January 8, 2025
Executive Summary
Equity markets registered significant gains in 2024, underpinned by healthy economic growth in the U.S. Fixed income portfolios recorded modestly positive returns for the year, with yields falling for short maturity issues and rising for bonds of longer duration. Resilience of the U.S. economy defied widespread expectations of a slowdown, while many overseas economies struggled to gain steam. Looking ahead, foreign economies are expected to grow moderately while momentum in the U.S. is likely to endure, driving another year of healthy corporate profit growth.
The Economic Year in Review
At the outset of 2024 the consensus expectation was for subdued economic growth in the U.S. Several reliable indicators pointed to recession, including the Index of Leading Economic Indicators and the inverted nature of the yield curve. Instead, growth persisted at an above-average rate of close to 3% for 2024, overcoming the burden of sharply higher interest rates instituted by the Federal Reserve during the prior two years. Consumer spending, the linchpin of U.S. economic growth, remained robust. Despite elevated interest rates and the lingering effects of above-average inflation, households had the wherewithal to spend liberally. Most workers who wanted a job had one and wages rose faster than inflation last year. The unemployment rate inched up to 4.1% from near a fifty-year low of 3.7% at the start of the year but remained quite favorable by historical standards.
U.S. Unemployment Rate - Past Forty-Five Years (log scale)
Source: Bloomberg
Additionally, household net worth reached all-time highs, lifted by appreciation in financial markets and real estate. Domestic business activity was also healthy. Corporate profits grew by more than 10% and capital spending was strong in key areas including construction, infrastructure and technology equipment enabling artificial intelligence. Overseas, the eurozone faced political upheaval in the two biggest countries, Germany and France, while the region teetered on the brink of recession. China’s economy decelerated substantially, buffeted by a shrinking population, turmoil in the property market, harmful deflation and subdued consumer spending. Dramatic government measures to spur growth are being instituted by Beijing but their effectiveness is in doubt. Geopolitical risks were more prominent than usual, but with little measurable impact on financial markets. Overall, the year was characterized by notable strength in the world’s largest economy compensating for lackluster activity in much of the world.
The Outlook for 2025
Economic growth in the U.S. picked up at the end of last year and the momentum should carry well into the coming months. Higher interest rates triggered many indicators that had historically preceded recessions, but there are scant signs of contraction ahead. Labor productivity, a key measure of economic vitality, was strong through 2024 and has the potential to remain elevated as capital spending and technological advances like AI boost worker efficiency. The forthcoming change in the political makeup has lifted business sentiment, which is likely to spur further investment. The Small Business Optimism Index registered its largest monthly increase on record in November, a reading likely to foretell solid activity in the period ahead.
NFIB Small Business Optimism Index
The NFIB Small Business Optimism Index registered its largest monthly increase on record in November.
Source: Bloomberg
In September, the Fed began reversing the rate hikes from 2022 and 2023, and has now cut rates by 1.0%, which with the typical lag time, should stimulate growth later this year. The 2017 tax cuts largely aimed at stimulating business investment and hiring were scheduled to expire at the end of this year but are now expected to be extended, and other tax cuts are possible. Additionally, a preponderance of regulations imposed in recent years is likely to recede some, helping promote commercial activity. U.S. political changes also present challenges to the economic outlook. Proposed tariffs have the potential to be destabilizing and inflationary, while immigration policy could disrupt the labor market and impede growth. Moreover, if all the new administration’s planned tax cuts were to pass, the fiscal deficit would rise to disquieting levels, even under optimistic scenarios for economic growth and government efficiency. The international outlook remains convoluted. China, the world’s second largest economy, could benefit from government stimulus measures but may also have to contend with a renewed trade war. European Union economies will also face uncertainty around trade policy, but new political leadership in several major nations holds promise for more favorable growth trends. On balance, the outlook for the U.S. economy is encouraging and 2025 is likely to be another consecutive year in which global growth is sustained by American economic vigor.
Fixed Income
Bond portfolios registered slight gains in 2024, despite a rise in long-term yields. For the year, the term structure of interest rates changed significantly. From mid-2022 until late last year the yield curve was inverted, with interest rates on short-term bonds higher than those of longer maturities. That unusual condition reversed in the final months of 2024, as the Fed slashed its overnight lending rate by 1% to 4.5%, while long-term rates rose.
2-Year / 10-Year U.S. Treasury Yield Spread
The 2-year / 10-year U.S. Treasury yield spread turned positive in the fourth quarter after being inverted for over two years.
Source: Bloomberg
The yield on the ten-year U.S. Treasury Note finished 2024 at 4.6%, up from 3.9% to start the year. Inflation moderated during the year to a 2.7% rate for the U.S. Consumer Price Index, prompting the Fed’s rate cuts and widening the spread between bond yields and inflation. The divergence of the Fed’s target rate and longer-term yields suggests that investors may be questioning the durability of inflation’s downward path. Higher long-term rates may also be signaling concern over the relatively high federal budget deficit and diminished prospects of it shrinking. In client bond portfolios we have been weighing the impacts of inflation and budget deficits, and selectively adding high quality bonds of medium duration to take advantage of attractive yields.
10-Year U.S. Treasury Note Yield
Source: Bloomberg
Equities
U.S. equity indices registered strong gains for 2024, with a relatively narrow group of large companies propelling the S&P 500 Index up by 25% for the year. The returns for other major equity benchmarks spanned a wide range, with the Dow Jones Industrial average up 15%, the equal weighted S&P 500 Index gaining 13%, U.S. small capitalization stocks increasing 12%, and international stocks as measured by the EAFE Index up only 4%. Corporate profit growth of more than 10% and expectations of interest rate cuts by the Fed underpinned gains in stocks. However, with appreciation in stock prices far exceeding the rise in company earnings for the year, equity valuations have increased to historically elevated levels.
S&P 500 Index forward price-to-earnings ratio (1990-present)
Source: Bloomberg
For the period ahead, further gains in stocks after two consecutive years of strong returns will be particularly dependent on a favorable economic backdrop. Investor expectations are high and any developments that deviate from the optimistic forecasts priced into markets would trigger a pullback. A resurgence of inflation would be especially threatening to the outlook, while geopolitical strife or setbacks to the new administration’s business-friendly agenda are other potential risks. Overall, our outlook for productivity improvement and moderate economic growth in the U.S. is consistent with additional gains for stocks this year. In client stock portfolios we are emphasizing companies with consistent earnings growth selling at reasonable valuations, to position for strong returns over the course of the business cycle.