Macro Outlook
- Earnings are strong
- Unemployment is low
- Investor Sentiment is Rising
- Inflation is stubborn
- Dollar is Stronger
- US over International
Valuations are Elevated
After 2 years of returns for the S&P 500, over 20% stocks are clearly trading at elevated levels. Some folks make comparisons to the tech bubble of the late 1990’s. Though valuations are elevated like that period the main difference is that in the late 90’s many companies did not make any actual profits. This time it’s not an internet boom; it is an AI boom, or artificial intelligence boom. The companies driving this market are very large well-heeled tech companies.
Asset Valuation Vary by Class and Style
We do think these companies have a strong possibility of living up to their earnings expectations. But they are priced for perfection. We are looking around at the rest of the market and into different asset classes for more attractive valuations going forward. We are going to likely continue adding in the small and mid-value space where stocks are not as elevated trading closer to their 20-year average valuation. We will continue to trim our large cap growth, one of our best performing asset classes, if valuations continue to remain elevated. Lower interest rates should encourage more rotation into small and mid-cap companies as the pressure on borrowing eases and these companies tend to access credit more than their larger counterparts.
Inflation
Inflation, while slowing is dealing with the more stubborn components, namely housing and wages. It is likely that inflation will take far longer to go back to the Fed target of 2%. One of the incoming administrations’ goals that could help drive inflation lower, is the significant increase in energy production from oil and natural gas. This would drive down energy prices which are an input cost in the PPI and CPI.
The FED and Interest Rates
The Fed is likely to continue to lower the rates on short-term treasuries and to normalize the yield curve, but as you can see from the chart the markets are forecasting fewer and more shallow rate cuts than the Fed is modeling. In fact, the bond markets are suggesting maybe 1 or 2 rate cuts at most in 2025. We are likely to consider extending the average duration of our remaining short duration bonds to lock in these attractive higher yields.
The yield curve will soon normalize, which is to say the short end of the curve on the left will be lower than the longer maturity at the end of the curve. The chart shows the movement of the yield curve over the last 4 years as inflation arrived after the Covid spending financed by a direct increase to the money supply. The yield curve is the US Treasury rates. As we examine opportunities in the bond market, the yields on corporate paper are slightly higher for high quality and higher still on more credit sensitive bonds. We have several strategic bond fund managers looking to take advantage of opportunities in those parts of the bond market.
US vs International
In 2024 we replaced our international manager and lowered our exposure to the emerging markets. The stronger US dollar and China’s slowing economy continue to be a drag in that region of the world, coming out of Covid. We continue to favor the condition in the US vs both international and emerging markets.
Public Debt and Taxes
Last year in our market outlook I made a reference to the amount of debt service. I said it would exceed $1 trillion dollars by the end of the year. You can find that piece here.
As of the fiscal budget year ending in September 2024, the interest payments you can see on the left are $1.016 trillion.
Now that the elections are over, the conversation has turned to this newly created Department of Government Efficiency that will attempt to find trillions of dollars of savings by running the government more efficiently. I am hopeful that some efficiencies can be achieved, but I am realistic about the difficulty in cutting government resources. Markets tend to ignore the size of the debt ratio and annual deficits, but we cannot maintain the deficit at current levels. One thing that I think most who look at this issue with clear eyes believe, is that it cannot be solved by just cutting spending. We will need higher taxes and higher growth, along with cuts to government spending. We will pay close attention to this.
The Trump administration has said that Social Security, Medicare and Medicaid are not going to be touched. The trust fund for SSI will start to run out as early as 2032. This is likely when we will be forced to deal with these programs, but not likely before.
TCJA Extension Likely
The TCJA will most likely be extended and may include sweeteners like an increase in the SALT cap deductions to bring in bipartisan support form states like NY, NJ , MA and CA who have high income taxes and were penalized most when the TCJA passed in 2017. This clarity will be very welcomed by the private sector, which is sitting on record cash on their corporate balance sheets. I see the potential for massive capital investment in the back half of 2025.
In Summary
We believe the near term is challenging as stocks, especially in the AI tech space are elevated so earnings must come in at or above expectations. Geopolitical challenges lie ahead. We expect higher volatility early in 2025 as the new administration tries to install their agenda. Later in 2025 could be very good for stocks if the Fed takes a little pressure off the interest rates, and the wars in the middle east and Europe can be resolved.
The views stated in this piece are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities. Due to volatility within the markets, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000.The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization. The Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index. The Russell Midcap Growth Index measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The stocks are also members of the Russell 1000 Growth index. The Russell Midcap Value Index measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The stocks are also members of the Russell 1000 Value index.