News And Insights Economic & Market Perspective: January 2025

With 2025 kicking into gear, it’s worth highlighting some areas of the U.S. economy and financial markets from 2024 to see what investors might be keeping an eye on in the months ahead. Last year, the economy navigated many challenges, including elevated interest rates, geopolitical uncertainty and the U.S. presidential election. Still, the economy and markets held up better than expected, characterized by sustained growth, moderating inflation and strong consumer spending. Whether this resiliency continues for another year remains to be seen and will depend, in part, on potential changes to domestic policies as well as geopolitical issues.

Economy Continues to Hum

U.S. Gross Domestic Product (GDP) growth consistently exceeded expectations in 2024, remaining above its long-term average rate throughout the year. To the surprise of many investors, the economy avoided a significant slowdown, having been supported by a strong labor market, steady wage growth and robust consumer spending. In 2025, Real GDP is expected to return to trend at a rate of 2.1%, coming off a 2.7% average in 2024 and 2.9% in 2023.

Inflation and Consumer Spending

Over the past year, inflation continued to show signs of moderation, dropping below 3% for the first time since March 2021, when it initially surged following the pandemic. Inflation stalled at around the 3% mark—remaining above the Federal Reserve’s target inflation rate of 2%, as shelter and housing costs, which are a large component of the Consumer Price Index (CPI), remain sticky.

In spite of lingering inflation, consumer spending, which accounts for 70% of GDP growth, was bolstered by a healthy labor market that saw wages rising faster than inflation. Wages were up 4% year-over-year based on total private average hourly earnings. There was some softening in job growth in 2024 as the unemployment rate increased from 3.7% in January to 4.1% in December. However, the labor market remained resilient, with the unemployment rate staying near historic lows.

These wage gains continued to support solid consumer spending, even though prices for many goods and services remain higher than in previous years. Overall, the number of job openings continued to trend lower, as did the number of people quitting their jobs.

Given the robust labor market and persistent inflation, the financial markets may be overly optimistic regarding the number of interest rate cuts coming from the Federal Reserve in 2025.

Federal Reserve Moves on Interest Rates

During most of 2024, the yield curve remained inverted, as short-term interest rates were higher than long-term ones. However, the inversion began to unwind in the fourth quarter, as the economy continued its steady showing, and there was minimal concern about a potential recession.

In September, with inflation still easing, the Federal Reserve began its monetary easing cycle with a reduction of half-a-percentage point of the Federal Funds Rate, to a range of 4.75% to 5.0%. Treasury yields rallied, helping to end the inversion of the yield curve for the first time since July 2022. This was followed by two consecutive quarter point cuts, in November and December, lowering the target rate by one percent in 2024 to 4.50% and signaling progress toward the Fed’s dual mandate of maximum employment and price stability.

While the Fed’s statement in December was generally consistent with previous ones, it did include new language about “the extent and timing” of future interest rate cuts, suggesting a slower pace of interest rate reductions in 2025 than previously anticipated. Since the Fed’s initial rate cut in September, long-term bond yields moved higher, likely reflecting the market’s recognition of the Fed’s guidance and a strong U.S. economy.

Financial Markets Break Records

During 2024, the S&P 500® Index set 57 record highs and achieved its second consecutive year of 20%-plus performance for the first time since 1998. For the full year, stocks and bonds both finished in positive territory. The S&P 500 was up 25.0%, while the Bloomberg U.S. Aggregate benchmark, a proxy for bond performance, gained a modest 1.3%. Bonds experienced another volatile year in 2024, with long-term yields rising despite the Fed lowering its policy rate by 1%.

Taking a closer look at the equities market, large-cap equities outperformed small-cap equities, largely due to the mega-cap stocks in the benchmark, namely the Magnificent 7—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. By the end of the year, these stocks represented roughly 33% of the weight in the S&P 500 and accounted for nearly 53% of the total return of the Index.

In the third quarter, as investors anticipated the Federal Reserve would lower interest rates, market performance broadened beyond the Magnificent 7. However, this trend reversed in the fourth quarter due to stickier-than-expected inflation. By December, the Fed signaled the possibility of just two rate cuts in 2025, down from an initial four. Should interest rate projections continue to fluctuate, the back-and-forth pattern of market leadership is likely to persist.

Mid-cap and small-cap stocks both underperformed their large-cap counterparts during the year, with the S&P 400® Index and Russell 2000® Index up 13.9% and 11.5%, respectively. The valuation gap, in terms of price/earnings, between small-cap (19.3x) and large-cap stocks (24.7x) is the widest it’s been since April 2003.

Looking at growth versus value investing, growth stocks outperformed value stocks across all size segments for the second consecutive year. Further, international markets, as measured by the MSCI EAFE, finished the year up 3.8%, lagging all U.S. indices.

Outlook

The outlook for the economy and financial markets in 2025 appears positive, though various factors could lead to increased volatility and uncertainty. In 2024, the U.S. economy was resilient despite slowing growth. Inflation pressures moderated, allowing the Fed to pivot to a more accommodative monetary policy. And, for the most part, the financial markets, particularly mega-cap stocks, enjoyed another strong year. Looking ahead, the markets are likely to experience volatility due to potential policy changes from the new administration on issues related to tariffs, deregulation, tax policy and geopolitical matters. Investors should remain cautious, as the financial markets may experience pullbacks due to elevated valuations among equities and potentially slower economic growth. Diversification can help reduce volatility as investors navigate through unpredictable markets.