2025 Market Outlook

As we say goodbye to 2024 and welcome 2025, we can reflect on an eventful year that was kind to many investors. At the beginning of 2024, investor concerns focused on the impact of the upcoming presidential election, fears of a potential recession, ongoing global conflicts and worries over elevated stock market valuations. Despite these concerns, 2024 will go down as another year of strong performance for many investment markets. Heading into 2025, some of the concerns from 12 months ago remain the same, but new worries always seem to emerge, such as concern over the impact of policies of the incoming administration. Despite “unprecedented uncertainty” (which seems to be ever-present rather than unprecedented) about the economy, geopolitics and the market, investors must press on. And as 2024 demonstrated, along with many other such years before, things are rarely as bad or as good as they may seem in the moment.

Stock Market Outlook

• Stocks, particularly large-cap U.S. stocks, have now experienced two consecutive years of stellar returns.
• While valuations in some market segments are high relative to history, valuation levels themselves have never been a good indicator of near-term broad market performance.
• Asset classes and sectors that have lagged in recent years and have not seen the same multiple expansion as large-cap growth stocks – such as small-cap stocks, value stocks and international stocks – may prove to be attractive opportunities going forward, in our opinion.

There were several issues facing equity investors as 2024 dawned:  the ongoing war in Ukraine, increasing levels of violence and conflict in the Middle East, and a presidential election in the U.S. Inflation was down from its highs, but the Federal Reserve had yet to cut interest rates and there was still some fear that a long-expected recession would eventually emerge. Despite strong returns for both stocks and bonds in 2023, concern remained for many investors about the coming year. Despite these worries, 2024 turned out to be similar to 2023 in terms of returns in public equity markets. U.S. large-cap stocks once again produced stellar returns. The S&P 500 was up 25.0% in 2024 after returning 26.3% in 2023. The S&P 500’s two-year annualized return of 25.6% is the highest rolling two-year return by calendar year since 1997-98, when the S&P 500 returned an annualized 30.9%. Large-cap growth stocks yet again led the market higher, as the Russell 1000 Growth returned 33.4%% in 2024 after returning 42.7% in 2023. Small-cap stocks didn’t keep pace with large-caps, but the small-cap Russell 2000 Index still returned 11.5%in 2024. While U.S. stocks soared, international stock returns were much lower, with the MSCI-ACWI ex US returning a more modest 4.7%.

When investors contemplate portfolio positioning for 2025, it’s easy to fall into the trap of anchoring on recent performance when setting market expectations. For those who have a more pessimistic mindset, or perhaps are just contrarian by nature, two strong years of equity market performance combined with elevated stock valuations may look like an indication to reduce equity allocations in their portfolio. However, there has never been a strong historical relationship between equity valuations, taken on their own, and near-term market performance. As can be seen in Chart 1 below, while there is a slight negative correlation between valuation and 1-year forward returns, at every valuation level there are both positive and negative years of performance. Many of the better performance years coincide with higher starting equity valuations, while lower starting valuations don’t ensure that market performance will be positive over the subsequent 12 months.

As we move into 2025, the strong recent performance of large-cap growth stocks, particularly those dominant technology stocks known as “the Magnificent Seven¹,” may provide investors with an opportunity to rebalance portfolios. Naturally, this tends to result in adding back exposure to asset classes or sectors that haven’t performed as well and are trading at more attractive valuations. This doesn’t mean to abandon, or even underweight, large-cap U.S. stocks. But rather, investors may consider using this as an opportunity to crystalize some of their profits and reallocate those proceeds to other areas of their portfolio. Rather than focusing solely on valuations without considering the context of the overall investment environment, using other contextual clues in addition to valuation differentials may help identify attractive opportunities to rebalance portfolios.

Small-cap equities may present such an opportunity in the current environment. The valuation spreads between small-cap stocks and large-cap stocks are at elevated levels relative to the last decade. The context surrounding this is that falling interest rates may prove to be especially beneficial to smaller companies, given that small companies tend to be more reliant on floating rate debt than larger companies. Even in a stable rate environment, small-cap stocks may benefit from a broadening out of equity market performance. Foreign stocks have experienced a similar valuation widening versus U.S. large cap stocks, and returns on foreign stock holdings by U.S. investors would be enhanced should the dollar depreciate against foreign currencies, providing additional context to support owning foreign stocks within a well-diversified portfolio.

US Market is represented by the Russell 3000. Large Cap and Small Cap are represented by the Russell 1000 and Russell 2000, respectively. Value and Growth are represented by the Russell 3000 Value and Russell 3000 Growth, respectively. Multiples are calculated as weighted harmonic averages. P/E is reflective of NTM (4-quarter sum) consensus earnings. The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company's stock. Next twelve months (NTM) refers to any financial measure such as revenue, EBITDA, or net income that is being forecasted for the immediate next twelve months from the current date. Standard deviation measures the dispersion of a dataset relative to its mean.

By following a disciplined rebalancing² process, could help investors stay aligned with their long-term goals. This may help prevent overexposure to recent winners should market leadership change, without completely sacrificing exposure to what has performed best of late.

Fixed Income

• Short-term interest rates fell in 2024 yet remain elevated compared to post-financial-crisis averages.
• Credit spreads have tightened, decreasing the relative attractiveness of corporate credit.
• A less-inverted yield curve², and the prospect of lower short-term interest rates, makes adding duration to bond portfolios more attractive.

In 2025, bond investors will be focused on the actions of the Federal Reserve. Starting in February 2022, the policy range for the Fed Funds Rate was incrementally increased from a starting point of 0-0.25% to a peak of 5.25-5.50% in July 2023, where it remained until early fall 2024. The Fed began reducing rates in September, lowering the Fed Funds Rate by 50 basis points, then cutting another 25 basis points in November. The Fed wrapped up 2024 with a final trim of 25 basis points in their December meeting, bringing the policy rate to 4.25-4.50%. The broad bond market rallied into the autumn rate cuts, erasing a challenging first four months of the year before selling off again after the cutting cycle commenced. The Fed has communicated quite clearly that further reductions in the policy rate will be data dependent. Fed Chair Jerome Powell signaled in the December meeting that they now expect only two rate cuts in 2025 unless there’s meaningful progress toward their 2% inflation target. Powell reiterated that the Fed intends to remain flexible should the balance of risks shift between their dual mandate of stable prices and full unemployment.

The yield curve is currently less inverted than at the beginning of 2024, with 10-year and 30-year Treasury yields being higher, and yields under 2 years being lower than this time in 2023. Larger fiscal deficits could push long-term bond yields higher. This dis-inversion of the yield curve, specifically the falling short-term rates, makes holding cash and short-term fixed income investments less attractive, relative to longer-term bonds, than has recently been the case. This environment suggests that bond investors should consider extending duration in bond portfolios, particularly if their duration is currently skewed towards the shorter end of the yield curve.

Corporate bond spreads have tightened meaningfully. While corporate balance sheets are in good shape, tight credit spreads limit any excess returns that might be earned from investing in corporate bonds versus government bonds. Despite this, bonds generally continue to provide a rate of return in excess of inflation. This is a substantial improvement over the experience of bond investors throughout much of the period following the global financial crisis (2008-09), which was characterized by the zero-interest-rate environment that dominated bond markets from much of 2008 forward. In the current environment, cash has become a much less-attractive option. Adding duration to bond portfolios now likely makes more sense. By doing so, investors may earn higher rates of return and enjoy higher levels of income that, in turn, can be reinvested at still-higher yields if rates rise further. It should also be noted that cash investments offer only income, and no possibility of price appreciation if rates start to fall, unlike intermediate and long-term bonds. Putting cash to work in longer-dated bonds, unlike in a world of deeply inverted interest rates, doesn’t impair the ability of investors to earn income; in fact, it adds the possibility of earning price appreciation should interest rates continue to fall.

Alternative Investments4

• Alternatives offer the ability to access attractive returns while diversifying mark-to-market risk in a potentially volatile market environment.
• We believe a successful allocation to alternative investments should enhance the overall portfolio’s ability to reach its strategic objectives. This allocation should, in most instances, be diversified across managers, sectors, and strategies. These strategies and managers should be thoughtfully sourced and thoroughly diligence by a deep, experienced team of analysts and feature institutional quality terms and pricing.

Alternative investments may provide an interesting rebalancing opportunity for investors who have the capacity to bear illiquidity risk in their portfolios and meet certain income or asset thresholds. In addition to the potential returns available to investors in alternative investments, some investors may find the lack of daily mark-to-market pricing that characterizes many alternative investments to be an attractive quality. Publicly traded securities that are continuously priced by the market may be subject to large price swings when market volatility rises owing to changes in investor sentiment. These securities are priced by the marginal buyer and seller. During periods of market stress, security prices may differ significantly from an investment’s intrinsic or underlying long-term value. Alternative investments that are not publicly traded may avoid exposure to some of these large swings in investor sentiment, making it easier to adhere to a long-term investment plan during periods of market turmoil. In addition to the reduction in mark-to-market pricing risk, management teams of privately owned businesses may be able to place greater focus on long-term strategic decision making rather than being forced to respond to price changes driven by market sentiment.

Implementing alternative investments in a portfolio can be a difficult task. Investing in alternative assets depends on the ability to access top-tier funds at favorable terms and attractive pricing. Investors who can accomplish these tasks and build a diversified allocation of alternative investments may improve the likelihood that their portfolio will help meet their goals. Alternative investments also allow investors to build a more customized and bespoke overall portfolio allocation that’s unique to their needs and circumstances.

Conclusion

• The current environment may offer an opportunity for investors to take profits from areas of the market that have outperformed, such as large-cap U.S. stocks, and use the proceeds to rebalance into asset classes and sectors that may have potential for attractive returns going forward.
• Strategic rebalancing can be used to bring portfolio risk back to its long-term target. Rebalancing and recognizing gains early in the year leaves plenty of time to utilize tax-loss selling and gifting strategies throughout the year to offset some (or all) of the realized gains.
• Bond yields remain higher than they have been since the global financial crisis despite the fall in short-term rates and appear well positioned to provide investors with returns above the rate of inflation.
• Given the high valuations in large-cap U.S. equities, alternative investments may be a compelling use of capital and an opportunity to decrease mark-to-market volatility risk in portfolios.

As we move into 2025, investors are faced with a number of concerns. There remains an elevated level of uncertainty around the specifics of economic policy, the timing of policy implementation, and the ultimate impact these policies will have on the economy and markets. Geopolitical risks remain elevated given the ongoing war in Ukraine, conflict in the Middle East, and increased tensions between the U.S. and China. While positive investor sentiment surged after the election in November, these broader policy and geopolitical risks may seem daunting. As is always the case, there are many possible paths for markets in the coming year, and investors should consider building portfolios built to survive, and hopefully thrive, across a wide range of outcomes.

The strong equity market performance enjoyed by investors over the last two years occurred despite elevated levels of inflation in 2023, wars in Europe and the Middle East, persistent recession fears, and a contentious election season in the U.S. in 2024. This should serve to remind investors that while worry is often focused on negative surprises, positive surprises and positive market performance can, and do, occur. Rather than focus on specific forecasts, investors may be better served by focusing on building portfolios designed to suit their specific needs and the reality of current conditions, rather than relying on forecasts that are only consistent in their lack of accuracy.

Finally, investors should always think about positioning their portfolio in a way that’s best suited for their specific situation. Market risks mean different things for different investors. Those with long time horizons may be better served by spending less time worrying about near-term market volatility and focusing more on staying invested in portfolios designed to generate attractive long-term risk-adjusted returns. By contrast, those with shorter time horizons, or in withdrawal mode, may need to focus more on managing shorter-term market volatility and generating sufficient income to help meet their spending needs. Despite facing the same macroeconomic and market conditions, each investor’s best path forward will be unique. The role of your financial advisor is to help plot the best path for you that takes into account the potential risks and opportunities ahead, while staying aligned with your financial goals, time horizon and tolerance for risk.

INDEX DEFINITIONS

The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency).

The Bloomberg US High Yield Index covers the universe of fixed rate, non-investment grade debt.  Eurobonds and debt issues from countries designated as emerging markets are excluded, but Canadian and global bonds (SEC registered of issuers in non-EMG countries are included.

The Bloomberg US Municipal Index 7-yr (6-8) covers the USD-denominated long-term tax-exempt bond market.  The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

The MSCI ACWI ex USA Index captures large and mid-cap representation across 22 of 23 Developed Markets countries (excluding the US) and 24 Emerging Markets countries. The index covers approximately 85% of the global equity opportunity set outside the US

The MSCI All Country World Index (ACWI) is a global stock index that encompasses nearly 3,000 companies from 23 developed countries and 25 emerging markets. It is used as a benchmark for global equity funds and asset allocation

The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Index captures large and mid-cap representation across Emerging Markets countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

NASDAQ 100 is a globally recognized index that tracks the performance of 100 of the largest non-financial companies listed on the Nasdaq Stock Market®, encompassing a diverse range of industries and sectors.

The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance.

The S&P 500 Index measures the performance of the large cap segment of the market. The index is considered to be a proxy of the US equity market.

Russell 1000 Growth Index measures the performance of the large- cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years).

Russell 1000 Value Index measures the performance of the large-cap value segment of the US equity universe. It includes those Russell 1000 companies with relatively lower price-to-book ratios, lower I/B/E/S forecast medium term (2 year) growth and lower sales per share historical growth (5 years) .

The Russell 2000 Index measures the performance of the small cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Russell 3000 Value Index is based on the Russell 3000 Index, which measures the performance of the 3,000 largest publicly held companies incorporated in America, as defined by total market capitalization.

¹ Magnificent 7 companies include the following: NVDA, AAPL, MSFT, GOOG, META, TSLA, AMZN
² Diversification, allocation and rebalancing does not imply you will make a profit and does not protect against losses.
³ Yield curves plot the interest rates of bonds of equal credit and different maturities.
⁴ Alternative investments are subject to greater risks and are not suitable for all investors. Information relating to alternatives is being provided for educational purposes only. Diversification, allocation and rebalancing does not imply you will make a profit and does not protect against losses.