Markets in Focus: 2025: A Year of Certain Uncertainty

As we look toward 2025, it’s essential that we reflect on our experiences in 2024 and focus on what we can learn from those experiences.

Market Returns

It’s an understatement to say 2024 was a good year for U.S. equity markets. U.S. large-cap companies, as represented by the S&P 500, delivered a 24.8% return for the year, led by the Communication Services (+39.9%), Information Technology (+36.3%), and Financials (+30.3%) sectors. The three worst-performing sectors for the year were Materials (0.0%), Health Care (+2.6%) and Real Estate (+5.2%). [1]

Overseas, international stocks broadly underperformed U.S. stocks but most major indices were still positive. The MSCI EAFE gained 4.3%, while the MSCI Emerging Markets index finished the year up 8%.

In Fixed Income markets, high-quality core U.S. bonds, measured by the Bloomberg U.S. Aggregate Index, were up 1.2%, while lower quality high yield bonds, measured by the Bloomberg U.S. High Yield Index, fared much better by delivering an 8% return. Internationally, the Bloomberg Global Aggregate Index experienced a challenging fourth quarter, ending the year down 1.7%.

Bouts of Volatility

Broadly speaking, most of the global indices were positive during 2024, but end-of-year returns hide bouts of volatility that investors had to persist through.

In August, stocks worldwide experienced 3 days of sharp declines due to the unwinding of the very crowded Japanese Carry Trade.

A carry trade occurs when money is borrowed at a low interest rate in one currency and invested at a higher interest rate via a different currency. This allows the investor to earn the difference in rates at relatively low risk. Because the Bank of Japan has kept rates below zero for nearly 10 years, there has been a high incentive to borrow Japanese Yen.

The carry trade breaks down if there’s a sudden increase in rates that investors are borrowing, which occurred when the Bank of Japan unexpectedly raised rates twice over the course of several months. Traders sought to repay the Yen they borrowed, which led to a stock selloff in Japan as they were forced to sell Japanese stocks. This selloff spread nervousness and volatility globally, though it was short-lived and material contagion never materialized.

More recently, market expectations for Fed rate cuts were tempered at the Federal Open Market Committee’s (FOMC) meeting on December 17th and 18th. While the Fed lowered rates another 0.25% at that meeting, they reduced their expected number of rate cuts for 2025 from 4 to 2. Markets reacted to the new expectations, leading to a selloff of both stocks and bonds. The S&P 500 was down 2.4% during December, while Mid-Cap and Small-Cap U.S. stocks were down 7% and 8.3%, respectively.

Despite these periods of volatility U.S. equity market returns were strong. Short-lived shocks should never drive investors away from their long-term game plan. It's easy to get scared by news headlines or seeing your account value decline, but it’s vital that investors resist urges to make large shifts in portfolios based on market fear.

Continued Economic Strength

Market returns only tell part of the story behind the strength that we saw in the U.S. last year. There are many other indicators that show how strong the economy is.

• GDP Growth - The U.S. saw consistent, strong GDP growth in 2024. Estimates are that the final GDP growth tally will be 2.7% in 2024, even with a sub-par Q1 reading of 1.6% in the first quarter. That’s even more impressive when compared to the rest of the developed world – the United Kingdom, Eurozone, and Japan are all on pace for GDP growth of less than 1% in 2024. Growth in the U.S. continues to be led by a strong consumer, which only got stronger over the course of the year. Additionally, 2024 saw strategic investments in technology by corporations, as well as deliberate investment in infrastructure by the government.[1]
• U.S. Job Market – Fueling the strong consumer is a continued robust job market. The unemployment rate in the U.S. was 4.1%. Even though unemployment rose steadily over the course of the year (it began the year at 3.7%), it is still low by historical standards. The average monthly unemployment rate going back to 1948 is 5.7% (Federal Reserve Bank of St. Louis FRED). Additionally, wage growth outpaced inflation in 2024 for the first time since the beginning of the COVID-19 pandemic (which helps explain why the consumer remains strong). While this is a sign of strength in the labor market, it’s also a contributing factor to inflation and one of the reasons why the Fed reduced their number of planned cuts for 2025.[2]
• Easing Fed Monetary Policy – The Fed began cutting interest rates to a more accommodative level in September, where they reduced the fed funds rate by 0.50%, followed by two consecutive 0.25% cuts in the November and December meetings. The Fed faces a dual mandate – to maximize employment while maintaining a low inflation level. Think about this as a seesaw – the Fed is trying to keep the economy balanced between these two goals. Over the past few years, it’s needed to focus on bringing down inflation, and its primary tool to do that was raising interest rates.

  The recent cutting of interest rates is a sign the Fed believes it is getting closer to meeting its 2% inflation target . Lower interest rates can help to boost economic growth in a number of ways; encouraging business investment and consumer spending because it’s less expensive to borrow money, and stimulating home construction and goods manufacturing by spurring . household creation (it becomes more affordable to move out of the parents’ house).

However, the fact that the Fed pulled back on their original estimate of 4 rate cuts in 2025 implies concern over sticky inflation, one of the key risks we see for the upcoming year.

Risks and Threats

Reignition of Inflation

As we kick-off 2025, the most imminent risk to markets and the economy is another burst of inflation. Upward price pressure could come from several different sources:

• Unknown policies – While we believe many policies the Trump administration will put forward are pro-growth, some proposals could lead to economic uncertainty. Tariffs were implemented during Trump’s first presidency, and they are once again hot in the headlines given recent rhetoric. Tariffs tend to be inflationary but can also be used as a negotiation tool that leads to increased open trade. Tariff “talk”, with or without implementation, is a potential driver of short-term market volatility but any long-term effects on the economy and prices will be determined but what actual policy looks like.

  High numbers of deportations from the current workforce could also lead to economic uncertainty and inflation stickiness. Trump’s campaign trial rhetoric was aggressive on plans to deport undocumented immigrants. It is estimated that ~4% of the U.S. population fit this category and mass deportation could have a large impact on the ability to source workers and overall labor costs.[3] From an economic perspective, this could be a very expensive undertaking, and we expect the administration to carefully work through any policy implications before moving forward.

• Higher inflation could also come from continued stubbornness of housing related prices. Shelter costs comprise about 37% of the CPI basket but accounted for an average of 66% of monthly inflation during 2024. As housing supply remains low, we could see shelter costs continue to rise. Two major sources of shelter costs are the cost of rent on a primary residence, as well as a calculation known as “Owner’s Equivalent Rent”, which estimates how much homeowners would have to pay to rent their own home in the current market. Another component of shelter that has had a meaningful impact on shelter inflation are renter’s and homeowner’s insurance, which grew by 11.3% in 2023.[4]
• Finally, the prospect of lower tax rates for individuals and corporations could lead to lower tax revenues for the federal government. This may fuel higher deficit spending unless government expenditures are reigned in.

Geopolitics

Investors continue to face the threat of escalating geopolitical tensions in 2025. Ongoing conflicts, particularly in regions critical to global food and energy supplies, pose significant risks. Escalations could disrupt supply chains and increase commodity prices, leading to higher inflation and reduced economic growth.

The conflict between Russia and Ukraine crossed the 1,000-day mark in late November of last year. While the stalemate continues, there is hope an end could be in sight. In the Middle East, continued efforts by Egypt, Qatar, and the United States hope to establish a ceasefire in the Gaza Strip between Israel and Hamas. At the time this is being written there are indications that ceasefire talks continue to be productive and hope that an end to the conflict is near.

High Valuations

The U.S. stock market has had a great run over the past two years. The 26.3% return in 2023 and 24.8% return in 2024 is the 6th best 2-year period for the S&P 500 since its official inception in 1957. [1]

A stock P/E (Price-to-Earnings) ratio, a way of showing how much an investor is paying for each dollar of a company’s earnings, is one metric used to determine if stocks are expensive compared to historical reference. At the end of 2024, the forward-looking P/E ratio for the S&P 500 was about 21.5x, while the 30-year historical average forward P/E ratio is 16.9x.[5] While there may be economic reasons for higher aggregate valuations, investors should not ignore the reality check that equities ended the year more expensive than they usually are.

At the same time, high-yield credit spreads, which is the measure of additional yield an investor receives for taking on the risk of investing in below-investment-grade bonds versus safe treasury bonds, is near a historic low. The average option-adjusted spread over the past 10 years is 4.34%, but heading into the new year the spread was 2.92%.[6] Spreads are low when credit bond valuations are high – if spreads were to normalize, it would likely mean declining values in many parts of the bond market.

Higher valuations do not mandate strong returns are off the table for 2025. On average, the S&P 500 finishes a calendar year with a positive total return about 78% of the time. However, achieving similar levels of returns becomes much harder moving forward. Therefore, as part of an overall financial plan, now is a good time to make sure that your overall stock-to-bond ratio is in line with your appropriate risk level.

Looking Forward

2025 kicks off with an intriguing combination of strengths and risks. From this backdrop we expect several trends to emerge:

• Higher Volatility – Elevated valuations, continued geopolitical conflicts, and the complex nature of policies expected from a new administration, led us to prepare for more overall volatility in the markets this year.
• Stickier inflation & higher rates – There is certain uncertainty on whether inflation will continue towards the Fed’s 2% target The Fed will be locked in a constant tug-of-war between achieving price stability and low unemployment. We expect they will be successful but that this may require higher interest rates for longer.
• Increased M&A Activity – as part of the pro-growth, pro-business policies that we expect President Trump to bring to the White House, we believe that there will be an increase in M&A and other corporate activity this year with lower scrutiny from the FTC
• Artificial Intelligence – after the huge leaps that we saw in 2024 surrounding AI, we expect continued innovation and growth in Artificial Intelligence, which will lead to greater efficiencies and productivity in the U.S.

Want to read more about the markets and economy? Check out our blog post, “Starting the Year Strong: Top Ways to Enhance Your Financial Plan for 2025”

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Sources:

[1] Market data provided by FactSet
[2] Bureau of Labor Statistics, “The Employment Situation – December 2024”
[3] Wall Street Journal, “The Staggering Cost Needed for Trump’s Mass Deportation Plan”
[4] S&P Global, “US homeowners insurance rates jump by double digits in 2023”
[5] JP Morgan, “Guide to the Markets"
[6] Federal Reserve Bank of Saint Louis, “ICE BofA US High Yield Index Option-Adjusted Spread”

Investment advice offered through OneDigital Investment Advisors LLC. The materials and the information provided are not designed or intended to be applicable to any person's individual circumstances. These statements do not constitute an offer or solicitation in any jurisdiction. Any reference to a specific company is not a recommendation to buy, sell, or hold any security. Any economic forecasts in this commentary are merely opinion, and any referenced performance data is historical. Past performance is no guarantee of future results. All investment involved risk of loss. Some information has been obtained by sources we believe to be reliable. OneDigital Investment Advisors LLC makes no representations as to the accuracy or validity of this information. Additionally, OneDigital Investment Advisors does not have any obligation to provide revised investment commentary in the event of changed circumstances. Views and Opinions expressed herein are provided as of January 10, 2025.