Market Commentary: Power Shifts & Pivot Points

Written as of January 10, 2025.

Highlights this Month

• Investor sentiment remains strong despite year-end wobbles.
• But what about the risks?
• The math behind Wall Street’s predictions.
• The bond market’s outlook.
• What is a “neutral rate”, and are we there yet?
• America’s growth story continues to challenge traditional economic wisdom.
• The risks of a strong U.S. dollar.
• The success of Trump’s agenda is not guaranteed.
• Tackling the biggest near-term challenge.
• Stocks, bonds, and charting the 2025 investment landscape.

December in Review

The stock market in 2024 was a tale of two stories: a strong performance for much of the year followed by an uncharacteristically rough December. U.S. exceptionalism was in full display last year, as the S&P 500 returned 25.0% (total return in U.S. dollars), handily outperforming the S&P/TSX’s +21.7% (total return in Canadian dollars) and the MSCI ACWI ex US’s +18.4% (total return in U.S. dollars) return. However, the final month saw declines across major indices, with the S&P 500 dropping 2.4%, the MSCI ACWI ex USA Index losing 1.9%, and the S&P/TSX falling 3.3%. The slump occurred primarily between Christmas and New Year’s, marking the S&P 500’s second-worst post-Christmas performance on record (Figure 1). 

Figure 1

Investor sentiment remains strong despite year-end wobbles. 

Normally, late December and early January are positive for stocks, with the S&P 500 averaging a 1.3% gain during the last five trading days of the year and the first two of the next. This is known as the “Santa Claus rally,” and it happens about 77% of the time since 1950. This year, however, Santa left a 0.53% lump of coal under the tree. According to market lore, if the rally doesn’t materialize, it can signal a rough year ahead, with the S&P historically averaging a -7.4% return following a "Santa no-show." But it's worth noting that last year’s similar slump didn’t prevent the S&P from finishing with a 25% return. January might be a more reliable indicator, with Strategas showing that positive Januaries typically lead to stronger gains over the next six months (Figure 2).

Figure 2 | Source: Strategas

Investor sentiment remains high. 

Despite the December pullback, investor sentiment remains strong. Strategas shows that sentiment was in the 77th percentile in December, not extreme, but still heading in that direction (Figure 3). Other measures, like the Levkovich Index (Figure 4) and Topdown Charts’ Euphoriameter (Figure 5), show market sentiment at euphoria levels. While high optimism can sometimes be a red flag, it may also signal continued market strength. 

Figure 3

Figures 4, 5

Bonds faced a challenging year. 

The bond market had a much tougher time in 2024. U.S. Treasury bonds ended the year nearly flat, with investors needing to take on more credit risk to see decent returns. Investment-grade bonds returned just over 2%, while non-investment-grade bonds saw returns above 8%. 

Unusually, Treasury bond prices fell after mid-September, even as the Fed began cutting rates—a pattern that isn’t typically seen. Normally, weaker economic trends would lead to lower yields, but this time, yields increased even as economic data weakened. 

Another year of navigating uncertainty. 

It’s clear there’s a lot happening—not just in the markets but globally. In a recent article by Marcus Ashworth and Mark Gilbert in Bloomberg, they suggest that 2025 will likely be a wild ride for stocks, bonds, and commodities. They liken the current investment environment to the "three-body problem" in physics, where predicting the movements of three independent masses is impossible due to their unpredictable outcomes. For investors, this translates to a complex mix of politics, economics, and markets, all influencing the direction of stocks, bonds, and commodities. While the consensus outlook for 2025 may seem straightforward, the reality is far more unpredictable. 

The consensus view: A soft landing. 

According to the Financial Times’ Alphaville, most analysts predict a steady 2025 for markets, with U.S. GDP growth expected to be around 2.2%—in line with the Federal Reserve’s projection (Figure 6). Unemployment is predicted to rise slightly, by about 0.1%, and inflation should settle at around 2.5%. Most economists are not expecting GDP to dip below 1% or unemployment to exceed 5% (Figure 7). In fact, 60% of respondents in a Bank of America survey are anticipating a “soft landing” for the economy, with only 6% predicting a hard landing. Wall Street seems to favour a merry-go-round outlook over a dramatic rollercoaster ride. 

Figures 6, 7

But what about the risks? 

While the consensus outlook is relatively calm, risks are lurking. Torsten Slok of Apollo highlighted 12 potential risks to global markets, with tariffs topping the list as the biggest concern. The December Bank of America Fund Manager survey also flagged global trade tensions as a major risk, with the possibility of a trade war pushing the economy into recession. Another major concern is the Federal Reserve hiking rates further due to inflation, which also poses a risk to market stability (Figure 8). 

Despite these risks, market risk as measured by volatility is relatively low (Figure 9), Additionally, indicators like bond spreads and default insurance suggest that market participants are not overly worried about risk, which has kept the cost of market protection relatively low. 

Figures 8,9

Wall Street’s 2025 outlook is strong, with a few caveats. 

Wall Street expects the S&P 500 to see a relatively strong return of 12% in 2025. While forecasts vary, with some analysts predicting as low as 1.9% and others as high as 20.6%, the majority of predictions cluster around the 12% mark (Figure 10). Historically, however, Wall Street forecasts have been wrong, often falling short or exceeding expectations. The S&P 500 has gained more than 10% in 51 out of the last 97 years, with many years seeing much higher returns. 

Figure 10

The math behind Wall Street’s predictions. 

Why is Wall Street predicting 12% growth? A large part of the S&P 500’s strong 2024 performance was driven by an increase in valuation, particularly among technology stocks. Even excluding the “Magnificent 7” (the big tech companies), U.S. valuations are near the top of their historical range, which means a lot of positive news is already priced in. To hit their target, earnings growth will need to be the primary driver of returns in 2025, and analysts expect earnings to grow by 12.7% (Figure 11). This forecast relies on companies, especially tech giants, maintaining high-profit margins. 

Figure 11 | Source: Strategas

The bond market’s outlook.

On the bond side, most strategists are predicting short-term interest rates will fall in 2025, with the median forecast calling for a 50 basis point drop by year-end. Longer-term rates are expected to steepen, though some strategists are skeptical of the sudden bearish turn in bond prices, which could result in higher yields. Notably, only 32% of bond investors are currently bullish about the bond market (Figure 12). 

Figure 12 

The recent movement in bond prices has been influenced, in part, by the Federal Reserve's outlook. The December Survey of Economic Projections revealed that the Federal Open Market Committee (FOMC) now expects the federal funds rate to decline to only 3.84% by the end of 2025, up from the 3.35% projected in September (Figure 13). The key change is that most FOMC members now view inflation risks as leaning upwards. The Fed continues to walk a tightrope, managing the risks of resurging inflation while observing a softening labour market. Sticky inflation remains above the Fed’s 2% target, though some cracks are emerging in the job market. Many companies are not hiring at previous rates, and those who are losing jobs are finding it harder to secure new positions. 

Figures 13

What is a “neutral rate”, and are we there yet? 

In light of this uncertain economic environment, it might be prudent for the Fed to move towards a neutral interest rate—one that isn’t either stimulating or restricting growth. However, there is no clear consensus on what that neutral rate should be. Estimates range from 2.375% to 3.875%, with 3.0% being the median. If the upper end of this range is correct, the Fed may only have two or three 25 basis point cuts left before reaching neutrality. Conversely, if the lower end is closer to the mark, the Fed has more work to do. Financial conditions, influenced by a stronger dollar and higher long-term bond yields, suggest 3.875% could be a reasonable neutral rate. Despite this, the impact of recent rate hikes on the broader economy has been somewhat muted, and it seems markets are starting to accept that higher rates may persist longer than previously anticipated. 

U.S. federal debt and its impact on bond yields. 

Beyond the Fed, another key driver of rising bond yields is the growing U.S. federal deficit, which has bloated the Federal balance sheet. Investors have become increasingly concerned about the unsustainable trajectory of U.S. debt, as noted by Goldman Sachs. While Treasury Secretary Janet Yellen has temporarily alleviated some pressure by funding the debt with short-term Treasuries, this strategy presents risks in the long term. With the incoming Treasury Secretary, Scott Bessent, likely to face the challenge of funding not just the current debt load but also an anticipated aggressive fiscal agenda under the new Trump administration, the outlook for U.S. debt remains complex. 

America’s growth story continues to challenge traditional economic wisdom.

Elon Musk’s recent establishment of the Department of Government Efficiency (DOGE) has sparked conversations about its potential to address fiscal challenges. Bloomberg Economics suggests that tempered tax legislation, tariff revenue, and DOGE savings could result in relatively unchanged debt-to-GDP ratios. However, as George Will of The Washington Post wittily noted, “Overhauling government isn’t rocket science. It’s harder.”  

While the idea of trimming government expenses may sound promising, it’s worth noting that most federal spending is tied to mandatory programs like Medicare and Social Security. Civil servant salaries, accounting for $200 to $250 billion annually, fall far short of Musk’s ambitious $2 trillion savings goal. Cutting programs or jobs to close the deficit is unlikely to be well-received, both by those directly affected and the broader public.  

Reducing deficits is essential to avoiding long-term financial crises, but it comes at an economic cost. Deficits can fuel short-term growth, and history shows the stock market often performs best when the ratio of deficit to GDP is high (Figure 14). Striking the right balance between fiscal responsibility and economic momentum will be crucial. 

Figure 14

Increasing GDP growth could help address debt-to-GDP challenges.

Another option to maintain or lower the debt-to-GDP ratio is to increase GDP growth, and the U.S. has been performing well in this regard. The U.S. economy has outpaced much of the developed world, including Canada, with Goldman Sachs attributing this success to an outsized increase in productivity (Figure 15). If productivity growth remains robust, the U.S. economy could sustain its momentum without overheating and triggering inflation. While it’s uncommon for a country to resolve debt challenges through growth alone, strong productivity gains offer a potentially viable path. 

It’s tempting to assume artificial intelligence (AI) is the driving force behind these productivity improvements. However, although the AI investment cycle is well underway, adoption rates remain low, and widespread productivity gains are still years away. This presents a silver lining: the most significant productivity boosts from AI are yet to come. Still, it raises an important question—what factors have fueled the recent surge in productivity, and can these trends continue?   

One potential factor is a flexible workforce that has efficiently adapted to the post-pandemic environment. Another key element could be the U.S.'s deep and efficient capital markets, which are well-positioned to connect the world’s brightest minds with the funding needed to bring their ideas to life. 

From an educational perspective, the U.S. does not stand out. According to the Program for the International Assessment of Adult Competencies, the U.S. ranks 14th in literacy, 15th in adaptive problem-solving, and 24th in numeracy out of 31 industrial nations. While top-performing U.S. workers (those in the 90th percentile) have seen their scores improve, the bottom 10% continue to fall behind, with 34% of US workers demonstrating math skills below a primary school level.  

Despite these shortcomings—especially in comparison to some European nations—US companies often outperform their global peers (Figure 15). A culture that embraces risk-taking plays a role, but the ability to supplement the domestic workforce with top talent from around the world is also an advantage. According to the Boston Consulting Group, the U.S. remains the leading destination for STEM experts. While some in the Trump Administration advocate for tighter immigration policies, innovators like South African-born Elon Musk underscore the critical importance of attracting and retaining global talent. 

Figure 15

Traders hold a more balanced view on Fed rate cuts. The risks of a strong U.S. dollar.

The U.S. has become a magnet for talent and capital, with American exceptionalism pushing the value of the dollar higher. However, a strong dollar comes with risks. It can hurt American manufacturers, as it often correlates with a drop in the Purchasing Managers' Index (PMI) and reduced capacity utilization. With 41% of the S&P 500’s revenue coming from abroad, a stronger dollar reduces earnings when converted.  

President-elect Trump’s approach to the dollar reflects a delicate balancing act. While the dollar’s status as the world’s reserve currency underscores its global significance, a strong dollar poses challenges for U.S. exports and puts domestic companies at a disadvantage against lower-cost foreign competitors. His administration's reliance on tariffs aims to level the playing field for manufacturers but risks unintended consequences, such as strengthening the dollar—particularly against the Chinese yuan. China’s large trade surplus with the U.S. makes it a prime target for tariffs, but Trump’s claim that China will bear the cost is a simplification. In reality, it is American consumers who often feel the impact through higher prices, although Chinese exports could decline if U.S. consumers cut back on their purchases. To offset tariff impacts, China may let its currency depreciate, which is what happened during previous tariff increases in 2018-19 (Figure 16). 

Figure 16

Decoupling the U.S. and Chinese economies is a rare point of agreement between U.S. Republicans and Democrats, with tariffs seen as one tool in this effort. While decoupling has risks for both countries, China appears more vulnerable. U.S. 10-year Treasury yields have been rising, signaling strong economic growth, while Chinese yields have slumped, even falling below those of long-term Japanese government bonds. Despite rate cuts, China faces weak inflation and negative producer price inflation, putting its economy at risk of a deflationary spiral. These challenges, compounded by the trade war with the U.S., make China particularly vulnerable if Trump escalates tensions. 

Uncertainty also looms in the U.S. economy.

While China faces economic challenges, the U.S. is also navigating uncertainty under the new Trump administration. The Financial Times reports that most economists expect Trump’s policies to slow economic growth, even within the U.S. (Figure 17). Interestingly, a poll by the Association of Certified Professional Accountants found that 67% of U.S. businesses feel more confident post-election, compared to only 26% before. Consumer confidence largely depends on political affiliation—Republicans are optimistic, while Democrats are more pessimistic, according to the University of Michigan.

Figure 17

The success of Trump’s agenda is not guaranteed. Some policies, such as tariffs, may be enacted via executive order, but others require congressional approval. Although Republicans hold majorities in both the House and Senate, the margins are narrow, and party divisions could hinder Trump’s agenda. His ability to unite these factions remains uncertain, especially after pushback on some of his cabinet picks. Additionally, the Supreme Court’s support for Trump’s policies may not be as strong as anticipated. Bloomberg notes that Trump’s win rate at the Court was the lowest of any president since the 1930s (Figure 18). 

Figure 18 

Geopolitical risks and Trump’s unpredictability.

Trump’s geopolitical approach could create significant risks. His negotiation style, often unpredictable, may work against allies like Canada but prove dangerous with adversaries such as Russia, China, Iran, and North Korea. As pointed out in a recent Bloomberg article, Trump’s unpredictability could mirror a classic prisoner’s dilemma with varying outcomes depending on how he approaches each situation. The war in Ukraine may serve as his first significant test on the global stage, and the stakes are high.   

Political uncertainty makes forecasting challenging. 

Investing in 2025 will likely be difficult due to the unpredictable influence of politics, especially Donald Trump’s impact on the economy and markets. Predicting his actions is challenging enough, and their effects on the market are even harder to forecast. His speeches, often seen as disjointed, signal a continuation of uncertainty that is likely to persist for the next four years.  This uncertainty is generally not favourable for investment returns, especially stocks. Higher levels of uncertainty tend to lower annual returns and increase market volatility (Figure 19). While this may pose risks, Trump’s influence could also extend U.S. economic strength, despite the uncertainty. 

Figure 19

Tackling the biggest near-term challenge.

A major challenge for the market is that strong economic growth could lead to inflation, which may in turn push interest rates higher. With 10-year US bond yields expected to exceed 4.5% by the end of 2024, we may see conditions similar to past market corrections. Higher bond yields could put pressure on stocks (Figure 20). Bonds currently appear more attractive than stocks, as the gap between stock earnings and bond yields is narrow. However, rising bond yields could start to affect stock prices as well, which complicates the strategy of using bonds as a safe investment to balance stock exposure. 

Figure 20

Stocks, bonds, and charting the 2025 investment landscape. 

Stocks are currently priced at relatively elevated levels, and with rising bond yields, 2025 may present a challenging year for investors. The reason for the rising rates matters—if they are driven by stronger-than-expected economic growth, the market could still perform well. A market correction might even be beneficial by resetting stock valuations. However, avoiding a recession will be crucial for maintaining stability. Based on a Goldman Sachs chart showing global equity returns around the first Fed rate cut, stocks tend to do well when the Fed cuts rates, as long as a recession is avoided. While earnings, not bond yields, are the primary driver of long-term stock performance, healthy earnings and no recession signs could still support growth in stocks. But the political risks, especially around Trump, remain significant. 

A balanced investment strategy, with both defensive stocks and riskier assets, may help mitigate the risks of a potentially tough 2025. From a total portfolio perspective, investors have historically used bonds as their safe asset when employing a barbell strategy. While rising bond yields may change traditional investment dynamics, they can still play an important role in a diversified portfolio. True diversification is a proven way to reduce risk and manage uncertainty, especially in a market that may face both opportunities and challenges. By spreading investments across different asset classes, investors can better navigate the complexity of the coming year. Nobel laureate Harry Markowitz famously quipped, "Diversification is the only free lunch in investing," and we agree.