Investment Commentary – January 6, 2025

Executive Summary

Following a five-day selloff, Wall Street ended its longest equities losing streak since April. The Nasdaq 100 rebounded sharply on Friday, gaining 1.7%, while the S&P 500 rose 1.3%. These gains partially offset the week’s selloff, which had been fueled by a December downturn extending into the first trading day of the new year. Traders appeared undeterred by warnings of slowing earnings growth for the so-called "Magnificent Seven" tech stocks and continued to acquire shares of AI leader Nvidia Corp. Stocks appreciated, supported by the reelection of Mike Johnson as House Speaker, signaling Republican unity around a business-friendly deregulatory and tax extension (possibly cuts) agenda. Meanwhile, bond yields climbed, with the benchmark 10-year Treasury yield touching 4.6% after Richmond Fed President Tom Barkin reiterated his preference for maintaining restrictive monetary policy. Data from the ISM showed U.S. manufacturing activity rose modestly in December to 49.3— above estimates but still below the 50-threshold, signaling economic expansion. Investors searching for signs of resilience in the U.S. economy are weighing these developments against the Federal Reserve’s hawkish tone. Chair Jerome Powell’s December pivot hinted at slower and shallower interest rate cuts ahead. This week, all eyes will be on the upcoming jobs report, which traders see as a critical indicator for the Fed’s next moves on interest rates later this month. While still below the peak of 2023, 30 year fixed mortgage rates have risen meaningfully to close out 2024 over 7% again. This past week, mortgage applications plunged 10% year-over-year. Over the course of 2025, we believe mortgage applications will likely be a key economic cycle indicator. Before, higher mortgage rates only had a modest impact on housing prices, but this time active houses listed for sale (inventory) have started to rise. In fact, some of the most popular housing markets from Florida to Texas now have housing inventory levels that are back to 2019 levels. The housing market has defied a slowdown even as affordability readings are near all-time lows. In 2025, the inevitable slowdown in housing prices may catch up. This would be a helpful development on the inflation front, but from an economic cycle perspective, it is not as positive.

Equities

The S&P 500 returned -0.5% for the week as yields rose and trading remained thin around the holidays. Small caps gained 1.1% for the week. Energy (+3.2%) and utilities (+1.3%) were the best performing sectors in S&P 500; materials (-2.0%) and consumer discretionary (-1.5%) were the laggards. EAFE markets returned -0.9% with gains in the U.K. (+1.0%) offset by losses in Europe (-1.1%). EM markets returned -0.8%, with gains in Korea (+1.7%) offset by losses in China (-2.6%). 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 +2.0, the NASDAQ is at +1.3, and U.S. small caps are at +2.0. For the next 12 months, EPS growth for S&P 500 is expected to be 9.9% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 21.5% (vs. 10.4% annualized over the last 20 years). For the next 12 months, EPS growth for the Russell 2000 is expected to be -0.8% (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 and edged lower across the curve. Municipals returned 0.6%, US AGG returned 0.2%, and US IG returned 0.1%. HY bonds returned 0.4% while bank loans returned 0.2%. EM debt returned 0.5% as the US dollar rose 0.9% and spreads compressed.

Rates

Rates edged lower across the curve as markets weighed the future path of Fed cuts and the impact of potential tariffs on inflation. The recession-watch 3M-10Y spread compressed 4bps but remains in positive territory at +29bps. The 2Y-10Y spread widened by 2bps to +31. Rates rose in other developed markets other than the U.K. The BTP-Bund spread is at 1.17%. 5-year breakeven inflation expectations rose 1bp and now sit at 2.41% (peak on Nov 6 of 2.44% vs. low of 1.88% on Sept 10); 10-year breakeven inflation expectations fell 1bp and now sit at 2.34% (peak on Nov 6 of 2.40% vs recent low of 2.03% on Sept 10); the 10Y real yield fell 1bp to 2.26%. The market now expects between one and two cuts in 2025 vs the Fed’s guidance of two cuts. At yearend 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 rose 0.9%. The commodities complex rose 2.0% as energy prices rose 3.9% for the week. Brent prices rose 3.2% to $77/bbl. US natural gas prices fell 4.6% while European gas rose 2.7%, each based on near term expectations for weather conditions.

Market Monitors

Volatility was flat for equities and for bonds (VIX = 16, MOVE = 93); the 10-year average for each is VIX=18, MOVE = 78. Market sentiment (at midweek) fell from 4 to 1 as year-end jitters have made investors more cautious.