Market Perspective - Winter 2025

Guide to the markets

Sifting through financial information online is becoming quite onerous with so many opinions out there, so we've consolidated what we believe to be informative and insightful into one Market Commentary.

2024 was a remarkable year for the U.S. economy (the largest economy in the world, and our most significant trading partner) and for financial markets, despite uncertainties from the election, shifting monetary policy, and global tensions. The economy showed resilience, supported by strong consumer spending, which accounts for 70% of GDP, while inflation eased and the job market stabilized. Stocks soared over 20%, driven by robust earnings growth and advancements in AI, although bond markets faced some turbulence. As inflation trended lower, the Federal Reserve began cutting interest rates, but the outlook for 2025 is clouded by potential policy shifts from the new administration. Proposed measures, like higher tariffs and stricter immigration policies, could boost inflation and slow economic growth, presenting challenges for both the Federal Reserve and investors.

Looking ahead, opportunities remain abundant for active investors. U.S. stocks, though richly valued, are poised for broader growth across more sectors, reducing reliance on the biggest tech companies. Globally, international markets, such as Japan, Taiwan, and India, offer attractive diversification options, supported by unique growth drivers like AI, tech cycles, and corporate reforms. While inflation may face temporary upward pressure from policy changes, it is expected to continue easing overall. With economic growth steady and interest rates likely to decline gradually, a diversified approach across stocks, bonds, and alternative assets could help investors navigate potential volatility and capitalize on market opportunities.

I have included below an economic & market update from J.P. Morgan Asset Management that I would like to share. This Guide to the Markets provides concise insights into economic trends globally, emphasizing growth, employment, and inflation. The commentary, and its many supporting charts, are presented by JP Morgan's Chief Global Strategist Dr. David Kelly, and they highlight the major themes and concerns impacting investors today.

From JP Morgan’s Dr. David Kelly:

Despite uncertainty stemming from the U.S. election, shifting monetary policy and heightened geopolitical tensions, 2024 proved to be an impressive year for the economy and financial markets. The U.S. economy was quite resilient, supported by a steadfast consumer. At the same time, inflation continued to drift lower, although downward momentum has faded in recent months, while the labor market appears to have settled into a healthy place. As the new administration takes office in January, investors will be closely watching for more details regarding policy plans and their potential impacts on broader economic conditions.

With inflation moderating and the labor market normalizing, the Federal Reserve’s rate cutting cycle is well underway. That said, the outlook for 2025 is largely uncertain. Policies proposed by the incoming administration, should they provide an inflationary impulse, could result in a more gradual pace of policy easing, or an early end to the rate cutting cycle altogether.

Still, markets have largely taken this uncertainty in stride. Stocks finished the year over 20% higher on the back of broadening earnings growth and AI tailwinds. Bonds modestly rebounded after a bumpy start, although interest rate volatility has been elevated since the Federal Reserve’s initial rate cut in September. With U.S. equities trading at over 22 times forward earnings and credit spreads historically tight, elevated valuations remain a risk. However, a relatively benign economic environment in 2025 should offer investors plenty of opportunities to deploy capital. Those who do so actively and with a keen focus on diversification should be best prepared for any shocks that arise.

In this commentary, we assess the recent performance of the markets and economy, considering trends in growth, jobs and inflation and how policies proposed by the incoming administration could impact the path forward. We also include comments on monetary policy and finally, a discussion of the global opportunity set across stocks, bonds and alternative assets.

2024 was another impressive year for the U.S. economy, with real GDP growing at an above-trend pace for a fourth consecutive year. To understand why economic activity has been so resilient, and where it is headed, we can analyze its different components.

The first graph looks at the key drivers behind recent GDP growth. Given that consumption accounts for almost 70% of the U.S. economy, it’s no surprise that the health of the economy is closely tied to that of the consumer. Supported by impressive gains in household wealth and 20 consecutive months of positive year-over-year real wage gains, consumer spending has powered the economy forward, contributing 2.4 percentage points to the 2.8% increase in real GDP in the third quarter. Other segments have also performed well. Despite higher borrowing costs, business investment has been buoyed by strong corporate balance sheets and fiscal support, while government spending has looked solid. On the other hand, home-building has remained subdued due to elevated mortgage rates, and the combination of a strong dollar and sluggish global economic activity has weighed on the U.S. trade balance.

Policy uncertainty is casting a fog on the economic outlook for 2025. Severe restrictions on immigration and aggressive tariff policies, should the incoming administration implement them, could boost inflation as could a full extension of the Tax Cuts and Jobs Act if supplemented by the further extensive tax cuts promised on the campaign trail. Still, none of these policies appears to portend immediate recession and as activity in interest rate sensitive sectors normalizes and consumer spending settles at a more moderate pace, 2025 should be another year of expansion, likely at a trend-like pace, for the U.S. economy.

After rising during the first half of 2024, the unemployment rate has stabilized. At 4.2% in November, unemployment is meaningfully above its cycle low of 3.4%, set in April 2023. That said, it is still lower than it has been almost 88% of the time over the past 50 years.

In 2025, steady economic growth should support continued job gains, reducing the risk of any further meaningful rise in unemployment. In fact, should labor force growth slow due to more restrictive immigration policies, unemployment might even drift lower over the course of the year.

With stable unemployment, wage growth should stabilize also. Loosening labor market slack over the past year has led to a moderation in wage growth. After peaking at 7.0% in March 2022, growth has continued to slow back to trend. Wages for private production and non-supervisory workers rose 3.9% year over year in November, putting them back in-line with the 50-year average. While slower immigration would likely put upwards pressure on wage growth, sustained strong productivity gains could help limit any pass-through to inflation.

S&P 500 earnings are expected to have grown 9% in 2024. Analysts are projecting even stronger growth of 15% and 13% in 2025 and 2026, respectively. Compared to the long-term average of 7.5%, these estimates seem a bit too rosy, particularly given our expectation for slowing nominal growth. Normalizing GDP growth could limit revenue growth, and slowing inflation could pressure margins. Nevertheless, trend-like nominal GDP growth combined with more stimulative fiscal policy should support solid earnings gains, especially when these gains broaden to beyond the largest stocks.

Notably, while earnings of the Magnificent 7 companies grew by 31% in 2023 and 36% in 2024, earnings for the rest of the S&P 500 contracted by 4% in 2023 then grew by just 3% last year. 2025 should finally bring the much-anticipated broadening: Mag 7 EPS growth is expected to decelerate to a still strong 21%, while EPS growth for the rest accelerates to 13%. Similarly, by 1Q25, analysts are projecting positive EPS growth for 10 out of 11 sectors compared to just 4 out of 11 in the first quarter of 2023. As lower interest rates awaken U.S. manufacturing activity, we think a cyclical recovery could drive the next phase of the broadening.

With this greater earnings breadth should come greater market breadth. 2025 leadership should be less narrow, reducing the risk of elevated concentration and valuations, and increasing opportunities for active investors.

Inflation made meaningful progress towards the Federal Reserve’s 2% target in 2024, allowing the Fed to kick off its rate cutting cycle. That said, downward momentum waned in the fourth quarter, sparking fears that progress on inflation has stalled. Indeed, headline CPI rose 2.7% year over year in November compared to 2.4% just two months prior. However, recent gains are largely due to base effects, and with little evidence that price pressures are building, inflation should resume its downward march in 2025.

For much of the last year, core goods prices had been a steady source of deflation as supply chains remained well managed, even with elevated geopolitical tensions. In recent months, however, prices have moved higher on a sequential basis, largely due to rising vehicle prices. That said, auto inventory-to-sales ratios have trended higher off from post-pandemic lows, suggesting pressure here should fade. On the more volatile components, lower gasoline prices have weighed on energy prices while food inflation has remained mild. Moving forward, sluggish global demand limits the likelihood of a surge in either of these categories.

That brings us to the key drivers of inflation, shelter and auto insurance. Shelter inflation accounts for over a third of the CPI basket and has held stubbornly above its pre-pandemic trend. That said, real-time measures of market rent point to more normal levels of shelter inflation ahead. Auto insurance, a consistent hot spot of inflation, eased slightly in November but is still rising by 13% year-over-year. Fortunately, as the rollover in vehicle prices feeds through the data, this trend lower should continue.

Overall, inflation should continue to ease in 2025. Price gains in shelter and auto insurance remain elevated, although real-time data continue to point to easing price pressures ahead. However, policies discussed by the incoming administration, should they be implemented as communicated, could cause progress on inflation to reverse course, at least temporarily.

Over time, economic globalization has led to increasingly relaxed trade policies. Indeed, the average tariff rate on U.S. goods imports has steadily fallen since the 1930s. However, geopolitical tensions and supply chain snarls induced by COVID-19 have prompted a re-evaluation of open trade policies. With promises to protect American businesses and address unfair trade practices, tariffs sit at the center of the Trump administration’s policy agenda.

Here, we try to put recent tariff proposals into context. Assuming a 20% universal tariff and an additional tariff on Chinese imports of at least 60%, calculations by the Tax Foundation suggest the average tariff rate on U.S. imports could rise to 17.7% in 2025, up from 2.4% in 2023. Admittedly, U.S. trade policy remains highly uncertain, and it is unclear whether tariff policies will be implemented as proposed. Moreover, it is unclear whether they will be implemented permanently or used primarily as a negotiation tool. Regardless, tariffs are likely to rise under the incoming administration, with a particular focus on China.

Beyond discouraging imports, tariffs can have negative unintended consequences. If enacted as stated, tariffs could lead to higher inflation and trigger retaliation, reducing the demand for U.S. exports. Overall, aggressive tariffs would add even more uncertainty to an already foggy economic outlook, complicating the Federal Reserve’s path forward.

The labor market has normalized from its post-pandemic boom but, looking through recent distortions from strikes and hurricanes, job growth has settled into a relatively healthy pace. That said, the Trump administration has expressed its intent to take a tougher stance on immigration, which could have meaningful implications for the labor market in 2025 and beyond.

After falling sharply during the pandemic, labor supply in the U.S. staged an impressive recovery over the last two years, largely due to increased immigration. In fact, CBO estimates suggest that immigration accounted for over 80% of total population growth in recent years. Moreover, in fiscal year 2023, Immigration Services approved over 2 million initial applications for employment authorization, a 70% increase from a record 1.2 million in fiscal 2022. With this surge in the migrant population and workers, employers were able to fill open job openings without applying upward pressure to wages, helping to explain why strong job creation hasn’t sparked higher inflation. However, if immigration were to be significantly restricted, it could hinder labor force growth, especially given weak domestic demographics in the U.S., and potentially lead to higher inflation through higher wages.

A strong recovery in the labor force participation rate has also boosted labor supply. While the continued aging of baby boomers into their retirement years has left the overall labor force participation rate below pre-pandemic levels, participation among prime age workers has fully recovered its pandemic losses and has been particularly strong among females.

Moving forward, steady economic growth and solid corporate profits should support a moderate pace of hiring. However, severely curtailed immigration could provide a stagflationary impulse, potentially weighing on economic growth while exerting upward pressure on inflation via higher wages.

Among other expansionary fiscal policies, the Trump administration has expressed its intent to fully extend the Tax Cuts and Jobs Act, or the TCJA, and reduce the corporate tax rate. At the same time, it has promised to dramatically cut costs. In determining whether these policy proposals are feasible, and how they could impact the fiscal health of the U.S., the above graph should be particularly useful.

The left chart shows CBO estimates for government spending and how that spending will be financed in fiscal 2025. To reach its cost cutting goals, the incoming administration may have to make some difficult decisions. Non-defense discretionary spending accounts for just 12% of the government’s budget, meaning they may have to explore spending cuts on defense or entitlements. The administration has also expressed its intent to use tariff revenues to offset the extension of the TCJA. However, tariffs are only a sliver of current government revenues, and that will likely remain the case, even if Trump’s tariff policies are implemented in full. Moreover, higher tariffs, by inviting retaliatory tariffs, would slow the economy, reducing revenues from other areas of income taxation.

On the right, we explore the outlook for the deficit and federal debt. With no revenue or spending offsets, the TCJA is likely to amount to significant stimulus and add to deficits. Every year, the federal deficit gets added to overall debt, which we show on the bottom right. According to the CBO, federal debt is expected to climb to nearly 120% of GDP by 2034 excluding the impacts of a TCJA extension, and nearly 130% with them. That is up from 98.2% in fiscal 2024. Other sources, such as the Committee for a Responsible Federal Budget, believe that a full implementation of President-elect Trump’s proposals could boost the debt to a whopping 143% of GDP by fiscal 2035.

Since the TCJA extension and any additional provisions will need to be passed through the once-a-year budget reconciliation process, they are unlikely to go into effect until early 2026. After that, expansionary fiscal policy will not only boost deficits, but could also act as a longer-term source of inflationary pressure.

With inflation trending lower and the labor market softening, the Federal Reserve, attentive to both sides of its dual mandate, cut interest rates by 100 basis points in 2024. In 2025, the committee will certainly have a preference to continue easing policy until it reaches a neutral stance. However, fiscal stimulus in addition to tariff and immigration policies, if passed, could make this difficult to achieve.

At its final meeting of the year, the Federal Reserve voted to cut rates by 25 bps, reducing the federal funds rate to a range of 4.25% to 4.5%. This move was largely expected, and investors found themselves more focused on the press conference and the latest set of economic projections. In his comments, Chair Powell noted that he is optimistic about the health of the economy and that downside risks to the labor market have largely diminished. He also noted that inflation, while still moving in the right direction, has been hotter than expected in recent months. These views were reflected in the Summary of Economic Projections, which showed a higher growth forecast and lower unemployment forecast for 2025, as well as higher inflation forecasts for 2025 and 2026. With solid economic activity and increased inflation uncertainty, the committee penciled in just 2 rate cuts in 2025 versus 4 in the September SEP. In acknowledgment that the economy may be less interest rate sensitive, the neutral federal funds rate ticked higher to 3.0%.

Today, market expectations remain more hawkish than the Fed’s forecast, highlighting investors’ fear that inflationary policies proposed by the incoming administration might force the Fed to consider a slower pace of policy normalization, or a pause altogether. We agree that a more gradual policy easing path is the most likely outcome, limiting any downside move in rates. However, until we gain more clarity on President-elect Trump’s policy agenda, the pace of rate cuts will continue to hinge on the incoming economic data.

Investment grade and high yield corporate credit finished the year up over 3% and 8%, respectively. While this rally has left corporate credit looking expensive, we continue to find opportunities across the asset class.

The above graph shows corporate credit spreads over time, and compare current spreads and yields to their long-term averages. Across both investment grade and high yield, spreads are sitting near all-time minimums as strong earnings growth, subdued default activity and improved credit quality have biased spreads narrower. While valuations in both sectors look expensive, and credit investors are unlikely to generate meaningful gains from narrowing spreads, investors should embrace credit for the attractive all-in yields. Investors can take comfort in the fact that widening spreads shouldn’t be an issue in 2025 either, as a benign economic backdrop and broadening earnings growth should keep them tight.

With the Fed likely to ease policy only gradually, it’s difficult to make any outsized bets on duration right now. For those searching for enhanced yield and higher returns, corporate credit offers an attractive opportunity. That said, not all bonds are created equal, and an active approach to fixed income investing will be key to finding attractive relative value opportunities while balancing potentially higher risks with higher rates.

At over 22 times, the S&P 500’s next-twelve-month price-to-earnings ratio is close to the dot-com-bubble peak. Other valuation metrics, like price to book and price to cash flow, are similarly elevated. While this doesn’t tell us much about short-term returns, history shows that high valuations are correlated to lower long-term returns.

Mega cap tech is getting a lot of the blame. Indeed, the 10 largest stocks have a forward P/E ratio of over 30 times, roughly 150% of the long-term average. This is especially concerning as these top 10 stocks now constitute almost 40% of the market cap of the S&P 500. Valuations for the remaining stocks in the S&P 500 are also elevated – but less so – with a forward P/E under 120% of the long-term average. This might be a good place to start hunting for less appreciated opportunities.

Though elevated index level valuations might give investors pause, dispersion suggests there are opportunities underneath the hood. The difference in valuations between the 100 most expensive stocks and the 100 least expensive stocks is currently wider than it has been 90% of the time over the last 28 years. So, odds are, there are a lot of stocks with price tags that are too high, and a lot of stocks with price tags that are too low. While this could cause elevated volatility at the index level, it should also create opportunities for active stock pickers, especially as earnings breadth increases.

As U.S. stocks have enjoyed an extended run of stellar performance, international stocks have long been the underdog. That said, 2025 could be their time to shine. Not only has strong U.S. equity performance pushed valuations to lofty levels, but the U.S. now also makes up over 65% of global equity indices despite accounting for only 25% of global GDP growth. This suggests that U.S. stocks are pricey, and it might be wise for investors to consider diversifying into other global markets.

While many international markets are facing cyclical challenges, structural tailwinds should continue to drive strong performance in select regions. Japan, for instance, is moving out of a long period of deflation, stagnant nominal growth and negative rates. Reflation in the country should support consumer spending and domestic earnings growth. Moreover, corporate governance reforms should continue to support flows into the region. While China’s path ahead may be bumpy and involve trade conflicts with the U.S., opportunities in EM ex- China remain promising. Taiwan outperformed the U.S. in 2023 and 2024 due to its strong ties to the technology sector and AI tailwinds, and should continue to benefit from the tech-cycle boom in 2025. Robust earnings and services export growth have supported strong performance in India. While elevated valuations leave the market susceptible to a pull-back, the region’s long-term investment case remains compelling.

As the slide above demonstrates, performance across countries has varied. By using an active approach to find the most compelling stories, investors can allocate abroad without having to compromise on performance. For investors overexposed to the United States, it might be prudent to take some profits and diversify across other regions. Historically, international equities have traded at a discount to the U.S. due to their value tilt, lower liquidity and economic and currency risks. However, the current discount appears larger than warranted by these factors.

As both stocks and bonds rallied in 2024, the challenges facing the traditional 60/40 portfolio became even more pronounced. Stocks and bonds remain positively correlated and continue to offer mediocre levels of income. Moreover, elevated equity valuations and low bond yields relative to history point to less impressive returns from the 60/40 moving forward. Against this backdrop, investors may have to look elsewhere for consistent outcomes across alpha, income and diversification. Investors willing to venture outside of the public markets can leverage a range of different alternative assets to reach their desired outcomes. The plot graph above offers that alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.

Real assets shown towards the left, such as real estate, infrastructure and transport, tend to be less correlated to a traditional 60/40 portfolio while providing robust income. Private equity and venture capital, towards the right, could provide much higher total returns but come with higher correlations to public markets and less income generation.

The classic 60/40 stock-bond portfolio still looks attractive, but adding a sleeve of alternatives can help long-term investors achieve strategic goals through higher alpha, better diversification and enhanced income.

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Your portfolio

I try my absolute best to ensure my human outlook does not spill into your investment strategy.

"Time is your friend; impulse is your enemy."

-Jack Bogle

As a strategic asset allocator (decisions made based on past outcomes) versus a tactical asset allocator (decisions made based on future outlook), my belief is that future short-term outcomes are not yet known, and that past outcomes are a matter of fact.

Based on this framework, we make systematic determinations for portfolio shifts every quarter. The end result of these determinations was to reduce your overall equity/stock holdings in July of 2021, increase them in July of 2022, reduce them in July of 2023, and then again in April 2024. We again made a systematic change in December 2024 - moving some assets out of US equities in favor of international equity, infrastructure assets, and fixed-income assets.

You'll note that we plan on shifting our quarterly evaluation schedule going forward from January, April, July, October to March, June, September and December. This should better coincide with end-of year tax planning andd less of interference during the income tax preparation deadline.

A graphical representation of what I describe above, contrasted against the S&P 500 index (just one of several market factors) over the past 5 years, can be found below, whereby green dots represent slight shifts into equity, and red dots represent slight shifts out.

From a historical perspective, you may find that this strategy has yielded results that had your portfolio overperform in 2020, underperform in 2021 (shifting out as stocks went up), and overperform in 2022 (despite the down year), 2023 and so far in 2024.

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We continue to monitor any potential new holdings on an almost daily basis, and continue to evaluate your existing holdings to determine if the reasons we bought them in the first place remain true today.

I hope you find this both interesting and informative in keeping pace with the events of today’s financial world.

This publication contains the opinions of the writer. The information contained herein was obtained from sources believed to be reliable, but no representation or warranty, express or implied, is made by the writer, Designed Securities Ltd. or any other person as to its accuracy, completeness or correctness. This publication is not an offer to sell or a solicitation of an offer to buy any securities. The information in this publication is intended for informational purposes only and is not intended to constitute investment, financial, legal, tax or accounting advice. Many factors unknown to us may affect the applicability of any statement or comment made in this publication to your particular circumstances. Hence, you should not rely on the information in this publication for investment, financial, legal, tax or accounting advice. You should consult your financial advisor or other professionals before acting on any information in this communication.

Embark Wealth is an investments trade name of Designed Securities Ltd (DSL). DSL is regulated by the Canadian Investment Regulatory Organization (www.ciro.ca) and Member of the Canadian Investor Protection Fund (www.cipf.ca ). Investment products are provided by Designed Securities Ltd. and include, but are not limited to, mutual funds, stocks, and bonds. Adam Schacter is registered to provide investment advice and solutions to clients residing in the provinces of British Columbia, Alberta, Manitoba, Ontario, Quebec, and Nova Scotia.