January 6, 2025

2024 Wrap-Up: Another strong year in equity markets as solid growth offsets inflation concerns.

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Fourth Quarter 2024: The quarter and year at a glance

Despite some fits and starts during the fourth quarter and a softening of the post-election bounce in the final half of December, equity markets booked another positive year in 2024.¹

Gains continued to be uneven, with US stocks, especially large growth and technology-oriented companies, far outpacing other segments.

The Fed followed through on delivering rate cuts, dropping the Fed Funds rate target range by 100bp over 2024, but Chair Powell signaled that future cuts would likely be less than the market had initially expected, which led to a steady rise in longer-term bond yields.²

The ‘higher for longer’ path of interest rates has resulted from slower than hoped for progress on bringing inflation back down to the Fed’s 2% target and the continued solid growth delivered by the US economy.

On the economy, the unemployment rate has increased, but labor markets remain relatively healthy and both GDP growth for the third quarter and consumer spending through November came in above expectations.³ Chair Powell has repeatedly said that the path of rate cuts will be “data dependent,” and the data on both the inflation and employment dimensions of the Fed’s dual mandate so far has not supported more aggressive easing.

The S&P 500 rose over 20% for the second consecutive year.⁴
US large cap growth stocks rose 35.86% for the year, well ahead of small cap and international equities.⁵
The Fed cut rates by another 25bp in December but signaled that they expect to make just 2 more 25bp cuts in 2025.⁶
Third-quarter earnings for the S&P solidly beat expectations, rising 8.7% from a year earlier.⁷
Consumers continued to spend, with retail sales up more than forecast for both October and November.⁸
Existing home sales rose in October and November and are now up 6.1% from one year ago, the largest year-over-year gain since June 2021.⁹
Inflation rose slightly more than forecast in the latest month.¹⁰
The yield on the 10-year Treasuries ended the year at 4.58%, up 63bp from the start of the year and 95bp since the September rate cut.¹¹

Stocks post another solid year, but gains remain concentrated

U.S. equity markets posted a second straight year of over 20% gains, the first back-to-back annual gains of that magnitude since 1998/99.¹²

Stocks rallied after the election and into early December but sold off after the Fed’s December meeting, with small cap and international stocks down sharply. The gains for the year were supported by generally strong corporate earnings as well as increased growth expectations from assumed (future) changes in regulatory and tax policies and continued excitement around the potential for AI. The market weakness at the end of the year reflected lower expectations for Fed rate cuts in the face of stubbornly high inflation.

US large cap growth stocks led for the quarter and are up over 30% for the year.¹³
Small-cap stocks rallied immediately post-election, but fell sharply in December and lagged large cap stocks substantially for the second consecutive year.¹⁴
International markets have slumped on more challenging economic conditions and potential increases in tariffs.¹⁵
- China’s equity market fell in October and immediately after the election but rebounded in December to end the year up 19.67%.
Returns for the quarter and year have been unusually concentrated in technology and technology-related sectors.¹⁶
- Traditionally more defensive sectors (utilities, real estate, health care, staples) lagged for the fourth quarter and full year.
- The rally in stocks post-election showed the top and bottom segments partly influenced by political developments.
  - Consumer discretionary stocks topped returns on a post-election surge for Tesla.
  - Financials rallied in Q4 on rising rates and potentially more favorable regulatory changes.
  - Healthcare stocks fared worst on concerns of regulatory changes for drug makers.

Source: S&P Dow Jones Indices [17], MSCI [18] NASDAQ [19]

Rising long-term rates challenge bonds

While the Fed continues to bring down short-term rates, longer term rates have increased since the Fed’s 50 basis point rate cut in September.

The 10-year Treasury yield rose 77 basis points during Q4 and is now up 95 basis points from the September rate cut.²¹ The Fed cut rates a further 25bp at their December meeting, but signalled that they expect just two rate cuts totalling 50bp in 2025, much less than investors had expected earlier in 2024.²²

Fixed income returns were negative in Q4 outside of the shortest maturity treasuries and more equity-like high yield.²³
The “barbelled’ result also characterizes the full year as short duration and higher credit risk (high yield, preferreds, emerging market debt) posted returns above 5%, more than double the returns of other sectors.
International bonds declined most for the quarter and were the only category posting negative returns for the year.

Mixed results in private markets

Private credit funds continued their strong recent performance, both for direct lending and other private credit categories. Many new private credit funds have been launched this year as assets have flowed into the category.

Private real estate funds continue to post the weakest returns, but the latest quarter and now year-to-date has been positive. Private infrastructure funds have been a bright spot in real assets.

Private equity returns remained strong through September, although results vary across managers. There continues to be uncertainty as distributions of invested capital have slowed as managers and owners await better exit opportunities.

Source: Cliffwater Perpetual Alternative Funds Report, September 2024

Stubborn inflation sparks fears of a 70s-like “second wave”

As we have noted in past commentaries, the Fed has a dual mandate to maintain price stability and to ensure full employment.

For much of the past two years, inflation has been the primary focus. Investors' expectations were that gradual improvements in inflation would allow the Fed to shift the balance of their policy focus to the employment side of the mandate, ushering in a shift to a rate cutting cycle. Unfortunately, inflation has proved to be stubbornly high, while employment, though slowing, has remained solid.

The chart below is an update of one we shared in last month’s commentary that showed the “second wave” of inflation that occurred in the 1970s. Part of the reason this 1970s deja-vu concern has surfaced is the recent patterns in inflation.

The latest release of the Personal Consumption Expenditures Price Index (PCE), the measure the Fed tends to focus on, showed an increase in inflation in November following a similar increase in October.²⁴

You can see the uptick in the PCE in the chart below.

Source: Bureau of Labor Statistics, Apollo Global Management. [25]

The comparison to the 1970s pattern is tempting, but the level of inflation currently is several percentage points lower now than it was in the 1970s. In addition, energy price spikes drove the resurgence in inflation in the 1970s second round (the price of oil more than doubled in 1979) while energy prices currently have been relatively stable.

Finally, Fed officials learned some valuable lessons over the years since the 1970s cycle about the effectiveness of monetary policy tools in balancing their dual mandate of low inflation with low unemployment.

Economic conditions remain strong

Because monetary policy works with lags that are “long and variable,” the fear is that the Fed kept rates too high for too long, increasing the risk of a recession at some point in the near future.

While there are certainly pockets of weakness in the economy, broader measures like GDP and corporate earnings continue to show solid growth. Labor markets also remain relatively healthy, with a gradual increase in the unemployment rate to 4.2% most recently from a low of 3.4% in April of 2023.

Employment is not considered a leading indicator of economic activity, so its relatively low level is not necessarily predictive of future economic activity. Still, so far, the restrictive monetary policy the Fed has maintained has not led to a recession, and the investors appear to have priced in the Fed achieving its dual goals and a “soft landing.”

Source: Bureau of Labor Statistics. [26]

The relatively solid path of the economy and an expectation that the Fed has managed to engineer a “soft landing” is reflected in a steady improvement in consumer sentiment.

Sentiment can be volatile, but the chart below shows a generally strong improvement since the low point in June of 2022, the same month inflation hit its recent high point of 9%.

Sentiment has improved noticeably since then, with consecutive increases in the two readings since the election. While higher growth expectations underlie the rise in sentiment, the survey also shows an increase in expected inflation, with year-ahead inflation expectations rising from 2.6% in October to 2.8% in November, the first month-over-month increase since May.

Source: University of Michigan, St. Louis Fed FRED database. [27][28]

Stocks are Expensive — Implying Weaker Future Returns?

With a second consecutive year of over 20% gains for the S&P 500, certain segments of the equity market have become expensive on many measures relative to history.

The chart below plots historical observations of the price-to-forecast earnings ratio (“forward P/E") for the S&P 500 vs the subsequent 3-year annualized return for the index. The current forward P/E ratio of 21.8 implies just 2.9% returns over the next three years. But the range of subsequent 3-year return outcomes is fairly wide with just as many strong returns as weak returns historically. Still, any further increase in the forward P/E historically has led to much more consistently negative future returns.

Of course, the S&P 500 is not the entire market and some parts of the market are actually very inexpensive relative to the S&P (for example, small cap, value, and international).

As we noted in our October commentary, a small set of companies, the “Magnificent 7”, have accounted for an unusually large share of the gains in the US equity market, but have also accounted for a substantial share of the market’s earnings growth. These companies are primarily responsible for the lofty valuation position of the S&P 500 in the chart and so the trajectory of their earnings growth (both forecasted and delivered) will largely determine where the subsequent returns will plot.

Outlook for 2025

Politics dominated much of the discussion in the fourth quarter, but ultimately investors care most about the pace of economic (and corporate earnings) growth, inflation, and the path of interest rates.

On those dimensions, we believe that investors have currently priced in the following conditions for 2025:

Continued strength in the economy driven by:
- Consumer spending remaining robust
- Fiscal policy still being expansionary
- The growth potential from AI investment and innovation.
- We also expect economic growth to remain higher in the US than in most other parts of the world.

Inflation likely to stay above Fed’s 2% target as a result of:
- Continued strong demand
- Potential tariffs
- Changes in immigration policies tightening the labor force

Interest rates remaining “higher for longer”
- As long as inflation remains stubbornly high and the economy stays healthy

For the market, the most important risk are:

Resurgence of inflation, forcing the Fed to raise rates and threatening the trajectory of economic growth
Weaker earnings growth outlook for the bellwether US market leading companies
Geopolitical risks:
- Continued or escalating conflicts in the Middle East and Ukraine-Russia
- Trade wars from aggressive tariff implementation
- China’s economy weakening substantially
Unsustainable federal debt

Investors have already begun to adjust to the shifts in expected inflation and interest rates. Those changes do not seem to be undoing the baseline assumption of a soft landing for the economy.

Indeed, the Fed lowering rates, even if less aggressively than expected a year ago, should increase growth expectations. That could support equity markets gains in the near term.

On the other hand, the higher path for interest rates relative to the expectations earlier in 2024 may continue to challenge traditional fixed income returns, but could allow for better returns from the private side of that market.

Across asset classes, the case for continued strong returns comes down to the fundamental strength of the economy. Investors should watch closely how those fundamentals evolve in the face of the risks and policy challenges that will certainly arise during 2025.

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Atomi Financial Group, Inc. dba Compound Planning (“Compound Planning”) is an investment adviser registered with the Securities and Exchange Commission and based out of New York. The views expressed in this material are the views of Compound Planning through the period ended January 3, 2025 and are subject to change based on market and other conditions.

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