2024 Year in Review
For the second straight year, U.S. equities produced stellar returns. The S&P 500 gained 25.0% in 2024, adding to the 26.3% rise in 2023. However, similar to 2023, gains were a little misleading as returns were driven by a small subset of the largest technology companies in the index. The average stock in the S&P 500 gained a more modest 13.0% (S&P 500 Equal Weight Index) while small-cap stocks rose 8.7% (S&P 600). International equities once again underperformed U.S. markets, with the MSCI EAFE Index rising 3.8% and the MSCI Emerging Market index rising 7.5%.
Driving U.S. stocks higher throughout 2024 was strength in the markets’ main fundamental drivers. Inflation moderated to a reasonable 2.7%, economic growth hovered around 3%, corporate earnings growth accelerated to roughly 10% and U.S. employment has expanded for 47 consecutive months. Adding fuel towards the end of the year was the focus on the new administration bringing a more business-friendly regulatory stance as well as a stable-to-favorable tax climate.
Bond performance, on the other hand, was quite muted. Broad fixed income indices rose just 1%-2% in 2024. 10-year U.S. Treasury bond yields rose from 3.87% at the close of 2023 to 4.57% at the end of 2024 while 2-year Treasury yields remained stable around 4.3%. Stronger-than-expected economic performance and sticky, albeit improved, inflation restrained bond returns.
Positively, the yield curve is no longer inverted. Also, because we are in a higher interest rate environment than in the recent past, income generation of bonds is also higher. As such, bonds were still able to post a positive total return despite bond prices easing somewhat.
2025 Market Outlook
As we turn our attention to 2025, we anticipate a slower but still positive pace of equity gains. In 2023 and 2024, a strong equity environment was relatively easy to predict. As we highlighted two years ago in our 2023 Outlook, equity markets tend to perform best when the mindset shifts away from recession towards re-accelerating economic and earnings growth. Over the last two years, these benefits have played out. We now appear to be beyond the best part of the Investment Cycle. A more mature phase can still bring solid equity returns but may also produce more volatility.
2025 will likely be a year of greater crosscurrents. Various factors will likely gain attention and play tug-of-war on financial markets. Ultimately, we believe that solid economic and earnings growth fundamentals will prevail leading to higher equity markets.
Let’s delve into these crosscurrents and their impacts a little further.
Economic Trends (Positive)
Ultimately, this should play the largest role in the direction of the markets and is why we call for positive equity returns. 2024 trends should remain in place. Namely:
a) Economic growth should continue in the 2%-3% range with recession unlikely.
b) Inflation should stay modestly elevated but within a reasonable range.
c) Corporate earnings growth could be up 8%-12%.
d) Employment will likely continue to expand although may be impacted by immigration policies.
Federal Reserve / Monetary Policy (Positive but sometimes perceived as a negative)
While the Federal Reserve typically plays a significant role in market behavior, the current debate around the scale and pace of future Fed rate cuts is misplaced. The goal of the Fed is to balance containing inflation while maximizing employment. Though nearly an impossible task, the Fed will stop lowering rates when they believe they have achieved a proper balance. As such, the specific Fed endpoint (whether 4%, 3%, or 2%) is not of paramount importance because the economy will be at the appropriate level regardless. We believe the Fed is already close to achieving this balance.
Equity Valuations (Negative)
Equity valuations are high. The S&P 500 trades at a Price-Earnings ratio (P/E) of 24x 2024 earnings and perhaps 21x-22x 2025 earnings. Ideally, we would like to see those numbers below 20x. One could argue that valuations can be sustained at higher levels than historically because the largest companies in the S&P 500 are some of the fastest growing companies in the index, but valuations are not ideal. The consolation is that valuations tend to be poor near-term market predictors. Fundamentals and earnings growth play a more significant role which is how we can still forecast positive equity returns. Nevertheless, given high valuations, stock markets have less room for error.
Deficits/Debt (Negative but unlikely a 2025 event)
The United States continues to grow its debt levels at an unsustainable pace – is a sentence I probably wrote 30 years ago. Back then, U.S. debt as a percentage of GDP stood at 65%. It has risen steadily to 123% today. The continuous march higher is a real problem for our children and grandchildren because the U.S. government has essentially borrowed from future generations to benefit today’s population. Yet is this an imminent problem? The unsatisfying answer is that problematic debt levels can be sustained indefinitely – as long as the markets allow them to occur. In other words, as long as there are buyers for U.S. bonds, the U.S. government can continue to run up huge debt. So, it is unlikely that the U.S. will face an existential debt crisis in 2025 and probably not for the foreseeable future. That said, whenever the markets decide that they no longer wish to continue the charade, U.S. government borrowing costs will skyrocket to the detriment of everyone.
Politics (Positive, Negative and Everything In-Between)
A new administration and a new balance of power brings new policies and initiatives. While still uncertain, for economies and markets we anticipate both positives, negatives and sometimes, like some quantum state, pros and cons to exist simultaneously.
Positively, a more business-friendly regulatory environment as well as a stable-to-better tax climate should spur economic growth.
Negatively, while tariff discussions may be a negotiating tactic (and therefore positive), actual tariff implementations would likely be inflationary and economically counterproductive. Additionally, a restrictive immigration policy would limit labor supply thus impeding business growth.
In the quantum state category of being simultaneously positive and negative are 1) the Department of Government Efficiency (DOGE) and 2) Disruption/Chaos. Regarding DOGE, let’s ignore the oxymoron of the creation of a new government agency to make the government more efficient. In reality, no one can pretend that the U.S. government is productive nor that it does not have incredible levels of waste. Thus, the concept of fresh eyes saving the taxpayers money by reducing waste and improving productivity is actually quite desirable. The problem is that the cuts may be excessive and undermine essential functions. As for Disruption/Chaos, it is hard to know which description will be correct. Disruption is good (even if it feels bad). If you never disrupt, you never advance and you become dated and uncompetitive. Chaos is bad. It is disruption without a vision. I will let our readers decide which is the correct term for what we are about to experience.
Market Forecasts for 2025
Led by solid economic fundamentals, we forecast U.S. equities to rise 7%-9% in 2025 – positive but more muted than the last two years since we believe that we are past the best part of the Investment Cycle and valuations are higher than ideal. We also forecast greater volatility during the year as the crosscurrents described above gain prominence through the course of 2025. Still, given U.S. companies’ inherent advantages over their international peers, we would not be surprised if U.S. stocks outperform international stocks for the seventh time in the last eight years.
As for fixed income, we expect total returns in the 3%-5% range, driven primarily by income generation rather than price appreciation due to a solid economic outlook and minimal Federal Reserve rate cuts.
So now let me end my 2025 outlook as I end all my outlooks: Of course, despite our best laid plans, events through 2025 will likely conspire to force us to alter our thinking. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy, Safe and Successful 2025!
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