Outlook 2025: Will the Fed Fumble Once Again?

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Bert Clark, President and CEO of Investment Management Corporation of Ontario, wrote a comment for the Financial Post over the holidays stating the S&P 500’s performance in 2024 made investing look easy, so why bother with strategy:

The S&P 500 has been on something of a tear. Total returns so far this year (as of Dec. 23), have been 26 per cent. That’s on top of total returns of 26 per cent in 2023.

This is the kind of investment performance that can make some investors wonder whether Warren Buffet was right when he suggested that, for most people, the best thing to do is own the S&P 500 index.

Whether this is the right investment strategy for an investor is something they would need to decide. This is in no way meant to challenge Buffet’s investment perspective. Or, for that matter, to suggest an alternative strategy for individual investors.

But recency bias can be powerful. So, with the S&P 500 up as much as it has been over the past few years, it is a good time to recall why a strategy that involves only investing in that index would require real patience and conviction at times, and why many investors stick with much more diversified strategies.

The S&P 500 has been a great long-term investment: $1,000 invested there 50 years ago would be worth approximately $360,000 today. That beats a 60/40 portfolio made up of the S&P 500 and 10-year U.S. Treasury bonds, which would have only grown to approximately $136,000 over that same period. And it beats an investment in other developed markets, such as the MSCI EAFE (Europe, Australasia and the Far East), which would have only grown to approximately $60,000.

However, a lot can get lost in long-term performance numbers, specifically the episodic and very large drawdowns the S&P 500 has experienced, and its underperformance relative to more balanced portfolios and other markets over a number of multi-year periods.

For example, investors who had 100 per cent of their portfolio invested in the S&P 500 in September 2000 would have lost 45 per cent over the following two years, about twice that of an investor in a 60/40 portfolio. It would have then taken the 100 per cent S&P 500 investor more than six years to recover their losses and almost 20 years to catch up to the 60/40 investor.

This was not the only period of S&P 500 underperformance relative to a 60/40 portfolio: In the late 1970s, it had more than three years of worse performance; in the early 1980s, it had about six years of worse performance; and in the late 1980s, it had more than seven years of worse performance.

Today, investing in the market cap (as opposed to equal weighted) version of the S&P 500 index involves a big bet on the continued strong performance of a small number of companies. The last time the Top 10 companies in the S&P 500 represented as large a percentage of the index as they do today (36 per cent) was in 1964. None of the Top 10 companies in 1964 are in the Top 10 today. In fact, three went bankrupt (General Motors Co., Sears Holdings Corp. and Eastman Kodak Co.) and two merged into other companies (Gulf Oil Corp. and Texaco Inc).

It is also important to remember that, while the U.S. public equity markets have been a good investment over the past 50 years, non-U.S. public equity markets have generated better returns over various multi-year periods. For example, between 1985 and 1989, the S&P 500 underperformed the MSCI EAFA (Europe, Australasia and Far East) index by 13.82 per cent a year, on average. And the S&P 500 again underperformed that index between 2000 and 2009 by 2.65 per cent a year, on average.

For all of these reasons, an all-S&P 500 investment strategy would, at times, require real psychological stamina on the part of individual investors. For many institutional investors, an all-S&P 500 strategy could result in drawdowns and periods of underperformance that would be hard to manage when more balanced, less volatile, strategies are possible.

Many institutional investors are not trying to generate the highest returns possible over the short term. They are trying to generate long-term, stable returns to cover a specific liability (such as pension obligations), while minimizing return volatility. Significant near-term return volatility can be hard to manage and require increased contributions. And this can result in intergenerational unfairness if those contributing need to pay more than prior generations because the fund was invested in a strategy that was unnecessarily concentrated and risky.

This is why, despite the extremely strong performance of the S&P 500, many investors still opt for more diversified investment strategies, combining non-U.S. assets, as well as government bonds, credit, real estate, infrastructure and public and private asset classes. And at times like these, with the S&P 500 continuing to generate outstanding returns, it is good to remember why.

It's time to start the new year and the article above is my lead article for a lot of reasons.

It's important to understand the objective of a pension fund isn't to beat the S&P 500 every single year -- a feat that even the best hedge funds in the world can't do -- it's to make sure there are more than enough assets to meet long-dated liabilities and that they're taking intelligent risks across public and private markets to make sure the returns aren't very volatile (keeps contribution rate stable).

The other thing we need to keep in mind (as noted by Bert Clark above) is the S&P 500 is coming off two extraordinary years with back-to-back 26% total return gains.

While this is great news for equity investors, the reality is a handful of large tech companies have led the rally.

In particular, the Magnificent Seven led the S&P 500 to these two extraordinary years and therein lies the problem, concentration risk is at its highest level ever in the index:

And if you include Broadcom and call it the Magnificent Eight (I would as it surpassed a trillion market cap), concentration risk is even higher.

All this to say, if you're wondering what will happen to the S&P 500 this year, you really need to make a call on mega cap tech shares and that comes down to making a call on rates.

The recent backup in interest rates doesn't portend well for tech stocks and the overall market.

This morning's red hot US jobs report confirmed that the US economy is growing nicely and nowhere near a recession.

Obviously, if the US labour market remains strong, rates will remain elevated and this favours value over growth stocks, small caps over large caps, short duration over long duration bonds.

But the real danger this year is inflation: will it rebound in the latter half of the year as wage inflation picks up, forcing the Fed to raise rates again or will it subside more if employment starts slowing down or China hits a hard landing?

There are so many moving parts to the macro background including the new Trump administration and policies it will implement that adds more uncertainty to the political and economic outlook.

On inflation, there are two camps. Some strategists like Francois Trahan of Trahan Macro Research, see a real risk it rebounds in the second half of the year, forcing the Fed to raise rates.

Francois had a very detailed conference call earlier this week titled "The Great Inflation Comeback Of 2025" where he went into detail on why he thinks the US economy will continue to do well, inflation pressures will pick up and the Fed will be forced to respond by raising rates:


 

Trahan sees inflation creeping back and the new Administration's policies could exacerbate this trend, forcing the Fed to respond. 

Not surprisingly, he sees the yield curve flattening as short rates rise and sees three dominant themes for this year and explains where he sees opportunities:


I'm just giving you a glimpse of what he covered so take the time to delve into his conference call as he covers a lot more material.

But while Trahan sees a pickup in inflationary pressures, other strategists see it waning further and think the market isn't pricing in enough rate cuts.

Joaquín Kritz Lara, Chief Economist and Strategist at Numera Analytics sees inflation pressures subsiding, allowing the Fed to continue cutting rates as the economy slows:

 It is is worth repeating this part:

What about unemployment? In a late cycle, the Fed stance depends mainly on macro conditions. The Fed’s hawkish signal reflects bullish growth perceptions, leading them to expect no change in the unemployment rate in 2025 – a view shared by the market. This is where our view deviates significantly from consensus. As we can see in F5, we expect cyclical conditions to weaken in 2025-26, as consumers and businesses run out of sources of support.

If growth disappoints and layoffs rise, this increases the incentive to cut. This is particularly true considering Fed policy remains highly contractionary. We can see this in F6, which plots real policy rates to our estimate of the US ‘neutral’ rate of interest (i.e. the rate consistent with full employment and trend inflation). While the neutral rate rose in 2023 and 2024 in response to higher productivity, the interest gap is very high by historical standards.

To be sure, the neutral estimate carries significant uncertainty, but it does suggests that the Fed has plenty of room to maneuver before it fuels inflation. This has key implications for the interest rate outlook. If inflation stays contained and unemployment rises, this translates into a very high probability of further Fed easing. In particular, our models point to 4+ cuts this year, with an 81% chance that the FOMC cuts rates by more than they and markets anticipate.

I must admit, I'm still stunned the US economy is still firing on all cylinders because credit card debt is at an all-time high, consumers are tapped out but yes, they still have a job and are holding on, for now.

Will Trump slap on tariffs and deport thousands of illegals migrants?

Honestly, I'm not sure how his administration will proceed but I can tell you from past experience, the market will not like it, and it will force him to rethink his policies.

My friends who just visited Miami/ Fort-Lauderdale tell me restaurants were packed, prices are insanely high, and it sure doesn't look like the US economy is slowing.

But that's a microcosm of the US economy, one where drug cartels and hedge fund managers flush with cash skew reality.

Moreover, even though today's jobs report suggests the US economy remains very strong, not everyone is convinced good times lie ahead:

The point we should all consider is with rates rising, housing activity will slow, the US economy is vulnerable to a slowdown, something even Trahan noted in his conference call.

Right now, the yield on the 10-year is close to its October 2023 high of 5%:

And inflation pressures have yet to pick up convincingly, this is all about the term premium, uncertainty about policy and fears of a budget deficit run amok.

If rates remain elevated, no doubt about it, stocks will get hit, beginning with high duration tech stocks and anything speculative.

This week was a taste of what's to come if rates don't come down to 3%.

Mega cap tech stocks got hit but the real carnage this week was in highly speculative quantum computing stocks where the bubble is deflating fast as well as small and mid cap biotech shares:

It goes without saying that higher for longer will not be good for private markets and that's why you saw many private equity stocks also get slammed hard today.

Private equity, real estate remain areas of concern, infrastructure and private credit have some inflation protection and floating rate protection but even there valuations remain stretched and any crisis or slowdown will impact private credit as well.

All this to say 2025 will present many challenges to investors, volatility will reign and everyone will be transfixed on every monthly jobs and CPI report trying to figure out the Fed's next move.

Whether or not we get higher growth and inflation, stagflation (inflation and lower growth) or a classic recession with lower inflation develops remains to be seen but you need to be prepared and pay attention to everything, including a potential credit crisis from private markets.

What else worries me? A significant slowdown in China which by definition is deflationary and will clobber risk assets all over the world.

Anyway, I kept my outlook short this year, forecasting the macro environment isn't easy, far from it, and many strategists/ economists including yours truly have been wrong the last couple of years.

Let me wrap it up and wish all of you once again a Happy and Healthy New Year. 

I am also thinking of people out in Los Angeles as the fires there decimate and ravage entire cities, just terrible to see the devastation on the news.

Below, Mike Wilson, CIO and Chief US Equity Strategist at Morgan Stanley, offers his outlook for investors in the year ahead and explains why he believes short-duration assets and cash are still viable options until earnings breadth improves. Mike speaks with Tom Keene and Paul Sweeney on Bloomberg Radio.

Next, Jeremy Siegel, Wharton professor emeritus, joins 'Closing Bell' to discuss the market's reaction to Friday's jobs report, the subsequent bond market reaction, and much more.

Third, Peter Boockvar, Bleakley Financial Group chief investment officer, joins 'Fast Money' to talk the market's reaction to the jobs report and possibility of less rate cuts.

Fourth, Rick Heitzmann, First Mark Capital founder, joins 'Closing Bell' to discuss how Heitzmann is thinking about the venture capital space, when investors will see more initial public offerings, and much more.

Fifth, Avery Sheffield, VantageRock senior portfolio manager and CIO, joins 'Closing Bell' to discuss the corners of the market where opportunity exists.

Lastly, 'Fast Money' traders look at the market action after better-than-expected jobs report.

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