. stock investors, with most of the major U.S. equity benchmarks printing double-digit returns for the year. The mega-cap dominated S&P 500 and Russell 3000 indices both outperformed their mid-and small-cap index peers. This was mostly due to the enthusiasm surrounding large-cap growth stocks, particularly the artificial intelligence (AI) themed stocks that fueled this year’s rally in the Technology, Communication Services, and Consumer Discretionary sectors. Like 2023, the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) accounted for over two-thirds of the S&P 500’s 2024 return.

Market leadership during the quarter was analogous to the 2024 trend of large-cap growth stocks leading the way. The S&P 500 managed to add to its annual return nominally during the quarter, with most of the gains stemming from the November rally following Donald Trump’s sweeping presidential election victory as investors assessed the positive impact that his proposed policies on deregulation and tax cuts would have on corporate earnings. However, this post-election rally ended at the Fed’s December meeting, when markets began to discount fewer rate cuts for 2025 on the fear of higher inflation and valuation concerns.

As the quarter concluded, it is fair to say that markets are relatively expensive based on many traditional measures. The S&P 500 now trades at forward P/E ratio of roughly 22 times next year’s earnings. You can think of the P/E ratio as how much you would have to spend to buy a company with $1 of future earnings. The long-term average has been roughly 17 times, and looking at the past 30 years of market history, there are not many periods where the market P/E climbed above 21. If we were to assess the valuation level of the Nasdaq 100 Index, a Technology heavy index, there are certainly many parallels between the late 90s and today. Although the Nasdaq’s current forward P/E is nowhere near its March 2000 peak, it still rivals the 1999 readings. However, it is still important to note that the Technology sector has evolved immensely since the late 90s, with most Tech companies today being very well-capitalized and producing positive earnings growth.

While we certainly acknowledge that the market is not cheap, the reality is that markets usually become more expensive when times are good. Based upon the set of current economic backdrop and earnings growth prospects, current levels may be justified. According to analysts’ consensus, U.S. companies grew earnings by 10% in 2024 and are expected to grow earnings by 13% in 2025. That is far above the 10-year average of 8%. Also, it is important to note that the dominance of many mega-cap growth companies in market indices has skewed valuations much higher. Take, for example, the Magnificent Seven, which is over 30% of the S&P 500. Since this group trades at a P/E level in the mid to high 30s, it has naturally asserted more influence on the index’s overall P/E ratio. Additionally, there are still many areas of the market that are fairly or even cheaply valued when shifting focus away from the mega-cap growth segment. In particular, many large- and mid-cap value stocks trade in most cases in the 13x – 16x forward earnings range.

International stocks provided very disappointing returns to close the year. Developed market stocks posted low single-digit gains, while emerging market stocks fared slightly better. Both categories lost most of their annual gains because of foreign currency weakness following the December Fed meeting. With the Fed slated to cut rates less aggressively, this caused the U.S. dollar to appreciate substantially against most foreign currencies, which in turn translated into losses for non-U.S. dollar-denominated investments. Although valuations are historically cheap in the international realm, the long-term structural growth issues and geopolitical risks that continue to plague Europe and China are why we continue to maintain a U.S.-centric investment theme across investment strategies.

FIXED INCOME

The bond market experienced significant fluctuations in 2024. The 10-year Treasury yield started the year below 4.00%, reached a high of 4.70% in April, dropped to 3.63% in mid-September prior to the Federal Reserve's initial rate cut, and ended the year around 4.58%. The U.S. Aggregate Bond Index started the quarter with a gain of nearly 5%. However, the move up in yields because of the Fed’s December meeting and concerns over higher inflation caused U.S. bonds to lose most of the annual gain in the final months of the year. As a result, the bond market struggled, providing slightly positive returns for 2024.

Interest rate volatility caused long-term bonds to perform poorly during the quarter, with long-dated treasuries   (10–20 years) losing approximately 8% of their value for the period. Intermediate bonds (3-7 years) posted losses in line with the broad bond market. Short-term bonds (1-3 years) on the other hand were little changed for the quarter.

When evaluating the bond market’s sector performance for both the quarter and year, the lower-quality segments thrived while higher-quality credit struggled. Convertible bonds led the way with low-double-digit returns for the year. While high-yield credit posted high single-digit returns to close 2024. Intermediate-term treasuries and high-quality corporate bonds substantially underperformed their lower-quality peers, posting low single-digit returns to end the year.

2025 MARKET OUTLOOK

The U.S. economy is entering 2025 in a strong position, with real GDP expected to grow by 2.0% - 2.5%. With the Fed expected to cut interest rates by an additional 0.5%, credit conditions should remain favorable. The labor market is also close to full employment, and productivity is now above pre-pandemic levels. Despite a favorable outlook, uncertainty around inflation trends and President Elect Trump’s policies remain key risks.

We are maintaining a positive outlook on U.S. stocks to start 2025, which is supported by the potential for lower inflation, projections for 13% earnings growth, and broader market participation than in 2024. In 2025, policy is a key focus. While tax cuts were the highlight in 2017, tariffs and immigration may take priority in 2025, along with a possible extension of the Tax Cuts and Jobs Act (TCJA). History shows that policy changes often bring market volatility and impact sector performance. For instance, the TCJA boosted cyclical sectors like Technology in 2017, while trade tensions in 2018 favored defensive sectors as markets declined. With growth stock earnings expected to slow, next year may see a more balanced performance between growth and value stocks.

Policy and market uncertainty are expected to increase in 2025, driven by proposals from the incoming Trump administration. Bond analysts forecast the U.S. 10-year Treasury yield to range between 4.00% and 5.25%, with a midpoint of 4.63%, based on inflation projections and the Fed's expected rate cuts. Yields above 5.25% would likely indicate inflation exceeding 3.25% for CPI. Historical data linking Treasury yields to nominal GDP growth supports the midpoint target. The Fed is expected to cut rates by 0.50% in 2025, which could slightly steepen the yield curve in the second half of the year. With current yield levels and continued uncertainty surrounding inflation, the intermediate-term structure of the yield curve may offer long-term bond investors more insulation from interest rate volatility in the year ahead.

As your financial professionals, we are dedicated to keeping you informed about the changes that might impact your unique circumstances. Our commitment is to offer you quality service and ensure your investments align with your goals, time horizon, and risk tolerance. We deeply appreciate the trust you have placed in our firm.