January Investment Comments
The Year In Review: A Reflection on Markets and the Economy
Equity investors have much to celebrate this year as indices continue to rise to all-time highs. The Federal Reserve cut interest rates in September for the first time since 2020, boosting investor optimism and supporting the strong rally in stock prices. In a reversal of recent trends, small-cap companies represented by the Russell 2000 index surged post-election, outperforming large-cap companies. Optimism for policies favorable to U.S. companies may have contributed to some of the outperformance as smaller companies tend to have more exposure to domestic markets.
Bond investors likely experienced some success in 2024, although it was not a year without challenges. Interest rates rose at the beginning of the year, accompanied by lower bond prices, but eased over the summer in anticipation of Fed rate cuts. After the initial cut, short-term bond yields moved lower as they are most affected by Fed policy action. Long-term yields had the opposite effect, moving higher as optimism for a strong economy raised the risk of higher inflation over the long run. Bonds issued by below-investment-grade companies have performed well this year. These bonds are commonly known as junk or high yield bonds. The extra yield earned above Treasuries with comparable maturities is approaching all-time lows. Below investment grade companies tend to issue short-term debt and will benefit from lower borrowing costs. Lower default rates expected with a stronger economic outlook have also boosted high-yield bond prices. After the strong rally, investors likely are not being adequately compensated over U.S. Treasuries for the inherent risks they bear.
Although investors in 2024 had many reasons to be optimistic, the economic environment faced several challenges. Concerns over rising unemployment and sticky inflation during the summer months saw the S&P 500 fall nearly 9% from mid-July to early- August. The Japanese Yen declined by nearly 8% following the Bank of Japan's decision to raise interest rates in July. This led to a selloff of U.S. assets as investors unwound a popular trade that involved borrowing Japanese Yen at low interest rates and investing in U.S. dollar-denominated assets. U.S. treasury bond prices rallied across all maturities during this period of risk-off sentiment.
Throughout the year, various events had the potential to shake equity markets. A strike involving more than 47,000 dock workers at 36 ports caused significant disruptions to operations along the East and Gulf coasts. This occurred during a crucial time for retailers preparing for the holiday season and impacted other industries, including automotive and agricultural imports.
Oil prices increased by nearly 25% in the first quarter, approaching $85/bbl. Higher oil prices can lead to inflation and detract from economic growth. Oil prices have recently declined due to weak demand from China and optimism regarding increased production under a less restrictive Trump administration. It will be interesting to observe how capital providers and management teams respond to this situation. Over the past decade, the oil industry has seen many significant bankruptcies, especially among companies that aggressively increased production by taking on debt during periods of rising oil prices. Companies that operate efficiently and maintain low levels of debt are better positioned to withstand the volatility of oil prices.
Economic data generally supports a “soft-landing” scenario where the Fed is successful in reducing inflation without causing a recession. Inflation is running higher than the Fed’s 2% inflation target, but the longer-term trend remains favorable. The Fed’s preferred measure of inflation, the core personal-consumption-expenditures price index that excludes food and energy, increased 2.8% year-over-year in October. This is higher than readings over the summer of 2.6% and 2.7%, but significantly lower than the 2023 range of 3% to 5%.
The unemployment rate has experienced a consistent increase from approximately 3.5%, recorded in the summer of 2022, to a current rate of 4.2% as of November. The labor participation rate has been mostly steady over that same period with November’s reading at 62.5%. The November jobs data showed that average hourly earnings rose 4%. The pace of earnings growth has declined from the 5.5% increase in July 2022. It is unlikely the Fed will hit its 2% inflation target if wage growth continues to increase at a 4% rate.
For those looking to buy or sell a house, the housing market is facing challenges. Recent cuts in the Federal Reserve's short-term interest rates raised hopes for lower mortgage rates and increased transaction activity. However, many soon realized that mortgage rates are more influenced by movements in the 10-year Treasury bond determined by the market than the short-term rates that the Fed directly controls. As long-term yields rose following the Fed's rate cuts, mortgage rates increased, leading to a higher cost of homeownership.
Existing homeowners with low mortgage rates feel strongly incentivized to remain in their homes, which has reduced the available inventory of houses for sale. As a result, home prices have continued to rise due to limited supply. Buyers and sellers may eventually conclude that current mortgage rates are reasonable, signaling the end of the era of 3% mortgages.
Technology disruptions and demographic changes are significantly impacting various industries. In the U.S., there is an ongoing demographic shift towards an aging population. This change will affect Medicare and Social Security, as older individuals typically spend more on healthcare. Additionally, the ratio of workers to Social Security beneficiaries is declining.
Artificial intelligence (AI) is being implemented in an increasing number of applications. Excitement around quantum computing is still in its early stages, but it holds the potential to unlock the full capabilities of AI. The demand for data storage and cloud computing was already high, but the rise of AI has intensified this need, leading to systems that consume massive amounts of energy. New technologies are being developed in the energy industry to satisfy demand. A notable advancement in the nuclear industry is the development of small modular reactors (SMRs). These reactors can be constructed more quickly and cost-effectively than traditional reactors and offer added flexibility and safety features.
While the S&P 500’s valuation appears elevated, corporate earnings have supported the strong stock market rally. According to FactSet, fourth-quarter earnings are expected to grow 12%. The forward P/E ratio for the S&P 500 is 22.3x, about 13% above its 5-yr average. The Information Technology sector has the highest forward P/E ratio at 29.9x, while the Energy sector has the lowest at 14.2x. Analysts expect another strong year for corporate profits in 2025, with earnings projected to grow by 15% and revenues by 5.8%. Equity valuations are likely sustainable if earnings growth expectations are met. Investing in growing companies at reasonable prices remains a rational approach to achieving long-term success.
Eric Wathen, CFA®