2024 Quarter 4 Commentary

“It’s kind of common-sense thinking that when the path is uncertain, you go a little bit slower. It’s not unlike driving on a foggy night or walking into a dark room of furniture. You just slow down.”

- Federal Reserve Chairman Jerome Powell

The quote above is from Federal Reserve Chairman Jerome Powell’s most recent press conference, in which the Fed announced another quarter percent cut to the Fed Funds rate, while simultaneously signaling that they would hold off on further rate cuts given that inflation’s downward trend has stalled. The chart to the right tells the tale. The two primary measures of inflation, Core Personal Consumption Expenditures in red and Core Consumer Price Index in yellow, show that price increases have diminished since 2022, but that rate of decline has slowed in recent months. Despite this, the Fed cut rates aggressively in September by a half percent, followed by two quarter percent cuts in November and December. While it is difficult to know the minds of the voting members of the Fed’s Open Market Committee, there was a prevailing belief back in September that inflation would resume its decline. When that did not materialize, a decision was made in December to delay further rate cuts.

The chart to the right shows how this delay is materializing. The September expectations among Fed members for the level of interest rates in 2026 and 2027 are shown as a black dotted line. It depicts a trajectory of continued, quicker reductions through 2025 to a terminal level in 2027 just under 3%. The updated December expectations, shown as a red dotted line, depict a slower more deliberate reduction over the next two to three years, reaching a terminal rate at just above 3%. This adjustment for expectations had an immediate impact in equity markets, which faded somewhat as 2024 closed.

Despite the stubbornness of inflation data, the overall picture of the U.S. economy has been surprisingly resilient. In aggregate, the economy can be said to be outperforming expectations. The most recent quarterly GDP result for Q3 (ended September 30th) was originally reported as increasing by 2.8% (seen in the chart below). In late December, that figure was revised upwards to 3.1%. (Q3 Revision) A primary takeaway from this reading is that, while generally higher levels of interest rates were originally expected to moderate economic output, that moderation has not materialized. Much of the strength of the U.S. economy can be attributed to the U.S. consumer, which continues to spend. As a matter of fact, U.S. consumer spending rose 0.4% in November, with retail sales up a strong 0.7%. (Consumer Spending) Looking ahead, the Atlanta Fed’s GDPNow estimate for Q4 GDP growth currently stands just above 3%, pointing to signs of continued economic expansion.

The equity markets have had a very strong 2024, with the Russell 1000 Index (large cap stocks) gaining 24.5%, the Russell Midcap index up 15.3%, the Russell 2000 Small Cap Index up 11.5%, and the MSCI All Country World Index ex-U.S. up 5.6%. Investors again showed  strong preference for domestic stocks. The chart below gives some insight on the rationale behind this difference.

Simply put, there are periods of time in which U.S. stocks outperform international stocks. We have been in an extended period- almost 14 years- in which U.S. stocks have done better than their international counterparts. Some of that can be attributed to better economic performance, although typically the global economic growth rate is higher than the U.S. alone. The chart does illustrate another factor, which is the U.S. Dollar Index. This index measures the value of the U.S. dollar versus a basket of other currencies. When the U.S. dollar is strong relative to other currencies, domestic stocks tend to outperform. When the U.S. dollar weakens, the reverse happens. At one point in late September, the MSCI ACWI ex-U.S. index was up more than 15%. After the U.S. election however, the dollar rallied, which lead to international stocks fading to close the year. Currency movements can be very difficult to predict. If interest rates in the U.S. remain elevated for a longer period of time, this could attract more investment in U.S. dollar denominated debt, which would support the value of the U.S. dollar, thus potentially extending the gap between U.S. and international stocks.

With two strong years of double-digit gains in stocks, investors may begin to question how much stocks can go up in 2025. Such questions could lead to consolidation early in 2025 as investors “take some money off the table.” However, it is important to note that, given the strength in the economy, such consolidating activity should be viewed as an opportunity to buy, not to panic. Another positive note for stocks has been the growth in earnings. Since the third quarter of 2023, corporate earnings have been posting positive results, with S&P 500 company earnings growing 5.8% for the recently completed third quarter. Expectations for Q4 are for 12% growth among those same companies (see chart). Results will begin posting in late January. For the full 2025 calendar year, earnings are expected to growth between 12 to 14%. While such results do not necessarily prevent markets from pulling back, they do offer support for stocks prices.

The strength in the preceding year in the stock market has also had outsized effects on treasury and the bond market, and in particular intermediate as well as long term securities. Over the past month we’ve seen drastic increases in the 5-, 10-, and 30- year yields and currently these bonds are reaching discounts not seen since prior to the 2006. In fact, the 10-year yield has increased a whopping 14.10% from the previous year as of the time of writing and potentially more as of the time of publication.

Historically, given the Fed’s interest rate cuts, market participants might expect yields to drop (and consequently, bond prices to rise). This is a sensible expectation for two reasons. First, shortterm yields typically correspond closely to monetary policy, meaning that lower interest rates generally mean lower short-term rates. In fact, we can see below that 3-month and 6-month yields mirror fed interest rate cuts, dropping about 20% over the past year. Second, when interest rates have decreased in the past, they have corresponded more times than not with long term interest rate decreases in addition to short term rate decreases, even if not as tightly correlated.

However, in this ‘rate cutting cycle’, we’re not seeing long term rates decrease – If anything, we’re seeing a spike. That’s because long term interest rates inherently have multiple other factors that affect them, including inflation expectations and stock market performance, in particular. Even economic news, such as a strong or weak job report can send long term yields in one direction or another.

The yield curve is now the steepest it’s been in quite a while. Since 2022 and the beginning of Fed tightening monetary policy, the 2-Year and 10-Year spread, essentially measuring the difference between the two yields, had been inverted, meaning the 2-Year was higher than the 10- Year curve. This inherently implies a bearish outlook for the future – inverted yield curves are anomalous for multiple reasons, and investors often look at yield curve inversion as bearish indicators. However, as a result of short-term rates dropping and long term rates rising, the curve has un-inverted for the first time since 2022.

Stakeholders have different explanations to explain why the long end of the yield curve is rising. Inflation fears are regarded as one of the biggest factors. If inflation erodes the long-term purchasing power of fixed income (which it does), then market participants require additional yield to make up for that discrepancy and yields increase. This can also be a secondary implication of a strong jobs reports, with good jobs data or GDP implying continuing inflation and increased interest rates as well.

In addition to those expectations, bond market is also affected demand for the products, as most securities are, and inadvertently by stock market demand. For example, the domestic stock market had one of its best years in quite a while, driven in part by AI excitement. If markets see a mad dash out of AI stocks given decreased expectations or some other geopolitical issue (i.e. pandemic, conflict), we yields may drop significantly as investors look to shelter in the fixed income market. However, yields would have to continue to rise to attract investors if stock performance continues to streak.

Unfortunately for consumers, long-term yields not only affect bond yields but also other consumer loans as well as asset backed securities. For example, mortgage rates reached a nadir in September 2024 but have hiked since that time and have increased to the highest levels since May 2022. Home buyers waiting for interest rate decreases to affect mortgage prices may be now stuck in limbo as home prices have increased while mortgage rates stayed the same. Refer to the Freddie Mac data below for detailed rate history.

Despite the recent increase, mortgage rates don’t necessarily correlate one for one with the ten-year yield. For example, one significant factor is home prices, which have continued to grow despite the squeezing of consumers’ wallets with increased mortgage rates. Since lows of almost 2% in 2021 and 2022, these prices have continued to increase. As seen below, Redfin data for the state of Maryland shows housing prices have continued to climb even despite increased mortgage rates.

Interestingly, these interest rate increases have also moved in conjunction with a great stock market correction over the month of December. As we’ve often discussed, investors sometimes consider fixed income a ‘ballast’ – the dead weight at the bottom of a ship that keeps it upright passively; this is an apt metaphor for an asset class that should have a low correlation with stocks. However, this metaphor has its limits because the correlation between equity and fixed income markets may fluctuate in vast swaths over time.

Regardless, after the United States presidential election many large cap stocks saw gains reaching after investors saw what could potentially be an administration more friendly to the tech sector win. Using SCHG as a proxy for large cap growth stocks, we saw significant gains until midDecember. However, the quick give also came with a quick take, stocks remained volatile over the next few weeks.

This volatility was a minor bump on a year that was significantly and overwhelmingly positive for investors, across all domestic equity asset classes. This didn’t extend to international allocations. Emerging markets, which rely on the performance of Chinese stocks especially, have fallen a whopping 6.57% since election day. Some of this performance can be attributed to expectations for tariffs imposed on foreign nations and emerging markets darlings. If tariffs are implemented, market participants generally expect the foreign currency to weaken against the dollar and that country’s stock market to perform poorly. We can examine whether this expectation is reasonable given current valuations, but given poor governance in some of these countries it remains to be seen whether performance will continue.

As we rebalance client accounts as part of our January rebalancing schedule, we are keeping these valuations, particularly the current domestic stock valuations, as well as rising bond yields, in mind. In a year where we saw equity performance trump fixed income – even with the best returns for fixed income in years – this may be adding to our fixed income reserves for our more conservative clients, while also considering the valuation expectations for an administration that seems to wield tariffs liberally against friends and foes alike.

Thank you and stay safe!