Market Outlook and Commentary
Key Updates on the Economy & Markets
Markets
There was no shortage of market-moving events in Q4. The stock market opened the quarter with a slow start in October, but the outcome of the presidential election triggered a broad rally in November. The rally faded as the year ended, although the S&P 500 trades only a few percentage points below its all-time high. The credit market was equally active in Q4, with the Federal Reserve cutting rates by another -0.50%. However, the major development was the changing 2025 outlook. The Fed and the market both now expect fewer rate cuts in 2025 compared to the end of Q3, which resulted in a sharp rise in Treasury yields in Q4. This letter recaps the fourth quarter, looks back on the 2024 stock market rally, provides an update on the economy and the Fed’s rate-cutting cycle, and looks ahead to 2025.
Looking Back on the 2024 Stock Market Rally
The past two years have been remarkable for investors, with the S&P 500 delivering strong returns in back-to-back years. 2024 was a year in which the S&P 500 set more than 55 new all-time highs. The S&P500 index posted gains of over +20% in 2023 and 2024. It marked the first time since the 4-year stretch from 1995 to 1998, and like the late 1990s, large-cap technology stocks played a major role in the S&P 500’s gains.
Economy
The U.S. economy has consistently defied expectations of a slowdown since the Fed started raising interest rates in March 2022. Economists and market participants initially expected growth to slow as the Fed raised interest rates. However, it has now been nearly three years since the Fed’s first rate hike, and the economy continues to grow at an above-trend rate. While higher rates have slowed housing demand and weighed on business investment, the U.S. economy has managed to defy expectations with solid GDP growth.
Economic growth is forecast to slow but remain solid next year, driven by the Trump administration’s pro-growth policies. The new administration’s policy agenda focuses on extending the 2017 tax cuts, reducing regulations across industries, and boosting domestic manufacturing through targeted incentives. These measures have the potential to stimulate capital expenditures, expand manufacturing capacity, and attract foreign investment to the U.S.
An Update on the Fed and Their Rate Policy
The Fed continued its rate-cutting cycle in Q4, lowering interest rates by -0.25% at both the November and December meetings for a total of -0.50%. The two -0.25% rate cuts were well telegraphed by the Fed and widely expected, but the big development in Q4 was the changing outlook for 2025. Despite the two rate cuts, Fed Chair Jerome Powell and other Fed presidents indicated they are not in a hurry to cut rates further. The change in tone follows the U.S. economy’s recent strength, which has caused the Fed to re-examine the need for additional rate cuts.
Recent economic strength has also led the market to re-evaluate its rate cut forecast. This dynamic can be seen in the bond market, where longer-maturity Treasury yields have risen sharply since the first rate cut in September. Since the first rate cut in September, the federal funds rate has decreased by -1.00%. While the Fed controls shorter-maturity interest rates, the market has more control over longer-maturity interest rates. Over the same period, the 10-year Treasury yield has had the opposite reaction: rising by nearly +1.00%. What caused Treasury yields to rise as the Fed cut interest rates? Two key data points contributed to the Fed’s decision to start cutting rates in September: falling inflation and rising unemployment. Inflation declined from 3.3% in July 2023 to 2.6% in August 2024, while unemployment rose from 3.5% to a high of 4.3%. The two trends caused the Fed to shift its focus from lowering inflation to supporting the labor market. However, since the Fed started cutting, the trends have reversed. Inflation progress has stalled since September, and unemployment has declined to 4.2%.
Heading into 2025, the Fed and the market have similar rate cut expectations: approximately -0.50% in cuts for the entire year. The question is whether they are placing too much emphasis on recent trends and underestimating the need for rate cuts. As both the Fed and the market saw in 2024, forecasting Fed policy is difficult, especially this cycle.
2025 Outlook – Key Themes to Watch
The S&P 500’s steady climb in 2024 reflects the market’s growing confidence. Investors are optimistic about the artificial intelligence industry’s growth potential. The U.S. economy outperformed expectations, growing at an above- trend rate in three of the past four quarters despite high interest rates. The stock market rally intensified after the election in November, as investors focused on the incoming administration’s policy agenda. Expectations for tax cuts, deregulation, and energy production are fueling hopes for stronger economic growth. The bond market echoes the equity market’s confidence, and corporate high-yield credit spreads are near their lowest levels in over 15 years. However, the equity market rally has made broad market indices like the S&P 500 more concentrated and more expensive. The question on many minds is whether the momentum can continue in 2025. The S&P 500 currently trades at nearly 22x times its next 12-month earnings estimate, a level not seen outside of periods like the late-1990s tech boom and the recent post-COVID recovery, when interest rates were near zero. Investors have shown a willingness to pay higher multiples, but with valuations now at extremes, earnings growth will likely play an important role in determining the stock market’s path in 2025.
The current bull market has performed in line with historical norms, but returns are often moderate as bull markets mature. This suggests that the market’s focus could shift to fundamentals and earnings as the next catalyst to push markets higher. 2025 is shaping up to be a year where companies will need to deliver on investors’ expectations to justify their high valuations.
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