Strong growth expectations and policy uncertainty weigh on rate markets

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Economic growth remained strong in the third quarter, with real gross domestic product increasing 3.1%. Estimates for fourth quarter growth have increased throughout the quarter and are above 2%. Consumer and government spending were the largest contributors to gross domestic product in the third quarter as consumers continued to increase expenditures on both goods and services.

Reviewing rate cuts

The Federal Open Market Committee (FOMC) cut the federal fund rates by 25 basis points (bps) in December, a smaller cut than was expected at the start of the fourth quarter. Expectations for further rate cuts by the fed diminished throughout the fourth quarter. The market now expects only one more additional 25bps rate cut in 2025, possibly occurring mid-year, indicating a year-end rate slightly below 4%. This is a stark contrast the end of the third quarter, when consensus expectations were for rates to end 2025 below 3%.

This has been a unique cutting cycle, with the 10-year treasury rate increasing by more than 100bps since the Fed cut interest rates by 50bps at the September meeting. On average, the 10-year yield has fallen after past cutting cycles have begun, and this is the largest post-cut increase we have seen in the 10-year in almost 40 years. Much of the rhetoric around the increase in longer-term rates can be attributed to expectations for stronger growth going forward, concerns around inflation reigniting, and policy uncertainty. With regards to inflation concerns, we have not seen a large move in inflation expectations since the first rate cut in September, with the 10-year breakeven inflation rate increasing 30bps to 2.4%. This means much of the increase in rates, based on market expectations, is centered around stronger expected growth and uncertainty around policy. While it is still too early to definitively assess the impact of potential new policies, it is widely assumed that the main levers of implementation will include lower taxes, deregulation, higher tariffs, and reduced immigration. Importantly, many of these forces will work against one another, and it remains to be seen which levers will be relied upon most, and in what order they will be pulled. Regardless, the net effect of any such policy recipe containing these ingredients is likely to be higher growth, inflation, and long rates. In the world of fixed income investing, there were few bright spots given the backup in 10-year rates, as bond prices move inversely to interest rates. The Bloomberg Aggregate Bond index was down more than 3% for the fourth quarter.

Inflation, jobs, and consumer health

The December inflation report confirmed expectations of moderating price increases. Core-CPI (excluding food and energy) increased 0.2% for the month of December, bringing the change over the last 12 months to 3.2%. The largest contributors are still shelter and transportation services, increasing 4.6% and 7.3% respectively over the last 12-months. The December report helped to ease inflation concerns following the ISM survey on of the prices paid in the services sector, which showed a sharp increase in the proportion of managers reporting rising prices paid. Given the largest contributors to core inflation are in the services sector, the ISM report is worth monitoring, as it was early in signaling inflationary pressures in 2021. All told, core inflation increasing 3.2% year-over-year, while a welcome improvement, is still above the Fed’s own long-term target of 2%, contributing to their renewed hawkishness.

Unemployment was unchanged over the fourth quarter, beginning and ending the quarter at 4.1%. The resilience of the labor market has also contributed to the Fed’s renewed hawkishness and has continued to show strength following short-term softening seen before the September rate cut. Job openings surprised to the upside in November, increasing to over 8 million from a near-term low of 7.3 million in September. Job openings is a data point worth watching. Increases in job openings may point to business hiring due to optimistic growth expectations. This could put stress on wage growth, which has remained sticky, increasing 3.9% year-over-year, up from a low of 3.6% in July 2024. Wage growth is the most important input for the services sector, where we have seen the stickiest inflation. On the other hand, job openings have been a noisy economic indicator due to low response rates, and swings plus or minus 1 million from estimates have not been uncommon.

The average consumer is in solid shape, with incomes and net worth well above pre-pandemic levels. Debt as a share of disposable income is still below pre-pandemic levels, despite the increase in rates, and households are reporting credit is more accessible than it was a year ago. These average numbers do not reflect the extremes, and those in the lowest cohort cannot point to similar strength in income or net worth. We have seen delinquencies rise dramatically for consumers with the lowest income, however, recent credit reports from the New York Fed point to the possibility that delinquencies may be turning a corner. With excess savings all but dried up, consumers will need to pull from income growth as well as borrowing or equity to continue to fuel spending. With real estate prices at all-time highs, more and more consumers have been taking advantage of their increase in home equity. Home Equity Lines of Credit balances have increased more than 10% from a year ago, the largest increase we have seen since 2008. All told, household optimism is at the highest level we have seen since the pandemic recovery in 2021, and small business optimism has reached levels not seen since 2018.

Market updates

The equity market posted another solid quarter to end the year despite some notable choppiness in the final weeks. The 2.4% return for S&P 500 in the fourth quarter was roughly in-line with average market returns over the long-term, even if appearing unremarkable by the standard set over the last couple of years. The S&P 500 posted one of its best yearly showings in decades, returning 25%. Coming on the back of last year’s 26% performance, these were the best two consecutive years since the late 90s.

The third quarter’s trend of market broadening took a pause in the final quarter of the year, with the equal-weighted measure for the S&P 500 down slightly for the quarter, falling 1.9%. Meanwhile, large-cap stocks were once again in the driver’s seat, with mid-cap and small-cap indices roughly flat for the quarter. Growth once again outperformed Value, after a short catch-up period for the latter in the previous quarter.

Within the S&P 500, sector performance reveals leadership by a list of usual suspects hinting towards a more concentrated market. For example, the Consumer Discretionary sector, which is heavily weighted toward Amazon and Tesla, was far and away the best performing sector for the quarter. The other three sectors which beat the market were Communication Services, Financials, and Tech. Notably, the top four sectors for the quarter were also the top four for the year, although not exactly in the same order. Each of them were up over 30% for the year, with Communication Services breaking the 40% threshold.

The underperforming sectors for the quarter were all negative. Materials were down double digits against a backdrop of continued weak economic growth outside of the US. Healthcare also suffered amid increasing policy uncertainty, and substantial competition. Real Estate was the third worst performing sector, as changing expectations for interest rates may have caused some to conclude that a recovery for the sector would be delayed. Utilities, Staples, Energy, and Industrials also underperformed, all posting negative returns for the quarter.

 Conclusion

Despite the lingering uncertainty, the trickier part for investors will be determining to what extent optimism for future growth is already priced in, with equity valuations currently clocking in at historical extremes on most metrics. While the fundamental upside is attainable, so too is the room for disappointment. When faced with uncertainty, a disciplined approach to diversification and a long-term focus can help investors pursuing more stable, predictable, and reliable returns.

With assistance from Scott Shattuck.

Matt Kelley is Chief Investment Officer, Cooper/Haims Advisors, an ESL company. In his role, Matt is responsible for institutional account portfolio management and oversees the portfolio strategy team, while supporting the broader ESL wealth entities.

Contributions also offered from Scott Shattuck, Senior Portfolio Analyst, Cooper/Haims Advisors.

The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.