New Year Perspective: Resilience, Rates, Wages > Inflation

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Happy New Year! We hope you are kicking off January with renewed commitment and excitement for creating joy and progress for your family… and that your peloton is dusted off and in good working order! As with each year, let’s reflect back on the last few months to close out 2024, and frame up some key themes for 2025. All major indices ended the year on a positive note, continuing in year three of a bull market. The best days, weeks, months, and years follow the most trying times, and two years of positive returns following a slog of a 2022 bear market is another reminder. However, Q4 2024 concluded with negative returns for all but the largest U.S. companies - a mirror image of Q3 2024 and a timely reminder that even in bull markets, pullbacks are common along the way. In the past 100 years, 47% of market days are down, while 75% of years and 94% of decades are up. Accepting the day-to-day blackjack odds as part of the journey is imperative to realizing the 94% probability.

2025 starts on solid economic ground, and our core themes for the year incorporate monetary policy cycles, inflation and trade policy, debt and deficits, and supply-side resilience. Let's go through some key points:

Major stock and bond indices finished in positive territory two years in a row, though Q4 offered a decline in every asset class aside from the largest companies.

• U.S. Stocks (Russell 3000): +3.06% Q4, + 23.81% 2024
• U.S. Small Cap Stocks (Russell 2000): +1.83% Q4, +11.54% 2024
• International Stocks (MSCI EAFE ): -7.55% Q4, +4.35% 2024
• U.S. Bonds (Bloomberg Barclays Aggregate Index): -3.35% Q4, +1.25% 2024
• Emerging Market Stocks (MSCI Emerging Index): -7.98% Q4, +8.05% 2024

2025’s economy starts on a solid foundation in terms of employment, wage growth, corporate earnings, and monetary policy. Unemployment is 4.10%, wages increased 5.2% (above inflation) in 2024, corporate earnings are expected to increase by double digits, and inflation is moderated at historical levels – leading to the Fed’s rate signal of ‘steady’ or ‘decrease’. Collectively, these economic indicators signal continued gross domestic product (GDP) expansion into 2025.

The monetary policy tightening cycle is over… for now. After a period of sharp increases in interest rates, rates have settled, and all eyes are on inflation for 2025. Thanks to the success of the earlier tightening policy, inflation is now 2.9%, below the 3.28% long-run-average. Further, the aforementioned wage growth means that in absolute terms, prices went down in 2024 (wage growth was > inflation)! The Federal Reserve is very transparent – far more than in the 90’s when rate decisions would be completely unknown until Alan Greenspan appeared from behind the curtain (yes, a subtle Wicked reference). As we have frequently written, if unemployment remains low (it is) and inflation is generally in line (it is), don’t expect the Fed to move on rates. In 2025, markets will pay close attention to the Federal Reserve’s rhetoric yet again, pricing in any rate reductions well before they occur.

What could slow the inflation progress? Tariffs on top trade partners pose a notable risk. By definition, a tariff is a tax on top of the price of imports and exports. In the instance of US tariffs on imported goods, the tax is initially paid by the domestic importer, not the foreign seller. In a capitalist system, there is a slim chance corporations importing goods with new and dramatically higher tariffs will absorb those costs by reducing their profitability. Rather, consumers will then pay them via higher prices (inflation), or supply will be stifled, also causing consumers to pay more (inflation). In Q4 2018, China tariffs spooked markets and triggered a bear market (20% decline), prompting a more targeted approach continued until today. Targeted tariffs have been, and will always be, used for strategic reasons, and a well functioning economy can typically absorb these with limited downstream impact on inflation. Blanket tariffs on major inputs such as lumber, electronics, and food, however, will ultimately be paid by consumers and creates inflationary pressure.

The resilience of the U.S. economy is explained by the supply side – labor and productivity. Typically, when monetary policy is abruptly and significantly tightened (higher rates), the result is a recession. The most recent tightening cycle avoided a recession because of labor gains and productivity gains. Domestic productivity and labor supply increased (4% and 1.8%, respectively) during the last year. Productivity is the key. Other developed countries saw labor gains without productivity, and their economic output was muted. This is a positive downstream impact of COVID. Workers switched to more productive employment in record numbers and workplaces have become more flexible. And, if A.I. truly is the broadly applied tool as it’s advertised, productivity may continue down this path, helping business of all sizes and workers in all industries. As the U.S. population continues to decline with birthrates falling and immigration policy uncertainty, productivity will hold the keys to future micro and macro economic strength.

We wrote that the market was historically top heavy last quarter (31%), and it’s even more top heavy now (37%). The last time the stock market was this top heavy was the dot.com bubble, which started one of the few decades in which the U.S. market delivered a negative return (part of the 6% for readers tracking the earlier probability). The major difference now: the largest cap companies have strong earnings and strong expected earnings. Still, the law of diminishing returns is a natural part of a company’s cycle. So, while muted returns for these same companies is a likely outcome at some point, the situation has a different profile than a bubble of some kind. The rising tide lifts all boats, and a broadly successful market is much stronger than one pulled along by a few companies as with the last few months. This will be important to watch in year three of the current bull market.

Diversification is misunderstood. It helps manage risk related to opportunity cost, not absolute downside. It also does not equate to a conservative investment strategy. It can aid growth because it increases the probability you’ll own the winners. A more diversified investor is more likely to have picked the winners, by definition. To put data to this concept, consider that from 1990-2019, the average global return was 7.9% per year. If you speculated and didn’t own the top 25% of performers, you actually lost 4.5% per year. This is the difference between turning $100,000 into $907,030.51 and turning $100,000 into $30,610.17.

The one thing we can always guarantee is that a new year will bring uncertainty and surprises. The second largest city in the United States is ablaze, affecting hundreds of thousands. Two significant wars rage on (one is on pause for now). Attacks in both New Orleans and Las Vegas resulted in death, injuries, and fear. In the midst of these challenging current and past situations, the common thread among successful investors is discipline. As we press forward in 2025, let’s ensure your planning framework is sound and remains aligned with your portfolio mix, so that your family can remain focused on controlling what can be controlled! As always, reach out anytime, and especially if there are any changes to your circumstances!

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Sources: Ycharts, ATL Fednow, Fred.com, Vanguard.com, Dimensional.com

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

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Index Disclosures:

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

Index Definitions:

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.

Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of fixed rate debt securities rated investment grade or higher by Moody’s, Standard & Poor’s, or Fitch rating services. All issues in the index have at least one year to maturity and an outstanding par value of at least $25 million to $1 billion based on the type of security. Indices are not available for direct investment and do not reflect any fees that may be charged.

S&P 500®: The S&P 500® index is an unmanaged index of 500 companies used as a representative sample of the United States economy. The S&P 500® index consists of only stock holdings. Indices are not available for direct investment and do not reflect any fees that may be charged.

MSCI EAFE: The MSCI Ex-US index is an unmanaged index used as a representative sample of the global developed economy outside of the United States and Canada. The MSCI EAFE index consists of only stock holdings. Indices are not available for direct investment and do not reflect any fees that may be charged.

MSCI Emerging Markets: The MSCI Emerging Market index is an unmanaged index used as a representative sample of the global emerging market economy outside of the United States. The MSCI Emerging Market index consists of only stock holdings. Indices are not available for direct investment and do not reflect any fees that may be charged.

The Russell 2000 index is an unmanaged index of the 2000 smallest companies in the Russell 3000 index. The Russell 2000 Index is used as a representative sample of the small companies in the United States economy. The Russell 2000 index consists of only stock holdings. Indices are not available for direct investment and do not reflect any fees that may be charged.

The Russell 3000 index is an unmanaged index of 3000 companies in the United States. The Russell 3000 Index is used as a representative sample of the United States economy. The Russell 3000 index consists of only stock holdings. Indices are not available for direct investment and do not reflect any fees that may be charged.