Stocks: Tougher Sledding Ahead As Policy ‘Fog’ Sets In
January 2025
2024 ended with a whimper as the S&P 500 fell 2.5% in December as a Santa Claus rally failed to materialize, but the broader index still managed to close out the year with a 25% annual total return. That makes it back-to-back calendar years with a 25%-plus gain for the S&P 500, which has led to concerns on the part of investors that some give-back must be in the cards after such a sizable two-year rally. While we share some of this healthy skepticism and expect more modest returns from U.S. stocks in the coming year, partially due to our view that the 2023-2024 market rally has left us with lofty valuations that stocks will need to grow and/or reprice into, we believe it premature to turn bearish on U.S. stocks as the S&P 500 is still expected to grow earnings by a respectable 12% year over year in 2025.
Much has been made of the current market backdrop sharing similarities with the 1996 through 1999 time frame. Most notably, both environments either were or have been characterized by powerful tailwinds for secular growth stocks, as the dawn of the internet kicked off the rally in the mid-1990’s, and the onset of the artificial intelligence (AI) revolution has acted as a catalyst for upside in recent years. From a performance perspective, the S&P 500 generated an annualized total return of more than 26% from 1996 through 1999 as the Index strung together four consecutive calendar years in which it generated a total return north of 20%. While we don’t expect another two years of 20%-plus gains for U.S. large-cap stocks given lofty starting valuations, valuation is a poor timing tool and indicator of when to expect a near-term market reversal, and we are aware that strong secular drivers like AI have a history of propelling stocks for longer and taking them to heights and valuations well above what most market participants believed possible.
This knowledge leaves us open to the possibility that returns could surprise to the upside in the coming year, but our base case calls for the S&P 500 to rise in-line with year over year earnings growth as policy ‘fog’ contributes to elevated volatility and a choppier backdrop for stocks along the way. Investors could spend much of the first half of this year recalibrating their expectations for economic growth, inflation, and the outlook for monetary policy due largely to potentially meaningful policy shifts out of Washington D.C. It’s also worth noting that, on average, the first quarter of a U.S. President’s term has generated the lowest S&P 500 return of any quarter in the four-year presidential cycle. Markets crave the certainty that often comes from gridlock in our nation’s capital amid divided government as this dynamic ensures that little in the way of sweeping policy changes are enacted. With one party set to control the White House, House of Representatives, and the Senate in the coming year(s), impactful policy changes could come fast with volatility in equity prices – both to the upside and downside – remaining elevated relative to recent years as a result.
Small And Mid-Cap U.S. Stocks To Benefit As M&A Outlook Improves, But Near-Term Rate Headwinds Remain. The fourth quarter was a winding road to nowhere for small- and mid-cap stocks as the S&P 1000 SMID index returned an unremarkable 0.1% even after posting a 9.5% return in November, as the Index gave back the bulk of those gains by falling 7.4% in December. The December drawdown started with a drift lower that accelerated around the FOMC meeting mid-month, as the Committee raised its near-term inflation forecast and signaled a near-term pause and a slower and shallower trajectory for rate cuts, forcing markets to recalibrate rate cut expectations. Futures are now pricing in just 25-basis points of cuts in ’25, down from 75 at the start December. A dose of reality on the rate front has served as a setback for more cyclical sectors, particularly those farther down the market cap spectrum but, notably, earnings expectations for smaller companies flattened out last month, one early sign SMid could be close to finding a near-term bottom.
After downward revisions to earnings estimates last year, expectations for SMid have been lowered drastically, which may set up potential upside surprises in the coming quarters. A pronounced uptick in mergers and acquisition (M&A) activity should provide a tailwind for small- and mid-cap sentiment as potential targets of acquisitions, but harsher immigration policies could disproportionately impact smaller companies and lead to downward revisions to the outlook for earnings growth. Given uncertainty surrounding smaller capitalization stocks, it’s no surprise market participants continue to trade these names rather than take long-term positions. At present, there is little to move us off our strategic neutral position as relative cheapness and oversold conditions are some of the only potential near-term catalysts we can point to for this segment of the U.S. equity market.
Some Stability Or Weakness In The U.S. Dollar Would Be Most Welcomed By Foreign Stocks. The U.S. dollar’s ascent throughout the 4th quarter and into the new year has put significant strain on international equities. The MSCI EAFE index and MSCI EM index fell by 8.3% and 8.1%, respectively, in the 4th quarter of 2024, with most of those losses coming from local currency, and losses have continued in the new year. To begin the year, the U.S. Dollar Index (DXY) has traded in the 109/110 range for the first time since late 2022, leading market participants to question how much stronger the greenback can get and if the currency has too much good news priced into it already and may be set to reverse course.
There appears to be room for mean reversion and a modest drop in the U.S. dollar given the magnitude and speed of the recent runup, much of which appears centered on uncertainty surrounding immigration and trade policies. A rapidly appreciating dollar will be a headache for the President-elect at some point as it lowers demand for U.S. goods from abroad, so policy changes that are announced could look quite different when implemented based on market reactions to them. International developed and emerging market stocks could get a reprieve in the coming months if the U.S. dollar has discounted policy shifts that either don’t materialize or are watered down to varying degrees. The case could be made that U.S. exceptionalism providing a boost to U.S. stocks relative to the rest of the world could still be in its infancy, which could imply persistent dollar strength in the coming years. We enter the new year comfortable with our international exposure as a play on mean reversion and potential dollar weakness, but should the dollar stabilize or move lower and international equities outperform on a relative basis, this would likely present opportunities to rebalance and shift more heavily into the U.S.
