January 28, 2025
Market Summary
A surprisingly decisive victory for Donald Trump set off a post-election rally that was watered down the last few weeks of the year by an unexpectedly hawkish turn by the Federal Reserve. The market was led once again by a handful of mega cap tech stocks for both the quarter and the full year. The hopeful signs of market rotation we saw emerge during the third quarter, which received an added boost by the outcome of the election, quickly reversed course during December. For the quarter, stock selection within discretionary and industrials held back portfolio performance versus the S&P 500 Index. For the year, stock selection was challenging across staples, financials, healthcare and discretionary.
The prospect of pro-growth policies from a Trump 2.0 administration, namely lower taxes and less regulation, enlivened investor spirits during the quarter. That is until the Fed signaled a slower pace of rate cuts at its December Federal Open Market Committee (“FOMC”) meeting. While the Committee agreed to lower interest rates by an additional 25 basis points (bps) in December, as expected, bringing the total reduction since September to 100 bps, the Fed was forced to recalibrate after seeing stronger economic growth and firmer inflation than they had previously expected. Additionally, the Fed prudently began to incorporate – at least partially – expectations for Trump policies into their forecasts for 2025 and beyond. The result was an upward shift in the committee’s projections for growth, inflation, and interest rates. The Fed now sees a total of 50 bps worth of rate cuts in 2025, down from its prior median forecast of a 100 bps reduction.
Economic Outlook
The U.S. economy continues to show surprising strength. Real gross domestic product (GDP) increased at an upwardly revised 3.1% annual rate in the third quarter, consistent with the 3.0% annualized growth recorded in the second quarter. Growth continues to be supported by resilient consumer spending. The possibility of lower taxes and less regulation now seems to be lifting sentiment not just for investors, but also consumers and small business owners. Such animal spirits have the potential to boost economic activity, leading to increased hiring and investment. For the fourth quarter, the Atlanta Fed’s GDPNow real-time forecasting model currently predicts real GDP growth of 2.7%. As a result, full year 2024 GDP growth will likely come in at the top end of our prior +2-2.5% forecast – a solid year indeed. Our initial forecast for 2025 real GDP growth is a similar +2-2.5%.
The pathway back to the Fed’s 2% inflation target, however, appears to have stalled. Monthly readings for both CPI¹ and the Fed’s preferred Personal Consumption Expenditures (“PCE”) measure have been firmer than hoped over the past several months, causing the year-over-year increases to move higher. This will need to change for the Fed to feel comfortable cutting rates further. At issue, core goods prices have stopped falling at the same time housing disinflation remains stubbornly gradual and prices for services outside of housing remain sticky. The most recent CPI reading for November showed a year-over-year increase of 2.7%, up from a September low of 2.4%. Core CPI, which excludes volatile food and energy prices, increased 3.3% in November, and has been moving sideways since summer. We now expect CPI to end the year at the upper end of our prior 2.5-3.0% forecast.
The Fed may find it more challenging to continue lowering rates in 2025 if inflation remains stuck at current levels, either as a result of stronger economic activity or if aggressive tariff and deportation actions by the Trump administration further exacerbate inflationary pressures as many economists believe.
The consensus bottom-up S&P 500 EPS estimate for 2024 has remained relatively unchanged at $241, +9% year-over-year, an improvement from flattish growth last year. Our preliminary estimate for 2025 is $270, +12%. For the past two years, the “Magnificent Seven²” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) have supplied the bulk of S&P profit growth, thanks in large part to heavy spending on AI infrastructure and large language model development. For 2024, we estimate the “Mag 7” to show earnings growth of 34%, which compares to just 3% growth for the rest of the S&P 500 excluding the “Mag 7”. This differentiated earnings performance has been the primary contributor to the differentiated stock returns between the “Mag 7” and everything else over this period.
For 2024, the “Mag 7” delivered a total return of 48.3%, which compared quite favorably to the 12.5% total return for the rest of the S&P 500 excluding the “Mag 7”. As such, the “Mag 7” had another outsized contribution to the market’s overall performance in 2024, accounting for 55% of the S&P 500’s total returns in 2024, only slightly less than the 63% contribution in 2023. Such concentrated returns are unlikely to continue in 2025 in our view. EPS growth for the “Mag 7” is expected to moderate at the same time the rest of the market begins to show improving EPS growth. We expect this convergence in profit growth to lead to more balanced market returns.
Solid growth in the economy and corporate profits, supported by rising animal spirits and relatively loose financial conditions, continue to underpin the near-term outlook for stocks. However, stock valuations and investor sentiment remain elevated and leave little room for error. The Fed has now signaled it will be less friendly than had previously been hoped. Meanwhile, the honeymoon for the new Trump administration will soon come to an end on Inauguration Day. Optimism is likely at a peak now before the details and timing of actual policy start to get fleshed out. Up to now, equity investors have seemingly been willing to give full credit to anticipated pro-growth policies (lower taxes/regulation) that require legislative or regulatory action that can take time while overlooking potentially offsetting restrictive policies (tariffs/deportations) that can happen quickly through executive action.
The U.S. fiscal situation remains challenging with record levels of debt and deficits (outside of war or crisis). Trump policies have the potential to expand them even further, barring unprecedented success by Elon Musk in reducing government waste. We know that President Trump likes to measure the success of his administration by the stock market. As such, it seems unlikely he will want to risk a disorderly upward move in long-term government bond yields that would not be welcomed by the equity markets. More limited deficit-expanding policies would likely mean less upside for the economy and profits.