The economy and markets navigated a mix of challenges and opportunities in 2024, shaped by fluid inflation rates, lowering interest rates, and a volatile Presidential election. Despite initial concerns, domestic markets repeated 2023 to finish the year over 20% again, and fixed income continued to provide adequate yield. As we look to 2025, we continue to be cautiously optimistic about portfolio risk and the ability to sustain viable growth. What this upcoming year has in store is unknown, but the following commentary provides a summation of the previous year and our strategic projections for 2025.
Q4 Equities
The fourth quarter brought modest volatility to the equity markets. After an initial strong rally led by small cap stocks following the election results and Fed rate cut, the markets gave back most of the early performance. Domestic markets still finished in positive territory with the S&P 500 (represented by SPY) up 2.5% for the quarter, and small cap stocks (IWM) up 0.3%.
Outside the USA the story was very different. Despite China’s stimulus package1 (worth about $1.4T), emerging markets (EEM) lost over 7%. Furthermore, the developed international markets (EFA) lost over 8%, continuing the trend of superior domestic performance vs the rest of the world. We continued with a strategic allocation of overweighting domestic stocks and underweighting international stocks, which benefited clients in the fourth quarter.
2024 Equities
Looking at the whole of 2024, the trends mentioned above are even more pronounced. Large Cap US stocks (SPY) dominated all other markets with a return of almost 25%. Small Cap US stocks (IWM) returned over 11%, and every other market we track ended in the low single digit range. Our distinct, consistent positioning during 2024 – overweight US Large Cap stocks and exclusion of US Small Caps and Emerging Markets – led to better-than-expected results for the year.
As mentioned in earlier articles, 2024 was a favorable environment to increase portfolio risk, as Fed rate cuts were expected, overall inflation was easing, and a strong employment picture created positive projections. These indicators proved correct, with SPY returning 25% after a similar result in 2023. It is important to note that back-to-back 20%+ years are uncommon and unexpected. This spasmodic feature is why we always own equities. Equities can lose value, but to not own them means you do not participate when there is a rally. Sitting out of equities these past two years could have led to a 50% shortfall in portfolio performance.
The same downside risks, particularly in US Large Cap stocks, remain prevalent in 2025. Valuations are a concern as the past two years of strong performance have increased the P/E ratio of the S&P 500. Additionally, the S&P 500 is enormously concentrated with over 37%2 of the index composed of 9 names (Google occupies two spots with different share classes). We understand this concentration is a risk, but we also acknowledge this is how the market has chosen to value and allocate capital. It is important to note that over the past several years the biggest stocks have delivered the highest returns.
Valuations are interesting with the S&P 500 – as measured by the P/E ratio – appearing stretched. However, when growth is incorporated using the price to earnings to growth (PEG) ratio, while not cheap, this ratio does not appear out of line (see the charts below). Therefore, if companies deliver on targeted growth objectives, the S&P 500 can grow into the current valuation. The risk is that we could see a noticeable pullback in equity values if growth disappoints and both earnings and multiples contract.
Q4 Fixed Income
Despite two additional rate cuts by the Fed in Q4 following a rate cut in September, Floating Rate bonds (FLOT) delivered the best performance of the group by a wide margin. High Yield (HYG) was flat, and Aggregate bonds (AGG) lost substantial value during the quarter. This movement is counterintuitive because, in general, when rates fall duration is rewarded. The nuance is for duration to make a meaningful positive impact on performance, the mid- to long-end of the yield curve has to drop, not just the short end of the curve. Remember, the Federal Reserve is only controlling the short-term portion.
The Fed delivered two rate cuts in Q4, but the yield curve rose as the market recalibrated expectations for fewer rate cuts in 2025. As shown in the below chart, the 5-year portion of yield curve (purple line) was at about 3.6% on September 30th, but rose to almost 4.4% by the end of the quarter. At the same time, almost the opposite was happening at the short-term portion of the curve. This movement of the yield curve is called “flattening” in fixed income parlance, meaning it has gone from a very inverted (downward sloping) curve to one that slopes upwards (in general) after the 1-year mark.
Before Q4 we rotated back into our Floating Rate overweight allocation to the benefit of the income-producing portfolio.
2024 Fixed Income
Fixed income markets proved tricky in 2024 with the market swinging from one extreme (i.e., anticipating six rate cuts at the beginning of the year), to none, to then almost begrudgingly accepting three by the end of the year. Understanding duration (i.e., interest rate sensitivity) and paying close attention to Fed policy led to substantial outperformance in fixed income portfolios for the year as we rotated weightings of Floating Rate, High Yield, and Aggregate bonds.
In general, our portfolios incorporated High Yield and Agg bonds in May when rate cut expectations fell to very low levels. That ultimately meant we began taking more duration risk when the markets future rate cut expectations were at a low. After benefiting from duration exposure during the summer, we rotated back to overweight of Floating Rate bonds at the end of the third quarter, believing that the middle part of the yield curve would be stickier and the curve would flatten rather than drop uniformly. As we wrote during in our Q3 update, “We believe the market has not only priced in the first 50 basis point move but also more aggressive cuts in the future, so we have continued to overweight Floating Rate bonds.”
Macro Environment
We are generally positive on the environment for taking risk, though some factors have changed.
- Short-term rates are lower
- Domestic markets (especially Large Cap US) are more expensive
- Inflation could be more stubborn than expected
On the positive side of lower short-term rates, companies that use floating rate debt will see lower interest costs which improves earnings. That said, investors are now paid less to make these loans, though the loans are arguably less risky. This impact is most noticeably felt in public Floating Rate bond and Private debt exposure.
On the equity side, as the market rallied on rate cut news and the anticipation of business-friendly policies from the new administration, the domestic market has become expensive. We do not expect another 20% year for equities, but we do believe the environment is still constructive for the same reasons: strong economy, low unemployment, and now lower interest rates with the prospect for a few more cuts in 2025. While we will likely see some rate cuts in 2025, it is likely that the middle and longer portions of the curve stay roughly where they are, meaning the benefits of duration may be muted.
In terms of risks, there is a decent chance the Fed will slow the pace of rate cuts due to inflation. And, as always, there are numerous geopolitical concerns that could knock markets off track and increase recession risk.
Positioning
We will maintain our equity positioning going into 2025 in the same place we began 2024: overweight domestic Large Cap stocks, and underweight other markets. We believe the US is best positioned for future growth as compared to the rest of the world.
In fixed income, our positioning of overweight Floating Rate bonds and smaller equal-weighted allocations to Aggregate and High Yield seems appropriate given current conditions and our expectations. That said, as the market attempts to determine Fed policy, we will attempt to profit, as we did in 2024, from outsized moves in the yield curve to create the best income-producing portfolios.
At LGT, we maintain heavy exposure to alternative investments and continue to show bias towards the risk/reward trade off in private equity and private debt. The lower rates have and will lower returns in the private debt markets but should be a modest positive for private equity. As for Real Assets, we are overweight Infrastructure but maintain a position in core real estate for diversification and yield.
Sources: China announces $1.4 trillion package over five years to tackle local governments' 'hidden' debt, SPLG: SPDR® Portfolio S&P 500® ETF
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Our team is always happy to discuss strategic portfolio positioning, especially how it relates to individual goals and objectives. Our team of investment managers and trusted advisors believe a comprehensive financial plan must include a sound investment policy statement to guide investment decisions, and we encourage conversations around aligning a portfolio with wealth goals. Reach out to our team today to have a better understanding of what you need to feel confident in your financial future.
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