January 2025 Market Commentary

January 12, 2024

• Santa Claus fails to arrive for investors.
• Fed cut rates by 0.25% at its December meeting.
• US holiday sales rose 3.8% from 2023.
• Returns: S&P 500 -2.5%. Bloomberg US Aggregate Bond index -1.6%.

Markets ended 2024 on a down note as both equity and fixed income markets pulled back in December, faced with disappointing inflation data, higher long-term rates, and hawkish Fed commentary. Despite December’s decline, the S&P 500 finished the year up 23.3%, marking the second consecutive year of 20%+ returns. Over the course of the year, the venerable index set 57 new record highs, placing 2024 in the top five years for new highs.

Inflation showed little progress towards the Federal Reserve’s longer-term 2% target in November as the closely watched consumer price index (CPI) rose 0.3% on a headline basis, up from October’s 0.2% monthly pace. Compared to a year ago, headline CPI accelerated to 2.7%, its fastest rate since July. Core CPI, excluding food and energy prices, rose at an annual rate of 3.3% for the third consecutive month, lending further credence to the idea that improvements in inflation seen during the summer largely stalled during the fall. Shelter prices, which account for ~1/3 of CPI, remained the largest contributor to continued upward pressure on inflation. Given that, one positive development within the November data was shelter prices registering their smallest annual increase since February 2022. Should that deceleration continue, it could lead to further improvement in inflation in the months ahead.

Higher prices did not seem to discourage consumers during the all-important holiday shopping season. According to Mastercard, online spending during the holiday period, measured from Nov. 1 to Dec. 24, grew 6.7% from last year, while instore sales rose 2.9%. The result was a 3.8% increase in total spending from 2023, exceeding economists’ 3.2% forecast as well as the 3.1% increase recorded in 2023. The strong holiday shopping figures provided further evidence that consumers remain willing and able to spend, and the economy likely entered 2025 with good momentum.

As expected, the Federal Reserve cut the Fed Funds rate by 0.25%, to a range of 4.25- 4.50% at its December meeting. However, given the near certainty of such a move, investors were far more interested in the Fed’s updated economic projections and Chair Jay Powell’s post-meeting press conference, both of which left investors disappointed. In its Summary of Economic Projections (SEP), Fed officials increased their year-end inflation projection for 2025 from 2.2% to 2.5%. Reflecting the more challenging outlook, members correspondingly reduced the number of expected rate cuts in 2025 from four to two. With respect to the broader economy, Fed members now expect 2025 GDP growth of 2.1%, up from September’s 2.0% projection, and unemployment ending 2025 at 4.3%, down from the prior 4.4% forecast.

At his post-meeting press conference, Powell addressed both aspects of the Fed’s dual mandate; price stability, i.e. controlling inflation, and maximizing employment. With respect to employment, Powell described current labor market conditions as “solid” despite recent cooling which he said is occurring in a “gradual and orderly way” and not one that “raises concerns.” However, Powell said that he and other policy makers are watching labor market conditions closely as they consider the timing and amount of future rate cuts.

Addressing inflation, Powell described it as “stubborn” causing the Fed’s prior year-end projection to “fall apart.” Powell noted the way in which housing services are calculated as one reason for why inflation readings have remained elevated. Powell also noted the difference between high prices and high inflation, the former of which consumers continue to face following the strong bout of inflation in 2021 and 2022. To tackle the pain of higher prices, Powell said the best thing the Fed can do is return inflation to the Fed’s 2% target and keep it there so that real wage growth exceeds the pace of inflation which he believes will ultimately “restore people’s good feeling about the economy.”

As to the timing and number of rate cuts in 2025, Powell said the risks to achieving the Fed’s employment and inflation goals are “roughly in balance” and as a result the Fed can be more “cautious” as it considers further adjustments to monetary policy. For its part, markets ended December pricing in just two rate cuts for 2025, with the first occurring in
June followed by a second cut in December.

Outside of the US, December bore witness to significant political upheaval around the globe. In France, the government fell after lawmakers voted to oust the Prime Minister, three months after President Macron appointed him, leaving the country in political paralysis. Germany experienced a similar situation, with the Prime Minister losing a confidence vote paving the way for early elections in 2025. The political uncertainty roiling Europe’s dominant economies comes at a time when the EU faces a number of challenges. In Romania, the country’s top court annulled the Presidential election results claiming they were corrupted by Russian interference. In South Korea, the country was cast into turmoil when the President briefly enacted martial law only to see Parliament overturn his decision and move to impeach him. And in Syria, after years of civil war, a lightning offensive by militants toppled the government of President Bashar Al-Assad in just two weeks, ending his family’s dictatorial rule over the country for the past 53 years. Assad’s fall further complicates an already complex and volatile situation in the Middle East.

The combination of disappointing inflation data, a resulting rise in interest rates, and the Fed’s reduced 2025 projections for rate cuts, drove markets lower with large caps (S&P 500) falling 2.5%. A hoped-for Santa Claus rally- the tendency for markets to experience positive gains over the last five trading days of December and first two trading days of January- failed to materialize as the S&P 500 shed 0.5% over the course of the seven days. Small caps fared particularly poorly, dropping 8.4%, largely reversing November’s 10.8% gain. International markets by comparison fared better, with developed markets (MSCI EAFE) declining 2.3% while emerging markets (MSCI EM) were down just 0.3%.

Similar to equity markets, fixed income markets also fell in December, with the Bloomberg US Aggregate Index, the broadest measure of the fixed income market, down 1.6%, as US Treasuries sold off steadily during the month. Initially global political turmoil provided a boost to bonds, as investors sought the safety of Treasuries. However, that quickly reversed following November’s CPI report and was further compounded by headline producer price index (PPI) inflation data which rose 0.4%, twice as fast as expected. The disappointing inflation data pushed yields higher as investors began to question the Fed’s appetite for further interest rate cuts.

Despite the Fed’s December rate cut, the fact that four of the 19 members signaled objections to it, coupled with Powell’s post-meeting comments, cast further doubt on the timing and amount of additional rate cuts in 2025. Though rates pulled back slightly at the end of the month on more benign core personal consumption expenditure (PCE) inflation data, 10-Year Treasury yields closed at levels last seen in May, while 2-Year Treasury yields closed near five-month highs.

The municipal markets saw a similar pattern to Treasuries, with longer-term yields seeing a sharper increase than shorter-term yields. The 10-year AAA muni yield followed the Treasury market higher, finishing the month near 13-month highs. Municipal yields typically lag Treasury movements and December seemed to be a catch-up month for the municipal market, likely boosted by year end rebalancing and loss harvesting.

Looking ahead to 2025, investors are generally excited by the prospect of lower taxes and less regulation in President Trump’s second term, a backdrop that would likely benefit financial markets and the broader economy. However, there are potentially countervailing forces that investors should heed.

Stronger economic growth could place upward pressure on inflation, in turn influencing the timing and amount of additional Fed rate cuts in 2025. Trump has also proposed policies to raise tariffs and deport millions of illegal immigrants, both of which could place additional upward pressure on inflation. Higher inflation and stronger economic growth would likely result in higher interest rates, putting downward pressure on bonds and possibly equities, particularly those trading at elevated valuations.

So while the broad policy backdrop in 2025 appears supportive, investors would be wise to remain attuned to how economic growth, inflation, interest rates, and fiscal and monetary policy unfold over the course of the year.