Weekly Investment Update (12/20/2024)

Our next Weekly Investment Update will be published on January 3, and our Quarterly Investment Perspective (QIP), which will discuss our year-ahead outlook in detail, will be published in early January. We wish you and your loved ones a happy holiday season.

Although the S&P 500 is only about 4% below its all-time highs, market breadth — a measure of how many stocks participate in a market move — has narrowed in recent weeks. After the nearly 3% decline in stocks on Wednesday, 70% of the S&P 500 hit a 20-day low, with 34% of stocks falling more than two standard deviations on the day. These conditions suggest a market that may be oversold in the short term, signaling the potential for some stability in the weeks ahead.

This recent volatility was triggered by a combination of expectations for fewer Federal Reserve rate cuts ahead (discussed further below) and the risk of a government shutdown following the failure of a new proposed spending bill. While such headline risks have increased, the broader macroeconomic backdrop heading into 2025 remains resilient. Inflation continues to trend lower, the Fed remains on a path of policy easing, earnings growth expectations are strong, and the labor market shows no significant signs of weakening.

Investor reactions to this week’s Fed meeting are likely overblown, in our view. We believe the Fed’s communication is a function of its strategy to preserve flexibility in future policy decisions, rather than a definitive hawkish pivot. While volatility may persist in the near term, we believe solid fundamentals — particularly declining inflation and steady earnings growth — will provide ballast.

Fed Delivers a 25-Basis-Point Rate Cut but Signals a Slower Pace of Easing Next Year

What is happening: The Federal Reserve cut rates by 25 basis points (bps) as expected at its December Federal Open Market Committee meeting, bringing the federal funds rate to 4.25-4.50%. Additionally, the Fed pointed toward a slower pace of cuts next year — the dot plot projected two additional 25bp cuts for 2025, a reduction from earlier projections of four 25bp cuts. The median longer-run dot also increased to 3.0% from 2.875%.

The December projections also indicated a higher path for inflation relative to September with core PCE inflation rising 20bps to 2.8% in 2024 and 30bps to 2.5% in 2025. The number of Fed members who said the risks to core PCE inflation are weighted to the upside rose to the highest level since 2023. 2025 GDP and unemployment estimates were left broadly unchanged at 2.1% (vs. 2.0% prior) and 4.3% (vs. 4.4% prior).

The market sold off sharply in reaction to the Fed’s announcement with the S&P 500 declining 3.0% and the 10-year Treasury yield rising 10bps to 4.5% on Wednesday. The Fed’s December projections brought the rate path closer in line with market pricing, though the bond market adjusted further to show an even slower cutting cycle next year with only one cut now penciled in for 2025.

Why it matters: The December FOMC meeting marks a turning point as the end of the Fed’s aggressive easing in 2024 transitions toward a more uncertain path for monetary policy. Chair Powell reinforced a lack of guidance and opened the door to skipping a rate cut in January as Fed members may be seeking to gain additional time to evaluate fiscal policy announcements.

While Powell highlighted that the disinflationary process is “still broadly intact,” he also highlighted a growing fear that inflation could remain stuck at a higher level for longer, a notion that was reflected in projections that the Fed’s 2% inflation target may not be achieved until 2027. Additionally, the increase in Fed members indicating upside risks to inflation suggests the possibility that the Fed is speculating on future fiscal policy outcomes, and Powell acknowledged that some Fed officials incorporated Trump policy changes in their forecasts.

Overall, we still expect at least two additional cuts to bring the funds rate closer to a neutral level from its current still-restrictive stance. Additionally, if there are more worrisome signs related to the employment backdrop that emerge, the Fed has ample room to provide accommodation, which can be a backstop for risk markets into 2025.

Small Business Optimism Spikes in Response to Republican Sweep

What is happening: The NFIB Small Business Optimism Index rose by eight points in November to 101.7, the largest monthly gain in nearly 40 years. The November report indicated that optimism was broad-based. The percentage of owners expecting the economy to improve rose 41 points from October to a net 36%, the highest reading since June 2020. Additionally, the share of owners believing it is a good time to expand their business increased by eight points, while those intending to hire more workers rose by three points.

Before the election, small business uncertainty hit a record high of 110 in October, surpassing September’s already record-setting level by seven points. While uncertainty typically rises prior to elections, this gain was particularly pronounced as small businesses weighed the potential impacts of the election outcome. Following the election, optimism spiked, and uncertainty fell as small business owners anticipated more favorable policies and improved economic conditions.

Why it matters: The rise in U.S. small business optimism can be attributed to increased clarity on future business conditions, driven by expectations for higher tariffs on foreign goods, reduced regulation, and lower taxes. President-elect Trump’s pro-growth and domestic-friendly policy proposals have inspired confidence among small businesses. Due to their heightened sensitivity to economic cycles and heavier reliance on domestically driven revenue streams, small- and mid-cap businesses are likely to benefit more from Trump’s pro-growth policies compared to larger firms.

While the favorable economic backdrop is expected to provide tailwinds for small- and mid-cap companies, how that narrative translates to market performance is still in question. Over the next 12 months, earnings per share (EPS) growth expectations for the S&P Small Cap 600 are currently 20.5% compared to expectations of 14.4% for the S&P 500. These expectations are in contrast to the trailing 12-month EPS growth results of -10.6% for small caps and 7.8% for large caps. Although there are potential catalysts for small caps to outperform, their success, in our view, will ultimately depend on whether the expected earnings growth materializes.