By: Brent Schutte, CFA
Equities finished the week lower, and bond yields moved higher (yields and bond prices move inversely to each other) as the latest Summary of Economic Projections (SEP), or so-called “dot plot,” from the Federal Open Markets Committee (FOMC) along with comments from Federal reserve Chair Jerome Powell set a higher bar for continued rate cuts in 2025. The latest dot plot showed the members of the committee are forecasting just two interest rate cuts in 2025, down from September’s forecast of four cuts. In his press conference following the release of the SEP, Chair Powell explained the evolving view of the FOMC, saying, “We moved pretty quickly to get to here, and I think going forward obviously we’re going to be moving slower, which is consistent with the SEP.” The dot plot, which came as the FOMC approved a 25-basis-point cut, also showed the Fed now expects inflation will be 2.5 percent at the end of 2025 and will not return to the Fed’s target of 2 percent until 2027.
For much of the past year, investors have viewed rate cuts as a key ingredient that would take pressure off struggling portions of the economy and lead to a broadening of the market. With the Fed forecasting just 50 basis points spread across two cuts next year, investors had to reconsider whether those parts of the economy that have labored under higher interest rates would get much-needed relief or whether the economy would continue to be propped up by a small sliver of businesses and industries that have been insulated from the negative impacts of higher rates.
Indeed, market breadth highlighted just how narrow the class of winners has become. As we highlighted in our Quarterly Market Commentary for the third quarter, equity markets began to broaden in July as the prospect for rate cuts grew. This was augmented following the presidential election, as expectations that policies from the incoming Trump administration and easing interest rates would boost growth and serve as a catalyst for companies more directly linked to the economy. But as expectations about the number of cuts in 2025 recently began to come into question, the market returned to favoring a small subset of large technology names that it believes will grow regardless of the economy. The upshot is that every trading day from December 2 through December 19, more individual stocks saw their prices decline than those that rose in price. For further context, this is the longest stretch of negative breadth in data going back to 1990. Despite this, the S&P 500 posted positive performance from December 2 through December 17. It wasn’t until the sell-off sparked by the Fed’s latest dot plot that the index turned negative.
We believe the market reaction to the Fed’s SEP underscores the risks we’ve been highlighting of an economy that is growing despite not running on all cylinders and a market that is moving higher in an incredibly narrow manner. Recent investor optimism has been based on expectations that rate cuts would heal flagging parts of the economy and business-friendly policies from the new Trump administration would provide a tailwind for businesses. Put simply, much of the strong market performance prior to last week was driven by expectations that a best-case scenario was the base case for 2025.
Our comments on risks also highlight opportunities for intermediate- to long-term focused investors as we move into 2025. Despite the overall strong performance of equity markets in 2024 that has resulted in rich valuations for a swath of stocks, many segments of the markets haven’t taken part in the rise and, as a result, remain attractively valued. We maintain that if the economy continues to grow in 2025, it will be in a broader manner, which will broaden earnings growth and lead to broad market participation to the upside.
Despite the near certain narrative that many believe is in the cards for 2025, we continue to believe many unanswered questions remain and that many twists and turns lie ahead. Will inflation continue to slow and allow the Fed to cut rates in 2025? What happens to the labor market, which has continued to show signs of weakness? What policies will the incoming administration be able to push through, and what will their impact be? These are just some of the questions that remain. Given this uncertainty, we continue to believe investors should follow a plan that accounts for inevitable twists and turns. We believe the best approach to an unknowable economic outcome is diversification. While diversification is often viewed as a defensive tool, we see it as an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
