Key Private Bank Investment Brief

Key Takeaways

Bond yields rose sharply late last week in response to strong jobs data. Stocks fell.

Rising interest rates are a risk to the stock market. After recent economic data, the likelihood of further Federal Reserve (Fed) rate cuts has diminished.

Bond yields may rise further, which could spark additional volatility. Stock market indexes remain concentrated, while valuations remain extended.

Near-term recession risks remain low, as evidenced by tight credit spreads, but risks of sticky inflation remain high.

Clients should remain Neutral to Risk and seek broader diversification via “New Tools,” such as alternatives and real assets, where appropriate.

The labor market regained momentum in December.

The labor market is strong, but there are pockets of softness. Nonfarm payrolls increased by 256,000 in December, above expectations, and the highest monthly reading since last spring. The unemployment rate fell from 4.2% to 4.1% (cycle low was 3.4% in early 2023).

The median duration of unemployment has been slowly increasing since late 2023, and the quit rate continues to decline. Both are signs of softness that suggest less upward pressure on wages.

Interest rates are rising globally. The era of “free money” is over, consistent with our secular view that we’re on the path toward the “Old Normal”.

Since the lows of last summer, yields have risen sharply across the globe. US 10-year yields have risen 114 basis points (bps) from trough to peak; German 10-year yields 54 bps; Japanese 10-year yields 65 bps; and UK 10-year yields 118 bps, according to Evercore ISI.

These higher rates are being driven by continued inflation fears. The Fed is likely to be cautious regarding further rate cuts – the Fed has no desire to see a repeat of the 1970s, where inflation spiked and receded on several occasions.

Bottom Line:

The rally in the S&P 500 off the late 2022 lows has led to one of the strongest two-year periods in history, and it is not surprising to see a pullback. Key Wealth remains a proponent of periodic rebalancing in accordance with long-term financial planning.

Stocks and bonds are once again moving together and have become positively correlated. Bonds may not provide their typical diversification benefits amidst continued strong economic growth and sticky inflation.

“New Tools,” such as alternatives, real assets, and hedge funds, provide additional important diversification in the current environment. These types of strategies can also offer downside protection during periods of market stress.

Equity Takeaways:

Stocks dipped in early Monday trading. The S&P 500 fell approximately 0.5%, to 5797, while small caps dropped approximately 0.4%. International shares were generally lower.

The stock market does not like higher bond yields. As yields rose sharply late last year into early this year, the S&P 500 entered a short-term topping pattern.

Support for the S&P 500 is around 5700, which corresponds to the summer highs and is also near the 200-day moving average. The S&P 500 is likely to test this technical support level in the coming days or weeks.

S&P 500 breadth remains weak, and the market is oversold. Only approximately 20% of S&P 500 constituents are trading above their 50-day moving averages, while the headline index is only approximately 3% below its all-time high. Large-cap technology stocks are holding up the market.

Crude oil has been in a 2-year long downtrend. In recent months, crude has showed a basing pattern and is trying to break out. We continue to watch oil prices closely.

Fixed-Income Takeaways:

Ten-year US Treasury yields have continued their relentless march higher and have risen more than 100 basis points since the Fed began its easing cycle last September 2024. Higher Treasury yields have been a major theme this year and have had an impact on all asset prices.

Longer-Term Treasury yields rose faster than short-term yields last week, resulting in a “bear steepener”. In early Monday trading, 2-year Treasuries were yielding 4.40%, 5-year Treasuries 4.60%, and 10-year Treasuries 4.79%.

After the recent data on economic growth and inflation, market expectations are for just 25 basis points of Fed rate cuts in calendar year 2025. The next rate cut is not expected until October 2025. The current Fed Funds rate is the range of 4.25% to 4.50%.

Despite rising Treasury yields and heavy new corporate bond issuance, credit spreads remain very narrow. Economic growth remains strong and near-term recession risk is low. Investors continue to gravitate towards the high all-in yields of corporate bonds.

Key Takeaways

Three major themes drove the markets in 2024.

1) Tech / artificial intelligence (AI) and Nvidia – especially in the first quarter following Nvidia’s major earnings report and later when the company reached $3 trillion in market capitalization.

2) Interest rates and Federal Reserve (Fed) policy. The Fed began cutting interest rates in September 2024, with major influence on assets across the globe.

3) The Election. Much optimism (perhaps an unwarranted amount) was priced into the markets after the election regarding tax cuts and deregulation. A level of uncertainty was also removed.

In 2025, similar forces may drive the markets, but there are risks to all three.

1) Markets remain concentrated, with the largest companies having outsized influence in both the stock market and the overall economy. Any hiccup in the AI narrative could be disruptive.

2) Intermediate- to longer-term interest rates have moved sharply higher since the Fed’s “jumbo” 50 basis point rate cut in September 2024. If the 10-year Treasury yield moves toward and through 5.00%, the broader markets could suffer.

3) Politics = pyrotechnics. Geopolitics and policy issues writ large are always a potential source of risk.

Economic growth is slowing but not stalling. In December, the Fed increased their projections for 2025 growth and inflation.

The Atlanta Fed’s GDPNow estimate for Q4:2024 real GDP is currently 2.4%, down from as high as 3.4% in mid-December. Growth expectations remain solid but have slowed in recent weeks.

In their December 2024 Summary of Economic Projections (SEP), the Fed raised expectations for both growth and inflation. Intermediate- to long-term interest rates have risen as a result, which has put modest pressure on asset prices in recent weeks.

While initial jobless claims remain low, the Fed should not forget about the labor market. On the margin, the labor market has been slowly weakening in recent months. The Fed is predicting a 4.3% unemployment rate at the end of 2025, versus 4.2% at the end of 2024.

Equity Takeaways:

Stocks rose in early Monday trading. The S&P 500 rose approximately 1.0%, to 6003, while small caps rose approximately 0.8%. International shares were generally higher.

The S&P 500 did not have a December to remember. Typically, December is a strong seasonal period. When seasonal strength fails to appear, investors should take note – such price action marks a change in tenor.

Earnings growth remains a fundamental tailwind for the stock market. The trajectory of earnings growth in 2025 will hold the key to market performance in our view. If earnings expectations downshift in the first half of 2025, the market could experience some choppiness.

Near-term, the market feels like it wants to work lower on the back of inflation fears and higher-than-expected interest rates. We still expect a solid year overall, as earnings growth should support stocks over an intermediate time horizon.

In recent weeks, the Nasdaq 100 has benefited from a rotation into “defensive growth” stocks. These days, defensive investors tend to rotate into large cap growth when the overall market gets turbulent. In the past, sectors such as health care, utilities, and consumer staples were the preferred safe havens.

The best sectors in 2024 were heavily influenced by the AI theme and included communication services, technology, and consumer discretionary. Financials also had a strong 2024. On a factor basis, momentum significantly outperformed.

Momentum can reverse quickly, especially when markets are concentrated. Growth stocks have outperformed the broader markets significantly over the past 10+ years. Periodic portfolio rebalancing to reduce growth stock weightings may be appropriate.

Indeed, we expect broader market participation in 2025. Whereas most earnings growth was concentrated in the top-10 companies in 2024, a wider variety of companies should experience earnings growth in 2025.

Despite much negative news flow, crude oil has moved higher in recent weeks. Price action contrary to news headlines is always something to watch. If interest rates continue higher, we think crude oil could also move higher.

Fixed-Income Takeaways:

As we enter 2025, spreads remain very tight. Some investors are extending duration as longer-term interest rates have risen over the past few months. New corporate bond supply remains heavy, and deals remain well oversubscribed, showing continued demand even at tight spreads.

Market participants remain focused on Fed policy. Current expectations are for fewer than 50 basis points of rate cuts in 2025. Investors are expecting fewer rate cuts going forward than they were several months ago. The current Fed Funds rate is the range of 4.25% to 4.50%.

Inflation remains sticky and economic growth continues to hold up well. Both dynamics are influencing investor behavior regarding interest rates.

As intermediate- to longer-term interest rates have risen relative to short-term rates, the yield curve has steepened in recent weeks. In early Monday trading, 2-year Treasuries were yielding 4.29%, 5-year Treasuries 4.43%, and 10-year Treasuries 4.62%.

Key Takeaways – 12/19/2024 (Special Edition):

Did Chair Powell Deliver a Lump of Coal? FOMC Fallout — Additional Thoughts Post-Fed Decision Day.

As noted in Cindy Honcharenko’s excellent FOMC Recap (see 12/18 FOMC Recap below), the Federal Open Market Committee (“FOMC” or “The Fed”) met yesterday. As expected by essentially all market participants, interest rates were lowered by 0.25%. What caught markets off guard, however, was commentary that was more hawkish than expected, and revisions to the Fed’s Summary of Economic Projections (SEP).

Two-year and 10-year Treasury yields both rose 11 basis points (0.11%), pushing bond prices lower by 0.8% (Aggregate Bond Index), and stock prices were down across the board: The S&P 500 sank (-3%), with cyclical stocks underperforming defensive stocks. Interestingly, large-cap growth stocks (-3.3%) fell harder than large-cap value shares (-2.4%), but small/mid stocks fared even worse (-4%).

Commodity prices (excluding gold) were little changed, the U.S. dollar rose 1%, and the VIX surged from 15.8 to close at 27.6 (though also curiously, it had been inching higher the past week). Most notably (and perhaps most importantly) credit spreads barely budged during the trading day: Investment-grade spreads widened 1 basis point, and high-yield spreads expanded by a non-concerning 6 basis points.

In our view, the revisions to the SEP and the Fed’s commentary were not a surprise to us and are consistent with comments we made recently within our Weekly Investment Briefings (see - Weekly Investment Briefing from 12/9/24 and Weekly Investment Briefing from 12/16/24).

Leading up to yesterday’s news, markets were becoming increasingly frothy over the past five to six weeks, leaving investors susceptible to an exogenous shock or a negative headline such as the Fed recalibrating policy. Such froth does not melt away in one day (usually), and markets will become increasingly thin as the end of the year approaches. Also, we would also not be surprised to see additional volatility as Inauguration Day nears and other policy proclamations are announced.

Therefore, we believe investors should remain Neutral to Risk, emphasize Quality, and use New Tools to ensure their portfolios are fully diversified. We also maintain the view that the economy is in reasonably good shape, acknowledging the Fed’s more hawkish view is accompanied with a more upbeat assessment of the economy (further supported by the fact that credit spreads barely moved, as noted previously).

For additional thoughts on the Fed’s commentary (and the markets’ reaction), we offer the following musings.

Fed Chair Jerome Powell’s press conference began with his acknowledging that the interest rate cut was a “close call." With odds of a rate cut as high as 97% prior to the announcement, the market probably found his characterization as concerning.

Similarly, at the end of Powell’s press conference, when asked if he could rule out an interest rate hike next year, he said no, another possible concern to the market.

Powell also offered some unusually forthright insights into the Committee’s early assessment of how a second Trump administration might alter the economy, suggesting that some felt it important to preemptively adjust their outlook before any of Trump’s proposals become policy. This is a sharp reversal from his stance last meeting, during which Powell said that he would not speculate until policy became law. Such a shift is somewhat unsettling, but it also suggests that the Fed’s projections are not ironclad and would change if conditions change. (Hint: They likely will.)

The Fed chair also noted that the FOMC may be nearing the point where it will stop lowering interest rates, although we reiterate that this stance could change as well. Nevertheless, this statement likely caught some by surprise, and the market readjusted quickly and abruptly. As noted above, we may see further adjustments in the days ahead (i.e., volatility), especially as market volume slows. At the same time, however, investors may be entering the new year with more reasonable expectations.

Key Takeaways – 12/18/2024 (FOMC Recap):

The Land of Confusion

• The Federal Open Market Committee (“FOMC” or “The Fed”) reduced the benchmark federal funds rate by 0.25%, setting the new target range at 4.25% to 4.5%
• The change was perceived as a “hawkish cut”
• Cleveland Fed President Beth Hammack dissented in favor of a pause; three non-voting members also supported a hold
• The Committee adjusted the reverse repurchase agreement operations (“RRP”) facility rate to be in line with the federal funds rate's lower bound for the first time since 2021
• There were significant adjustments to the Summary of Economic Projections (“SEP”)
• Investors should stay (or get to) Neutral to Risk, for while the economy is still in reasonably sound shape, the range of outcomes is exceptionally wide

The FOMC voted to cut interest rates by 0.25%, setting the benchmark federal funds rate target range at 4.25% to 4.5%. The interest on reserve balances and the discount rate were also adjusted lower by 0.25%. With these actions, the Fed now has lowered interest rates by a cumulative total of 100 basis points (1.00%) in the past three months.

The accompanying statement received only a slight adjustment with the addition of “the extent and timing of” into the sentence discussing future policy. The revised sentence now reads: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.” This addition opens the door for the possibility of alternating decisions at future meetings (e.g., cut-pause-cut-pause), or possibly an outright pause of future rate cuts.

The bigger change came in the form of several notable shifts in the SEP (the Fed’s own economic projections, which were more dramatic than expected. The median year-end projections for interest rates for 2025 and 2026 rose by 0.50% each, implying two fewer rate cuts over that time frame than the Fed had forecast three months ago in September. The longer-run projection for interest rates was also revised up to 3% — a level last seen in 2017/2018.

Although the shift is a bit larger than economists anticipated, the revisions are at least directionally consistent with the changes that the Committee has made over the past year. However, the decrease in interest rate cuts conflicts with the Committee’s economic forecasts, which show higher near-term growth, higher near-term inflation, and lower near-term unemployment. At this stage, it is unclear why more rate cuts were not taken out of their projections, or the longer-run dot was not revised higher, given this context. This seems to indicate that the Committee will tolerate above-target inflation for even longer than previously communicated.

The projection for real GDP growth for year-end 2024 was adjusted higher to 2.5% from 2%, reflecting the momentum seen recently in the data, and is going to carry through to 2025 as well. The unemployment rate projection was revised down 0.2% in 2024 and 0.1% in 2025. The projections for Headline PCE inflation were revised up 0.1% to 2.4% for 2024 and up 0.4% to 2.5% for 2025. Finally, projections for Core PCE inflation were also revised up 0.2% in 2024, 0.3% in 2025, and 0.2% in 2026.

Nothing in the forecasts really sticks out here, but it is difficult to understand why there weren’t bigger shifts. The bottom line is that the Committee does not expect to continue with aggressive rate cuts and will proceed cautiously while assessing the incoming economic data releases.

In light of the Fed’s more cautious approach to future rate cuts, investors should reassess their portfolios. Continued emphasis on diversification and a bias toward higher credit quality will help navigate the evolving economic landscape and uncertainty as to the direction of fiscal policy with the incoming administration.

Key Takeaways:

Revisiting our core thesis – we are on the road back to the “Old Normal.”

The “New Normal” comprised the period from 2009 to 2021. In response to the Great Financial Crisis (GFC), the Federal Reserve (Fed) expanded their balance sheet and lowered interest rates to effectively zero. Growth and inflation were both modest during this period.

Interest rates were raised briefly between 2017 and 2019, but the COVID crisis saw the Fed quickly revert to the same playbook on an even larger scale. At the same time, a massive amount of federal spending (fiscal stimulus) was pumped into the system.

Beginning in March 2022, the Fed raised interest rates during its most recent rate-hiking cycle and, as such, rates turned positive in real terms (net of inflation) once inflation declined. The Fed has also begun reducing its balance sheet, but it is still seven times (7x) larger than it was pre-GFC.

The “Old Normal” is back – money has a cost, growth is faster (back to pre-GFC levels), and inflation has settled at a higher level. We believe this environment is likely to persist for some time.

Both inflation and real interest rates are not likely to revert to the 0.00% to 2.00% range in this environment.

A higher inflation, higher interest rate environment has implications for portfolio construction, and suggests that allocations to New Tools, such as alternatives and real assets, will continue to provide important diversification in the years ahead.

The Fed is likely to cut interest rates at this week’s December 18 meeting. After that, the Fed may pause.

One month ago, there was a 62% probability that the Fed would cut interest rates by 25 basis points at their December 18 meeting, according to the CME’s Fed Watch tool. Early Monday morning today (December 16), that probability was 96%.

In the meantime, the labor market has remained firm, economic growth has accelerated, and risk assets have appreciated. Inflation has ticked higher relative to the Fed’s previous projections.

For these reasons, the Fed’s Summary of Economic Projections (SEP) will be closely watched this week. Predictions of stronger growth or fewer projected rate cuts could push bond yields higher.

Both US consumers and corporations are feeling cheery, but uncertainty is increasing.

According to Evercore ISI (citing the University of Michigan’s sentiment survey), many US consumers are expecting household goods prices to increase, and may be making purchases in anticipation. Evercore ISI’s Christmas Tree Survey also shows that the 2024 holiday season is off to a strong start.

Consumers may be “pulling forward” demand due to uncertainty around tariffs.

Bottom Line:

Due to strong equity performance year-to-date (YTD), many portfolios have likely drifted overweight equities. Key Wealth believes in periodic rebalancing, and now is likely a good time to revisit risk exposures and rebalance portfolios where appropriate.

Remain Neutral to Risk and emphasize Quality investments. Employ small tactical tilts to areas that carry less-demanding valuations. Use New Tools, such as alternatives and real assets, where appropriate. Don’t let your politics undermine your financial goals.

Please find the replay to our recent 2025 Economic and Investment Outlook Call here: 12/4 Key Wealth's National Call Replay

Equity Takeaways:

Stocks rose in early Monday trading. The S&P 500 rose approximately 0.3%, to 6071, while small caps rose approximately 0.6%. International shares were mixed.

Overall trading volume is likely to decline after Wednesday’s Fed meeting on December 18. However, options expiration and S&P index rebalancing on Friday, December 20, may cause some elevated volatility on that day.

Despite some potential volatility mentioned above, the last two weeks of December tend to be a strong seasonal period. The S&P 500 is likely to drift higher into year end.

Corporate earnings growth continues to underpin the stock market. The trajectory of earnings in 2025 will hold the key to market performance. Consensus expectations call for significant earnings growth in 2025.

Key Wealth’s bull/bear projection scenarios are wider than last year’s. Our 2025 outlook envisions a wide range of potential policy outcomes, combined with elevated valuations – which could exacerbate volatility and inhibit future returns.

Our base case envisions a dip in earnings growth in the first half of 2025, followed by a strong second half. We believe volatility could increase in the first half of 2025 as a result. A potential risk to our 2025 outlook is that inflation runs hotter than expected.

Breadth is narrowing, a negative sign (caution flag). The headline S&P 500 index has been moving higher, while the cumulative advance-decline line for the NYSE has flattened. Broader participation would be a welcome signal.

Fixed-Income Takeaways:

Last week, longer rates rose faster than short-term rates (a “bear steepener”), as market participants reduced their expectations for rate cuts in 2025. Inflation remains sticky, which may force the Fed to cut rates slower than previously expected.

In early Monday trading, 2-year Treasuries were yielding 4.24%, 5-year Treasuries 4.24%, and 10-year Treasuries 4.39%.

As longer-term rates have risen relative to short-term rates, the Treasury curve has un-inverted. If the curve continues to normalize, we should see higher demand for longer-term bonds, all else equal.

A rate cut of 25 basis points is fully priced in for this Wednesday’s upcoming Fed meeting. Market participants will be focused on the Fed’s Summary of Economic Projections and the forward outlook for the economy and interest rates. The current Fed Funds rate is the range of 4.50% to 4.75%.

Credit spreads remain very narrow. That said, demand remains strong for high-quality corporate bonds. Investors continues to seek the higher all-in yields of corporates relative to Treasuries.