BY: Jim McElroy

A New Year

January, named after Janus, the Roman God of doorways and gates, is upon us.  The month is well named: it’s both the gateway to the new year and the door we think we’re shutting on the old.  Of course, this is only metaphorical—2024 and 2025 are a continuum—and whatever happens in 2025, both good and bad, likely had its genesis in 2024 and earlier.  If only we knew what in 2024 would continue into 2025.  But that’s why Janus is a god: he disdains any inclination to warn or advise mere mortals.

We could be well satisfied if 2025 were a repetition of 2024.  GDP was positive for each of the first three quarters of 2024 (the fourth quarter, like December, won’t be available until early 2025), and the third quarter recorded an annualized pace of 2.83%.  Core inflation (CPE, the Fed’s preferred gauge) declined sharply, with some hiccups, from January’s annualized rate of 6.14% to November’s annualized rate of 1.39%.  During this period, the unemployment rate has increased only marginally —from 3.7% to 4.2% — averaging 4.0% over the twelve months ending in November 2024. And the stock market, as represented by the S&P 500, is up over 20%, the second time in two consecutive years.

Will inflation resume its decline towards the Fed’s preferred 2%, or will it reverse course and exceed the highs of 2021 and 2022?  Will the Fed declare victory over inflation and reduce borrowing costs in time to prevent a job-crushing recession?  Will the record-setting 2024 stock market remain bullish and continue to new highs in 2025, or will there be a reversal of fortunes? Will the yield curve—the difference between long-term and short-term interest rates—finally become meaningfully positive, or will it remain largely flat (a narrow difference in yield of 0.3% to 0.4% between T-Bills and 30-year bonds), or worse, will it turn dramatically negative?

Near the beginning of 2024, we opined that the Fed’s record of engineering an economic soft landing in the face of accelerating inflation was not good.  In fact, in our lifetime (longer than we care to admit), we’ve never seen it done.  The Fed usually tightens too aggressively and precipitates a recession with unacceptable levels of unemployment.  The other path—failure to tighten enough—usually leads first to hyperinflation (think of the Weimar Republic in Germany) and then to an intractable economic depression.  The goal of this tightening and/or loosening is to arrive at a soft landing in which the Fed strikes the perfect balance between price stability and full employment.  It seems to us that in order for 2025 to be an improvement over 2024, something very close to a soft landing may be necessary.  We continue to be skeptical about the Fed’s ability to accomplish miracles, but we are encouraged by its willingness to take steps unpopular with the short-term demands of the equity and fixed-income markets.

The Fed has been working towards a soft landing since March of 2022: first fighting inflation by raising the effective overnight rate from 0.08% to 5.33%, then, beginning in March of 2024, battling unemployment by cutting the effective rate a full percentage point to a range between 4.25% and 4.5%.  In its notes from its last meeting of 2024, at which it cut its overnight rate by 0.25%, the Fed suggested that it has a diminished concern about the labor market and is now focused on achieving and maintaining an inflation rate below 2%.  The notes further indicate that the members of the Open Market Committee almost did not approve a rate cut—according to Chairman Powell, it was a close call—and expect to make only two cuts in 2025.  This could well be a miscalculation on the Fed’s part, but it seems in keeping with its past willingness to make unpopular, well-telegraphed, and mostly incremental steps at each of its eight-per-year regularly scheduled meetings.

The actions of the Fed clearly have an impact on stocks.  In the simplest and most general terms, stock prices tend to move in the same direction as expected corporate earnings and in the opposite direction of expected interest rates.  Strong bull markets usually occur during periods of accelerating corporate earnings and decreasing interest rates.  The Fed has a direct impact on interest rates but only an indirect impact on corporate earnings.  When the Fed recently announced that it was moderating the rate of interest rate cuts, effectively telling the market not to expect the kind of interest rate cuts to which it had grown accustomed, the S&P 500 fell 2.9%, and the Dow Industrials dropped 1100 points.  This probably represents the beginning of the end of the Fed’s support for the bull market in stocks, the one that’s been roaring almost non-stop since October of 2022.  Going forward, the burden of extending the bull market will rest squarely on the shoulders of corporate earnings.  The good news is that the dynamism of artificial intelligence continues to accelerate corporate earnings, both for tech companies and for companies that take advantage of AI efficiencies to boost their earnings.  However, a note of caution seems warranted here: with P/E multiples of expected earnings at almost 26 — the historical average is 16 — there’s probably not a lot of room for disappointment.

Probably the most significant sight glimpsed through the forward Janus gates is the return of Donald Trump to the White House.  Under the best of circumstances, the actions of a second- term president are hard to predict due to changes in political realities and personal experience.  In the case of a mercurial personality who enters his second term following a rancorous “inter regnum” of four years, predictions of likely outcomes have a high degree of uncertainty.  We know from his statements that the new/old president is a fan of tariffs, but we don’t know if his tariff talk is strictly a negotiating tactic or a means of increasing domestic investments in plant and equipment.  We do know that tariffs will increase prices and create more confusion in the Fed’s goal of bringing inflation down to a sustainable 2% level.  We also know that Donald Trump is a strong supporter of tax cuts, programs that should increase consumption and buoy the overall economy, although likely also to drive up the national debt and overall interest rates.  It should be a very interesting year!  Now more than ever, it’s a good time to pay attention to the risk mitigation of asset allocation.

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This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.