Investment Commentary – January 21, 2025

Executive Summary

Earnings season starts strong, and U.S. economic data keeps beating estimates.

Last week, stocks and bonds were up on the week (bond prices up / yields down). The S&P 500 outperformed the MSCI EAFE and MSCI emerging markets indices. The best-performing sectors in the S&P 500 were energy, financials, and materials. Across U.S. style & market cap indices, mid-cap value did the best.

As for fixed income, the 10-year treasury yield fell 16 bps on the week to 4.61%, and the 2-year – 10-year treasury yield spread flattened to +34 bps. High-yield bond spreads were down on the week to 262 bps, well below their 20-year average of roughly 500 bps.

We started the Q4 earnings season with the large cap and regional banks with strong results and guidance. Financials earnings results were helped by a lower base effect from Q4 2023 depressed numbers (SVB-related charges across the industry), but even with that, these results were strong. We saw investment banking businesses start to pick up, trading activity improves, and then, of course, capital market appreciation was a tailwind. We often get the question of when there will be market broadening from the top 10 stocks and the growth style; financials showing earnings power is a good sign of a broadening market. Financials are the largest sector in value indices, with a 23% weight in the Russell 1000 Value index.

Equities

The S&P 500 returned 2.9% for the week. Yields fell after two reports showed a surprise slowdown in inflation and reinforced bets that the Fed remains on track to further cut interest rates later this year. The week also saw solid earnings from the large banks with optimistic outlooks. Mid-caps rallied +4.5%, while small caps gained +4.0%. All sectors in the S&P 500 posted positive returns; energy (+6.2%), financials (+6.1%), and materials (+%) were the best-performing sectors. EAFE markets returned +1.9%, with gains in Europe (+2.9%) and the U.K. (+3.0%) offset by losses in Japan (-0.9%). EM markets returned +1.3%, with China (+3.3%) and Brazil (+4.4%) leading the index higher, while India (-1.4%) underperformed.

From a valuation perspective, U.S. markets (other than midcaps) trade above +1 standard deviation based on historical forward P/E ratios as the S&P 500 is at +2.1, the NASDAQ is at +1.3, and U.S. small caps are at +2.0. For the next 12 months, EPS growth for the S&P 500 is expected to be 10.4% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 19.0% (vs. 10.7% annualized over the last 20 years). For the next 12 months, EPS growth for the Russell 2000 is expected to be 8.9% (vs. 6.3% annualized over the last 20 years). All U.S. indices, including the S&P 500 (US Large Cap), NASDAQ, Russell Midcap (US Midcap), and the Russell 2000 (US Small Cap) trade at or above their 20-year averages based on forward P/E ratios while the MSCI EAFE (Non-US Developed Market Equities) and MSCI EM (EM Equities) are inline.

Fixed Income

Investment-grade fixed-income sectors posted positive returns as rates fell across the curve. Municipals returned +0.2%, US AGG returned +1.0% and US IG returned +1.1%. HY bonds returned +0.8% as the spread compressed 12bps, while bank loans returned 0.1%. EM debt returned +0.4% as the US dollar fell -0.3%.

Rates

Rates fell across the curve as inflation data surprised to the downside. The recession-watch 3M-10Y spread compressed 11bps to +32bps. The 2Y-10Y spread compressed 4bps to +34. Rates rose in other developed markets other than Japan. The BTP-Bund spread is at 1.11%, its lowest level since 2021. 5-year breakeven inflation expectations rose 1bp to 2.54% - their highest level since April 2024 (vs. low of 1.88% on Sept 10); 10-year breakeven inflation expectations fell 1bps to 2.43% (vs. recent low of 2.03% on Sept 10); the 10Y real yield fell 11bps to 2.20%. The market now expects between one and two cuts in 2025 vs the Fed’s guidance of two cuts. At year-end 2025, the market expects the Fed Funds rate to be 3.9% vs. the Fed’s guidance of 3.75%-4.00%.

Currencies/Commodities

The dollar fell -0.3%. The commodities complex rose 1.7% as energy prices rose 2.1% for the week. Brent prices rose 1.3% to $81/bbl. US natural gas prices fell -1.0%, while European gas rose 4.6% due to colder weather.

Market monitors

Volatility fell for equities and bonds (VIX = 16, MOVE = 96); the 10-year average for each is VIX=18, MOVE = 78. Market sentiment (at midweek) fell from -3 to -15 as market jitters have made investors more nervous.