Macro
This Christmas week has been relatively quiet, with minimal market movement and limited economic news. Investors are now focusing on the upcoming year, with growth remaining a key concern. Reducing the Federal Funds Rate is expected to create a virtuous cycle by lowering real interest rates, encouraging capital spending, enhancing productivity, and accelerating economic growth. However, achieving this outcome depends on the Federal Reserve reaching its inflation target—a goal it has yet to meet.
The prevailing view is that if PCE inflation stabilizes near 2.5%, rate cuts for 2025 could total around 50 basis points. Should the labour market soften further and relief emerge from the pressure of rising shelter prices, even more cuts might follow. Nonetheless, the overall outlook is complicated by anticipated significant changes in fiscal policy under the new administration.
Other economic data presented a mixed picture. Consumer confidence fell in December due to weaker sentiment regarding current conditions and future expectations, though labour market perceptions improved. November home sales rose from the prior month but missed expectations. Durable goods orders were weaker than anticipated at the headline level, but core capital goods orders showed resilience. Jobless claims declined week over week, though continuing claims reached their highest level since late 2021.
While the US economy is performing well overall, income inequality persists. Lower-income households continue to struggle while higher-income households thrive—a phenomenon often described as a K-shaped recovery that highlights growing disparities within the economy.
The US faces severe federal debt and budget deficits, which now total approximately $36 trillion, or about 120% of GDP. Despite these high levels, the economy remains robust. Economists advise focusing on the primary deficit, which is manageable, and note that confidence will persist as long as economic growth outpaces debt accumulation. Furthermore, DODGE movement is aiming to deliver aggressive fiscal cutting, however question is if this can counterbalance the effects of recent expansionary policies that have ballooned public deficits. the US is likely to maintain its financial stability thanks to its unique economic position, the dollar’s status as the primary global reserve currency, and robust demand for Treasury securities. In addition, if necessary, the government could significantly increase tax revenues—albeit potentially at the expense of further economic growth.
Over the past three years, the much-anticipated recession has not materialised despite the Federal Reserve’s tightening measures. Given that the US has managed to avoid a recession during that period, it seems unlikely that a recession will occur now that the Fed is easing. Moreover, the economy has shown that it can sustain strong growth without further rate cuts—though it is important to acknowledge that a significant portion of this performance is attributable to substantial fiscal stimulus. This resilience is particularly notable as productivity is rebounding.
US productivity is indeed accelerating. In 2015, productivity growth ranged between 0 and 50 basis points; today, it stands at about 2%. Under optimistic scenarios—particularly considering the impacts of AI, automation, and robotics—productivity could potentially rise to as much as 3–4%. The expectation is that the further implementation of AI applications will affect a broader range of industries simultaneously than the internet did in the 1990s. This boost in productivity should, in turn, lead to real wage growth.
While the US economy is growing rapidly, China continues to face challenges. Chinese economic weakness is largely attributed to weak domestic demand and persistent deflation resulting from a prolonged downturn in the property market, with additional concerns that potential tariffs could further harm its export-driven economy. Nevertheless, the World Bank has raised its 2025 growth forecast for China to 4.9% (compared to Beijing’s forecast of 5%), acknowledging recent policy relaxations and strong export performance. The Bank also urges China to implement comprehensive structural reforms—in taxation, education, healthcare, and social welfare—to boost confidence and address long-standing structural issues. Following a change in direction this year, Beijing’s focus has shifted toward achieving high-quality growth by enhancing efficiency, equity, and stability through more effective resource allocation.
Rates
This week, treasuries weakened, leading to a steeper yield curve, with the 2/10 spread reaching its best level since June 2022. Treasury auctions, totalling $183 billion for the week, were well received. The dollar gained strength against the yen and remained largely steady versus the euro and sterling, and the Dollar Index climbed by 0.4%—marking increases in 12 of the past 13 weeks. Concurrently, money managers have been offloading Treasuries while long-term bond funds face heavy redemptions. Even cash is now yielding over 4%, prompting many to reconsider their fixed-income allocations.
Recent months have witnessed fundamental changes in the interest rate market, reshaping investor sentiment and market dynamics. On December 26, U.S. Treasuries – tracked by an ICE BofA index – returned only 0.4%, significantly trailing short-term T-bills, which yielded 5.2%. This marks the fourth consecutive year of underperformance for Treasuries.
Wall Street’s earlier optimism about high-quality debt has given way to caution. Recent weeks saw record outflows – such as a $5.3 billion withdrawal from BlackRock’s iShares 20+ Year Treasury Bond ETF – and yields on the 10-year Treasury rose from 3.86% at the end of 2023 to over 4.6% by late December. This increase has pushed average 30-year mortgage rates back toward 7%, fueling a broader re-evaluation of risk and prompting some investors to favour short-term T-bills over longer-term bonds.
Not all market participants are pessimistic, however. Economists at Goldman Sachs forecast that inflation will decline next year, potentially allowing the Federal Reserve to make three rate cuts and positioning 10-year Treasuries to outperform T-bills in 2025. They cite strong U.S. growth and a significant federal budget deficit as factors already priced into the market.
On a global scale, central banks in developed markets (excluding Japan) have been moving in lock-step for the past three years. The U.S. and U.K. maintain similar rate levels, the Eurozone’s rates trail by roughly 125 basis points, and Japan’s rates remain near zero. Currently, rates are high relative to 12-month expectations, and some analysts argue that the 2025 inflation forecast may be overly pessimistic.
In Turkey, investors have found profitable opportunities in carry trades involving the lira. The Turkish central bank recently cut its base rate from 50% to 47.5%—its first reduction in nearly two years—as the economy slipped into a technical recession, with inflation now at 47.1% (down from over 75% in March 2024). With a target of reducing inflation to 21% by the end of 2025, a successful moderation could yield significant gains for carry traders.
Credit
This was a relatively quiet week for the credit market. Due to a risk-off sentiment, IG corporate spreads ended the month at 80 basis points. However, for the entire year, these spreads tightened by 19 basis points, reflecting overall investor confidence. High-yield bonds faced modest challenges due to risk-off sentiment, leading to minor negative returns in December. Nevertheless, the high-yield sector remained a strong performer throughout 2024.
The Private Credit space keeps growing and is estimated to be between $1.5 and $2 trillion globally. Direct lending accounts for the largest portion, $800 billion to $1.2 trillion. In contrast, the combined US and European High-Yield Bond and Leveraged Loan markets are just under $4 trillion, US Commercial Real Estate debt is nearly $6 trillion, and US family residential mortgages exceed $14 trillion.
Borrowers in Private Credit are typically sophisticated entities with strong incentive alignment, reducing the likelihood of systemic issues. They tend to be much smaller companies than those borrowing through leveraged loans or bonds (and much smaller than IG bonds). Overall, borrowing is supported by cash flow from a diversified group of sectors. Private credit borrowers tend to have higher Debt/EBITDA ratios than those in Leveraged Loans and High-Yield Bonds. They also tend to have lower Debt/Asset ratios comparable to Investment-Grade Bonds.
Equities
The S&P 500 is on track for a second consecutive year of robust returns exceeding 20%, driven by factors like the potential for a soft landing, resilient consumer spending, positive investor sentiment, and anticipated benefits from AI and quantum computing. A business-friendly regulatory environment under the incoming Trump administration, along with steady capital inflows and share buybacks, further bolsters bullish expectations. However, risks remain, including the narrow breadth of market gains (concentrated in the “Magnificent 7”), the Federal Reserve’s likely reluctance to cut rates, potential consumer financial strain, and the threat of increased inflation due to possible trade wars.
This week saw sector performance led by Energy (+1.21%), followed by Healthcare (+1.09%), Communication Services (+0.92%), Financials (+0.88%), and Technology (+0.85%). Consumer Staples (-0.32%) and Materials (-0.27%) lagged, while Real Estate (+0.35%), Utilities (+0.38%), and Consumer Discretionary saw modest gains. Industrials were flat.
Corporate news was light. Rumble saw a 112% surge after a $775 million investment from Tether. Honda and Nissan announced merger talks, targeting a deal by mid-2025. Index-related moves included GDYN and INSW joining the S&P Small Cap 600. Xerox is acquiring Lexmark for $1.5 billion, and Nordstrom is going private in a $6.25 billion deal.
Despite high interest rates, market conditions appear loose, driven by post-election investor enthusiasm and expectations of deregulation and increased M&A activity. This bullish sentiment has contributed to high valuations. While high Treasury yields and a strong dollar currently act as headwinds, they could become tailwinds next year. Investors concerned about valuations are looking towards small and mid-cap stocks, and the S&P 493 (S&P 500 ex-Magnificent 7). Small business confidence has also rebounded. Companies effectively implementing AI, automation, and robotics are expected to see significant gains.
The equal-weighted S&P 500 has underperformed the market-cap weighted index by 14%, suggesting a potential reversal. The Russell 2000 had its worst quarter since Q3 2022, and only 30% of S&P 500 stocks are above their 50-day moving average. If the S&P 500 maintains its high P/E multiple of 25, a year-end target of 7,000 (a 16% upside) is possible. While cost-cutting and government spending have boosted revenues for some companies, broader earnings growth is needed for sustained market gains. Currently, high multiples are the primary driver of returns, reflecting investor confidence in continued US economic growth.
While either the valuations or the growth prospects make most sectors look expensive, attractive opportunities exist in REITs. Publicly traded Real Estate Investment Trusts (REITs) have historically performed well at the end of interest rate hiking cycles and the start of easing cycles. This pattern was evident in the fourth quarter of 2023, when the market began anticipating rate cuts in 2024 and 2025, leading REITs to become the top-performing sector in the S&P 500. However, this rally was short-lived. In early 2024, stronger-than-expected inflation data and expectations of a “higher for longer” interest rate policy caused REITs to decline. As the year progressed and the prospect of the first rate cut (in September) drew nearer, the market once again began pricing in multiple rate reductions, triggering another period of REIT outperformance. Currently, with the 10-year Treasury yield above 4.5%, the interest rate environment is considered favorable for REITs, as they are trading at significant discounts to their net asset values (NAVs).
This combination of a constructive interest rate backdrop, substantial discounts to NAV, a large valuation gap compared to the broader S&P 500, and relatively low investor allocations creates a compelling investment opportunity in the REIT sector. Adding to the sector’s attractiveness is the increasing demand for data center infrastructure, a service provided by many REITs. Therefore, both economically and cyclically, the setup for REITs appears highly favorable.
Meanwhile, India has overtaken China to become the leading destination for IPOs in the region this year, ranking just behind the United States in global equity fundraising, according to Dealogic’s 2024 data. The National Stock Exchange of India is expected to emerge as the top venue for primary listings by value, surpassing major exchanges such as Nasdaq and Hong Kong. India’s capital markets have exhibited robust growth, driven by strong domestic investment flows. The “democratisation of investment” has heightened retail investor participation, further reinforcing market dynamics. While GDP growth slowed to 5.4% in Q3 2024, the country remains one of the fastest-growing economies, providing a solid foundation for future earnings expansion.
As the year-end approaches, analysts project that S&P 500 returns for the coming year will be slightly above the historical average, typically in the +10% to +15% range. However, actual market returns often deviate significantly from the average.