The U.S. economy extended its run of above-average growth despite stubbornly high interest rates. U.S. stocks posted modest gains during the quarter to reach new all-time highs, while most other asset classes experienced losses for the period. The outlook for the economy, inflation, and interest rates continues to evolve as investors contemplate the new administration’s expected policy changes.
Stronger Than Expected Economic Growth Continues
The U.S. economy continued its string of above-average growth, gaining 3.1% in the third quarter. Economic growth has averaged nearly 3% for the past two years, significantly greater than the 25-year average of 2%. This growth has been achieved despite the highest interest rates in 10 years, highlighting the resiliency of the U.S. economy.
The downward trend in inflation stalled, with the Consumer Price Index (CPI) drifting up to 2.9% in December after reaching a low of 2.4% in September. This is still an improvement from 3.4% at the start of the year, but above the Fed’s target level of 2%. Presumed policy changes have caused future inflation expectations to rise above 3%.
Employment conditions continue to be strong, with both unemployment and wage growth hovering around 4%. Importantly, worker productivity has been robust, increasing by more than 2%. When output per labor hour is increasing, the impact of wage growth on inflation is reduced. This has been a key factor in allowing inflation to decline during the recent period of above-average economic growth.
Growth forecasts for the fourth quarter of 2024 center around 2.5% with the potential for an upside surprise if consumers and businesses pull purchases forward to avoid possible tariffs. While the economy appears poised for continued expansion in the new year, the pace of growth should slow. This is partly due to rising interest payments on U.S. government debt. The combination of sizable debt issuance in recent years and higher interest rates has significantly increased the government’s interest expense. The added debt service creates a drag on economic growth and lowers expectations for 2025 to about 2%.
U.S. Stocks Accomplish a Rare Feat
U.S. stocks held on to the gains from the first nine months of the year and added a bit more in the fourth quarter. The period 2023–2024 is only the fifth occasion in the last 100 years that the S&P 500 index produced back-to-back annual returns greater than 20%, and it is the first time that has happened since the late 1990s.
| MARKET SCOREBOARD | 4Q 2024 | 2024 YTD |
|---|---|---|
| S&P 500 (Large U.S. stocks) | 2.41% | 25.02% |
| MSCI EAFE (Developed international stocks) | (8.11%) | 3.82% |
| Bloomberg Aggregate Bond (U.S. taxable bonds) | (3.06%) | 1.25% |
| Bloomberg Municipal Bond (U.S. tax-free bonds) | (1.22%) | 1.05% |
| Wilshire Liquid Alternative (Alternative investments) | (1.87%) | 4.33% |
Source: Morningstar Inc, December 31, 2024.
The “Magnificent 7” technology stocks led the market higher in 2024. These seven stocks accounted for 55% of the total market gain for the year and represented 34% of total U.S. stock market capitalization at year-end. As a result, the large-cap growth category delivered performance of 33% for the year, far outpacing the 14% gain of large-cap value shares.
Meanwhile, bonds and international stocks posted losses during the quarter. Bonds were affected by a significant rise in interest rates, as the yield on the benchmark 10-year Treasury note rose from 3.80% to 4.57%. The rise in rates was caused by concerns about potential inflationary pressures in 2025. International stocks fell due to a strengthening dollar and the potential negative impact of tariffs on foreign companies.
The Fed’s Rate Cut Plans Have Changed
The outcome of the December Federal Reserve meeting surprised investors, as the 2025 policy outlook changed significantly from September. The Fed reduced the number of expected 0.25% rate cuts from four to two. While the 2025 Fed forecast for economic growth and unemployment was largely unchanged, expected inflation increased by 0.3%. While investors thought the rate outlook for 2025 might be adjusted, most expected the Fed to only reduce the number of cuts from four to three.
This change in forecast resulted in futures markets adjusting to slightly less than a 0.50% drop in the Fed Funds rate for the coming year. Debate swirled as to why the Fed moved to such a conservative stance, with many pointing to concerns about how changes in trade and fiscal policy would affect inflation. The new Fed projection also prompted market interest rates to rise significantly during the quarter. While there is still uncertainty as to the actual path forward for rates, the Fed seems likely to be cautious and focused on key government policy changes in the new year.
Policy Changes Could Impact Markets
The “red sweep” by Republicans during the elections removed some of the mystery around trade and fiscal policy for 2025. The platform for the new administration includes lower taxes and increased tariffs. While campaign ideas included a wide range and degree of possible actions, more modest changes are likely for a couple of reasons. First, the Republican majority in Congress is very slim. Competing agendas and priorities among members of Congress may limit the scope of what the administration can carry out.
Second, recent upside surprises in both growth and inflation may be a roadblock. Policies that meaningfully increase the deficit or lift inflation could lead to a further rise in market interest rates. U.S. bond yields have already risen over these concerns, as have yields in certain foreign markets due to many of the same issues. Given these constraints, targeted tariff increases and limited fiscal expansion seem a more likely outcome.
2025 Market Outlook
The U.S. economy was stronger than expected last year. Economic growth should continue in 2025, albeit at a slower pace. Inflation expectations have risen above 3%, causing the Fed to temper the pace of future rate cuts. Interest rates seem likely to stay higher for longer, which could create a drag on growth. On the positive side, the potential for lower tax rates and less regulation from the new administration could provide a boost, helping to keep the economy moving forward.
Looking back on 2024, U.S. stock market returns were better than even the most optimistic forecasts at the start of the year. The outsized gains were driven by above-average economic growth, Fed easing, strong profit increases for U.S. companies, and excitement over the potential benefits of artificial intelligence (AI).
Gains of more than 20% in U.S. stocks drove balanced portfolios to above average returns. This contribution was important since both bonds and international stocks ended with modest performance for the year after a weak fourth quarter.
While U.S. stocks have had great momentum over the past couple of years, the rally has pushed overall market valuation toward the upper end of the historical range. But since gains have been concentrated in the largest technology stocks, the average S&P 500 stock is valued much closer to the long-run norm. Given these circumstances, U.S. stock market returns should moderate in 2025, while participation broadens to more sectors and companies. As enjoyable as it has been, consecutive years of 20%-plus returns are rare and should not be expected to continue!
The valuation picture is better for international stocks, as foreign markets have only been this cheap compared to U.S. stocks about 5% of the time historically. International stocks also offer dividend yields roughly double that of the S&P 500 index. But the potential for U.S. tariffs on foreign goods and a strengthening U.S. dollar are negative offsets from an investment standpoint. Because of this, our Investment Committee recently reduced the target allocation to international stocks.
Despite three Fed Funds rate cuts, longer-term interest rates rose during the fourth quarter. While the rise in rates cut into bond gains for the year, it also increased expected returns going forward. The combination of outsized stock market gains and higher bond yields translates into a favorable environment for rebalancing diversified portfolios. While rebalancing has always been an important discipline from the standpoint of risk management, the current environment makes this practice particularly appealing now.
Change is in the air as we enter the new year, and with that comes the potential for increased market volatility. Encouragingly, the past five-year period offers a great example of the importance of maintaining portfolio discipline throughout difficult market environments. Despite a pandemic recession, two bear markets for stocks, and a bear market for bonds, the average annual returns of our balanced allocation models finished remarkably close to long-run financial planning assumptions over this five-year period!
If you have questions about your personal investment portfolio or financial situation, please contact your Forvis Mazars Private Client team. Best wishes for a successful and prosperous 2025!