A Look Back, A Look Ahead

Market Performance: Total return

Let’s start with the markets. U.S. stocks and bonds largely declined in December. What happened?

I think the markets got a little euphoric in early November post-election. That set the foundation. Elevated rates continue to defy market expectation. Indications of U.S. economic strength is causing the Fed to be less dovish in their narrative. Additionally, the markets are coming to grips that the proposed incoming policies, particularly new tariffs and reductions in segments of the labor force, are inflationary in nature, which strips away a path to push rates lower.

Can you breakdown December’s performance?

The S&P 500 Index in December was down about 2.4% but is up 25% for 2024—an outstanding year. The S&P 500 Equal Weight Index was up 13% for the year, but it was down about 6.25% in December. Meanwhile, the Russell 1000 Growth Index—led again by tech stocks—was up slightly in December and for the year returned an amazing 33%. The big loser on the equity side in December was the Russell 2000 Value Index, which was down 8%, though it finished the year up 8%.

Magnificent 7

How did the Magnificent 7 fare?

December was a risk-off market, but it was still positive for the Mag 7. It was interesting to see a big flip from November to December. Prior to December, the Mag 7 had lost its place as the leading contributor to the S&P’s 2024 returns, but last month, it took the lead again. Another thing that caught my eye was Tesla finished the year up 62%--with much of those gains coming during the fourth quarter. For the year, six of the Mag 7 outperformed the S&P 500, while the S&P 493 was up 12.04%. Essentially, if you picked any one of the seven, it outperformed the rest of the S&P 493.

What about fixed income?

With rates moving up, most investment-grade bonds were negative in December, but finished up a little over 2% for the year. This is well below coupon. The Bloomberg US Aggregate Bond Index (Agg) was up 1.25% for the year, again well below coupon. Meanwhile, bank loans—an asset class we’ve been constructive on for about two years—was the winner in the liquid side of fixed income, finishing up 9% in 2024. And the volatility was extremely low for loans, which meant you got strong returns with low volatility.

10-year Treasury Yields Remain Range Bound

U.S. Treasury yields rose across intermediate and long maturities in the second half of December. What prompted the move higher?

The economy has been more resilient than predicted at the start of the year, which translated to Fed’s less dovish stance. The 10-year Treasury closed the year at almost 4.6%. Expectations are now adjusting. The catalyst for rates dropping is getting smaller and smaller with the resilient economy and the expected policies from the new administration. To summarize, rates were up 70 basis points through 2024 on the curve, and market consensus that rates would drop for the second straight year incorrect.

Economic Dashboard: GDP, Inflation, Jobs, and Consumer Spending

What’s the current economic data telling us?

That economy continues to be resilient. GDPNow now estimates GDP to be about 2.7% for 2024, which is a solid number and above blue-chip consensus entering the year. On the inflation side, the current 2.5% is probably a smidge high for the central bank, but not alarming. Consumer confidence is only slightly lower than last year. Taken all together, the prints aren’t optimal, but they’re certainly in the range of a steady economy.

Fed Futures: A Reduced Number of  Expected Cuts

The Federal Reserve lowered the fed funds rate by another quarter point December, and some market commentators called it a “hawkish rate cut.” Can you unpack that phrase?

At a high level, an interest-rate cut is inherently dovish, but the Fed’s guidance around fewer upcoming cuts gives the cuts a hawkish tilt. A large part of this post-pandemic cycle uncertainty is understanding where rates and GDP will settle. The Fed is now suggesting rates are going to normalize at a higher level than people thought. This indicates that capital, at least right now, is expected to be tighter than originally thought a year or two ago.

Do you think the Fed is done with cuts for the next few months?

That’s an interesting question. Here’s where it sits today. The chances of a Fed cut in late January stands at just 5%. As for March, there’s a 30% chance. So, in the first quarter—as of today—there’s a 70% chance the Fed does not cut. For the Fed’s May meeting, the odds are 50-50, but June is really where they’re expected to make the first cut. To think we would now stop at five cuts—four in 2024 and one in the first half of this year—would leave interest rates substantially higher than the market thought just six, seven months ago. I think it would take a lot of economic data going the wrong way for them to cut in the first quarter, and I don’t see that as probable.

GDP: Year-End Forecasts for 2025 by Major Banks

The noted philosopher Yogi Berra once said, “Forecasting is very difficult, especially when it involves the future.” With that in mind, let’s take a look back at 2024 forecasts and look ahead to the new year. Starting with GDP, how did sell-side banks do with their 2024 forecast, and do you think their 1.93% prediction for 2025 is too pessimistic?

For 2024, they predicted a slow economy, with 1.2% GDP growth, and it looks like that number will come in around 2.5%, which is double what the economists thought entering 2024. For 2025, consensus is GDP growth to be around 2.5%. I think it’s going to run stronger than that, especially in the first half of the year given business expectations and confidence.

10-Year Treasury Rates: Year-End Forecasts for 2025 by Major Banks

What are your thoughts on the 10-year Treasury yield?

Consensus for 2024 was wrong on this as well. They thought rates were going to drop. For this year, the bias remains lower. We’re at 4.7% now, and estimates for 2025 are between 4.65% and 4.25%, though the media’s picking up on some who are saying it’s going to hit 5%. I still take the under on consensus, but I’ve been dead wrong for a couple years now on predicting where the 10-year Treasury was headed.

CPI: Year-End Forecasts for 2025 by Major Banks

For 2024 and 2025, the sell-side forecast for CPI—around 2.7%—has been similar year over year. What do you think?

The macro factors are around tariffs and the availability of labor. I think the Street has got it mostly right, but my belief is the number will come in slightly under consensus in the 2.4% to 2.5% range.

S&P 500 Index: Year-End Forecasts for 2025 by Major Banks

How about the S&P 500?

Most underestimated the markets in 2024. The Street estimates had it at 4,500, and the S&P closed 2024 at almost 5,900. Now, consensus for 2025 ranges from 6,500 to 6,700, which is somewhere in the neighborhood of an 11% increase. I’ve been doing this for 25 years, and most annual estimates on equities tend to be 8% to 10% above where it closes the year. I think it’ll hit that consensus number and probably surpass it, but at the same time, it would not surprise me if it came back down, especially if inflation stays elevated.

Fed Funds: Year-End Forecasts for 2025 by Major Banks

Do you think duration will be an anchor or a sail for bond investors in the new year?

I think it will be a slight tailwind. High fours seems elevated on the 10-year Treasury. And then on fed cuts, two cuts to four cuts in 2025 is where projections sit now, but if economic conditions stay relatively the same, I think four cuts this year is
too aggressive.

Fixed-Income Yields and 2024 Returns

Credit spreads are at the lower end relative to their history. What’s the outlook for investment grade, high yield and loans?

Absolute yields are attractive. The 10-year Treasury is in the high fours. Investment-grade corporates, high fives. High yield is sitting at 7.5%—I think that’s tight relative to investment grade. I’m a bit more constructive on investment grade than high yield. And then loans still are coming in at 8.5%, and spreads aren’t as tight as they are in the fixed-rate asset classes. So, you can genuinely get 5% to 7% in fixed income and not take a ton of risk. For equities, to compensate for the risk, I believe returns need to be beyond 11% or 12%. If equities get a 10% or lower return, I’d say fixed income is the better trade.

Now it’s time for the random round. First word, phrase or question: Intel.

It feels like a dinosaur. It was the third worst performer in the S&P 500 last year. That’s incredible, but not surprising.

Will AI rule the stock market again in 2025?

I think derivatives of it will. It may not be Nvidia again; it could be other AI-related companies that start to enter that space and begin taking market share

What economic or market indicators will you be watching most closely in 2025?

I think the Consumer Price Index (CPI) is one to watch. If it starts to elevate, that to me could be a black swan. If you see CPI go to above 3%, then all of a sudden you could have another taper tantrum in there. Another thing I’ll be watching is how much the new administration will cut government spending, which could be very disinflationary. This could be a large determinant of rates because the government spending has grown to a substantial part of GDP and, in particular, deficits. If they’re able to eliminate hundreds of billions of dollars in spending, I think that matters.

Google’s new quantum AI chip, which they call Willow.

Quantum AI computing is a next-level jump for computing, and Willow’s speed is mind-blowing. It’s being reported that the chip can complete computations in under five minutes that would’ve taken today’s fastest supercomputers an estimated 10 septillion years. By the way, septillion has
24 zeros.

Honda and Nissan merger discussions.

I think it’s a strategic move to position for scale against China’s car industry. China is in Japan’s backyard and knocking on their door. They’re also knocking on markets internationally.

The second season of “Squid Games.”

I haven’t watched a single minute, but I’m watching “Beast Games.” “Squid Games” is fiction, but “Beast Games” is a reality show. One thousand people start the game, and the single winner gets $5 million. The game theory is brutal and fascinating.

The winner of the College Football Playoffs.

I grew up in Indiana, so I’m hoping for the Fighting Irish of Notre Dame, but Ohio State is the heavy favorite.

How’d you do on your 2024 resolutions?

Decent on the health resolutions and not so decent on the rest of them.

Any new resolutions for this year?

To focus on habits, not goals.

Let’s close with a personal reflection.

Over the holidays, I saw my brother, who was terminally ill and has recently passed away. Earlier this month, I flew across the country to visit him. When I got there, he was having trouble breathing and talking, but he managed to ask if I had come to the East Coast for a business meeting. I said, “No, we’re just here for you.” I found this next part out after I left the room, but apparently, he got emotional that I had been there just for him. In my mind, of course I was going to go see him. There was no debate. But when I heard his response, I got emotional, too. Since then, I’ve been reflecting once again on the power of just showing up for someone. So, if there’s someone in your life who could use your presence and  support, just show up. It will mean a lot more than you probably realize.

Definitions

10-year Treasury yield is the interest rate the U.S. government pays to borrow money for a decade.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level.

Basis points, otherwise known as bps or bips, are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

A black swan event in the stock market is often a market crash that exceeds six standard deviations, making it exceedingly rare from a probabilistic standpoint

Blue chip consensus refers to the collective opinion or general agreement among financial analysts regarding economic indicators or the performance and outlook of large, well-established companies.

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.

The Consumer Confidence Index (CCI) is a monthly report that measures how optimistic consumers are about the economy, labor market, and their finances.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

A dove prefers an interest rate policy that is more accommodative to stimulate spending in an economy.

Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.

Fed funds futures are a tool used by traders and institutions to hedge or bet on changes in the federal funds rate, which is key to U.S. monetary policy.

The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their extra reserves to one another overnight.

Fixed income refers to assets and securities that pay a set level of income to investors, typically in the form of fixed interest or dividends.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. The nominal GDP growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

GDPNow is a forecasting model that provides a "nowcast" of GDP growth.

Hawks are policy makers and advisors who favor higher interest rates to keep inflation in check

High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return.

A risk-off market happens during uncertainty, leading to safer investments.

The sell-side is the part of the financial industry involved with the creation, promotion, analysis, and sale of securities.

Spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, represented by treasury bonds. Spread income refers to the additional income from this difference.

The Street is short for Wall Street and often refers to consensus opinion of economists.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

Yield is the income returned on an investment, such as the interest received from holding a security.

A yield curve plots the interest rates of bonds that have equal credit quality but different maturity dates.

Yield to worst is the lowest potential yield that can be received on a bond without the issuer defaulting.

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