Investment Overview: 4th Quarter 2024

The economy

Economic growth surprised to the upside for most of 2024 led by consumer spending. Third-quarter GDP increased at a 3.1% rate, ahead of the 3.0% growth printed for the second quarter. Importantly, consumer spending advanced 3.7%, which highlighted the continued resiliency of the U.S. consumer who account for over two-thirds of GDP. At least some of the positive economic data can be attributed to the wealth effect, as household net worth in the United States has hit a new record high buoyed by rising markets and increasing home prices. The S&P 500 capped off a second straight year posting greater than 20% gains, its strongest two-year performance since the late 1990s.

A healthy labor market is undoubtably key to continued strong consumer spending and sentiment. As of the most recent data, the unemployment rate is 4.2%, which is higher than a year ago but still relatively low by historical standards. The economy has added approximately 186,000 jobs per month on average for most of 2024, with that number increasing to 227,000 in November. Weekly unemployment claims remain benign but are edging higher and figures for long-term unemployed persons have increased, potentially signaling a tighter labor market ahead.

Inflation generally declined to more tolerable levels throughout 2024, although the fourth quarter saw evidence of “stickier” inflation data, which poses some concerns going forward. Headline CPI inflation rose 2.7% over the past 12 months, a modest increase from prior readings. The Fed’s preferred measure of tracking inflation, called the core PCE price index, rose at an annual rate of 2.8% in its most recent reading, a level that is modestly above the Fed’s targeted level. Additional inflation-related data was more concerning, as the producer price index rose 3% annualized, its largest increase since early 2023. Taken as a whole, the inflation data is now closer to targeted levels, but some worries of a resurgence of inflation have surfaced.

December’s Federal Reserve meeting saw another quarter-point rate cut, and the Fed Funds rate is 1% below where it started the year, now standing at a range of 4.25%-4.50%. However, the cut in December was accompanied by hawkish language noting still-stubborn inflation rates, therefore the path to even lower rates will likely come at a slower pace than originally anticipated. Following the meeting, yields on longer-dated treasuries rose, and the benchmark 10-year Treasury Bond ended the year yielding over 4.5%, which is 80 basis points higher than the bond’s yield prior to the Fed’s first cut of the year in September.

In contrast to the positive state of the consumer, the manufacturing side of the economy has resided in contractionary territory for 25 of the past 26 months. However, December’s ISM reading increased to 49.3, its highest level in over two years, as positive data with regards to new orders and production suggest that demand may remain firm in the coming months. Any sustained improvement in manufacturing would be a welcome development for the U.S. economy.

Across the globe, geopolitical tensions are high and may continue to escalate, posing an elevated risk profile. These conflicts may adversely affect trade, consumer behavior, and impact commodity prices. Further, the incoming administration is expected to increase tariffs, which is likely to further restrict international trade and could impact supply chains as well. Most major countries continue to wrestle with slow growth, and several central banks are easing monetary policy, so far with limited progress to show for it. China appears willing to implement large stimulus programs to reignite growth, but uncertainties are still prevalent for the world’s second-largest economy.

The U.S. economy continues to shine on a relative basis globally. With the election behind us, the markets appear to be looking forward to a backdrop of less regulatory burden and favorable tax policies. A soft landing for the U.S. economy is now the base case, and stands in contrast to a difficult global backdrop, where more political uncertainty and a far more challenging growth profile exists. Perhaps the biggest risk facing U.S. markets is this favorable backdrop is at least close to fully priced-in, so the ability to repeat upside surprises in 2025 may be limited.

Fixed income

Interest rates increased significantly over the fourth quarter on all but the shortest-maturity bonds, despite a 25 basis-point mid-December Fed Funds rate cut. This marks a reversal from the third quarter where investors witnessed falling rates and spectacular bond-market performance.

The 10-year Treasury Bond finished the year at 4.57%, up from 3.78% at the end of the third quarter. As bond prices move inversely to interest rates, bond market performance suffered. The Bloomberg U.S. Aggregate Index was down over 3% for the quarter and is up a meager 1.25% over the last 12 months. The Fed Funds target range now stands at 4.25%-4.50%.

The bond market ended its 26-month inversion (the longest on record) during the third quarter with the yield curve gaining positive slope over the most recent quarter. The 10-year Treasury now yields almost 30 basis points more than the 2-year, reflecting a more “normal” maturity structure. Historically, inverted curves have been reasonable recession indicators. However, economic readings and a still healthy employment backdrop suggest a recession isn’t likely to materialize at least over the next several quarters.

Much of the bond-market selloff may be attributable to recent Fed comments. While officials indicated that labor market conditions have eased, and inflation readings have progressed toward their 2% objective, officials also stated that inflation remains “somewhat elevated.” In conjunction with their statement, the committee also updated their economic projections, which reflected just two rate cuts in 2025, a revision from its September forecast that suggested four cuts were in order.

Treasury yields are now at the upper end of their two-year range, driving 30-year mortgage rates back up near 7% which may affect housing demand. Some investors are also expressing concern that the tough environment for bonds may persist if President-elect Trump pursues inflationary policy changes relating to global trade (tariffs) and labor markets (immigration).

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Equity markets were choppy over the fourth quarter. While the S&P 500 Index was up a respectable 2.4%, investors reverted to favoring growth-oriented stocks (up 6.0%) over their value counterparts (down 2.7%). Meanwhile, international stocks experienced a significant selloff with both developed and emerging markets decreasing approximately 8% on an unhedged basis.

Market momentum stalled in mid-December after Fed officials signaled a revision to their rate-cutting campaign, suggesting two rate decreases rather than four in 2025. Economically sensitive stocks such as small caps pulled back from the highs they set after Trump’s election victory. Smaller companies generally benefit as the Fed lowers interest rates given that the group tends to issue more floating-rate debt compared to larger firms.

Despite a generally lackluster finish to the year, U.S. stocks posted strong returns in 2024 with the S&P 500 finishing up an astounding 25%, notching 57 record closes, and posting its best consecutive years since 1997 and 1998. Investors were certainly spurred on by healthy economic growth, lower inflation, and optimism over the prospects for big technology firms and artificial intelligence applications.  

We remain concerned with the valuation of U.S. large-cap growth stocks. The Magnificent Seven (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla) accounted for about one half of the total return for the S&P 500 in 2024. Nvidia alone made up over 20% of the return, as the maker of artificial-intelligence chips saw its market value leap past $3 trillion. The S&P 500 now trades at roughly 22 times its expected earnings over the next 12 months, above its 10-year average of 18.5 times.

We continue to find the valuation of smaller-capitalization stocks compelling. Relative to large caps, small caps are trading at discounts similar to the Nifty Fifty era of the 1970s and the dot-com bubble of the late 1990s. In the aftermath of both periods, small-caps went on regain leadership and significantly outperform their blue chip counterparts.

Moving into 2025, uncertainty abounds on the political front. Stocks performed well after the Republican November election sweep on hopes of tax cuts and regulatory reform. However, recent proposals from the incoming Trump administration suggesting extensive tariffs and mass deportations have quelled optimism and ignited fears of slower growth and rising inflation.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

Fourth-quarter sector returns reflected a rotation back into growth stocks on the back of a potential slowdown in the Fed’s pace of rate cuts coupled with speculation on impending Trump second-term agenda policy reforms and their effects on specific industries.

Three of the four top-performing sectors representing the rotation back into growth exhibited strong quarterly performance. The Consumer Discretionary, Communication Services, and Information Technology sectors were up 14%, 9%, and 5%, respectively.

The Financials sector, up 7%, was the lone cyclical sector to post positive performance for the quarter. Investors anticipated that potential tax and regulatory easing, including a reduction in the corporate tax rate, could spur investment banking and bank lending as we move into 2025.

The Health Care sector, down over 10%, continued to lose momentum during the quarter over concerns about a range of policies from the new administration. In particular, the appointment of Robert F. Kennedy Jr. to lead the Department of Health and Human Services has pressured drugmakers given Kennedy’s vocal opposition to vaccines.    
 
For the year, names tied to the artificial intelligence theme dominated stock returns. Nevertheless, stocks from many industries also contributed to the rally that resulted in the S&P 500 returning 25%. The financial sector climbed 28% for the year, while the utilities and industrials segments gained 20% and 16%, respectively.

As we move into 2025, hopes of broader stock market participation abound given an economy that continues to perform well, continued Fed easing, and renewed investment in infrastructure.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).