A New Year but Unresolved Questions Remain

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

The new year typically brings with it a host of market predictions for the coming 12 months, including educated predictions of the closing levels of the major indices at year-end. The forecasts can make for interesting reading but often fall short in predictive value. Last year was no different, with Wall Street analysts at the beginning of the year forecasting an average price target for the S&P 500 of 4,800 by the end of the year (for context, the index opened the year at 4,769). Instead, the index closed out 2024 at 5,881, surpassing even the high end of the range of predictions made by the most optimistic analysts. Perhaps reflecting how badly many of the forecasts underestimated the upside for the markets, some of the projections we’ve seen for the year ahead are more bullish, coming in at an average of 6,600, or a roughly 12 percent gain.

We highlight the spotty track record of market performance projections not to point fingers at any of our competitors—after all, our call for a mild recession to arrive in 2024 missed the mark—but instead to highlight how no one can know for certain how the ever-evolving economy and markets will play out in the year ahead. As such, we believe a more worthwhile exercise is to identify risks in the current economic backdrop and try to determine whether they are reflected in the market over a longer time horizon as opposed to an arbitrary year-end date. The reality is that no one can time the market perfectly, but we believe that risks and opportunities over reasonable time horizons can be identified. At times those risks can be to the upside, as we correctly noted during the arrival of COVID and thought the market would rise despite the global pandemic. Other times, there are risks that can lead to heightened volatility and a bumpy ride for investors. And, of course, all of this needs to fit into the context of focusing on investing for the long term, with a diversified approach, guided by a well-thought-out financial plan.

As we look ahead in the new year, we believe the path of the markets and economy will be heavily influenced by many of the same questions and risks that went unanswered in 2024. Primary among them: Will consumers and businesses that have struggled under elevated interest rates be able to strengthen and join those parts of the economy that have endured and grown despite (or even because of) high interest rates? The answer to that question may ultimately depend on the outcome of several other unknowns.

• Will the Fed be able to cut rates enough to alleviate pressure on interest rate-sensitive pieces of the economy?
• Will the bond market follow the Fed’s lead on interest rates, or will yields on intermediate- and longer-term bonds continue to set their own course?  
• Will weakness in the job market spread, or will businesses add to payrolls to keep up with increased demand?

Evolving opinions about each of the above questions had a direct impact on the performance of the markets throughout last year. Optimism about rate cuts in the beginning of the year led to a fast start for equities, with the market broadening to include economically sensitive businesses on the hopes that lower interest rates would ease their pain. The move was short lived, however, when signs of sticky inflation dampened expectations about the number and timing of rate cuts and pushed bond yields higher.

As investors concluded the Fed would take a muted approach to cutting rates, investors once again flocked to the perceived safety and interest rates insensitivity of the so-called “Magnificent Seven,” and the group trounced the rest of the market beginning late in the first quarter and throughout the second quarter. It wasn’t until July, when a weak jobs report and encouraging inflation data raised the prospects of rate cuts, that breadth in the market improved as Treasury yields reversed course and pushed lower.

Indeed, as expectations of rate cuts grew, Small-Cap stocks (which traditionally are more sensitive to economic growth) outperformed the S&P 500 by nearly 14 percent and the Magnificent Seven by 23 percent in the span of just 20 days. The ebb and flow of market breadth continued for the remainder of the year as prospects for a broadening economy rose and fell along with expectations of rate cuts.

While investors viewed rate cuts as integral to the economy broadening, the bond market’s reaction highlighted that reducing short-term rates isn’t the magic elixir many thought it would be. Since the Fed approved its first cut in September, yields on intermediate- and longer-term bonds have risen. For example, the yield on the 10-year Treasury went from 3.61 percent on the eve of the first cut to closing at 4.6 percent at the end of last week. Because mortgage rates are closely tied to yields on 10-year Treasurys, borrowing costs for would-be homeowners have also risen since the first rate cut by a similar amount and have added to the affordability issues that are affecting the housing market.

Finally, the strength of the job market may prove to be the linchpin that determines how the economy fares in the year ahead. During the second half of 2023 and throughout much of 2024, when several normally reliable economic indicators were flashing caution, the strength of the job market was often cited as a counter to the argument that the economy was cooling. As last year wore on, signs that the labor market was softening began to show up in data, including revisions to initially strong estimates of jobs creation from the Bureau of Labor Statistics (BLS) Nonfarm payroll report.

However, as the unemployment rate picked up and eventually breached the threshold to trigger the so-called “Sahm rule,” which has historically signaled a sharp uptick in job losses, the Fed decided it needed to take action and voted to reduce rates by a larger-than-expected 50 basis points.

Since then, the unemployment rate has improved modestly, and the Fed has signaled that it believes it can take a slower approach to cutting rates as it views risks to the employment picture to be in balance with risks from inflation. Going forward, we believe a move higher in unemployment could create a challenge for the Fed should inflation remain sticky. However, if economic growth shifts higher, businesses may need to hire more workers, which could lead to wage pressures unless there is a rise in available workers or strong business investments in artificial intelligence (AI) start to pay off through gains in worker productivity.

To put it in the Fed’s language, it will be forced to navigate between cutting too aggressively and risking a reawakening of elevated inflation, all the while being mindful that if it cuts too slowly, it could cause additional pockets of weakness in the economy.

To be sure, there are other factors that will shape the economy in the year ahead, including a new administration in Washington and an ever-growing national debt, as well as possible geopolitical events that could produce short-lived volatility. We highlight these questions and risks not to discourage investors or to paint a bleak outlook—indeed, the future remains bright. Instead, our comments highlight opportunities for intermediate- to long-term focused investors as we move into and through 2025. Despite the overall strong performance of equity markets in 2024 that has resulted in rich valuations for a swath of stocks, many segments of the markets haven’t taken part in the rise and, as a result, remain attractively valued. We maintain that if the economy continues to grow in 2025, it will be in a broader manner, which will boost earnings for many companies and lead to broad market participation to the upside.  

Despite the near certain narrative that many believe is in the cards for 2025, we believe that many twists and turns lie ahead. Given this uncertainty, we continue to believe investors should follow a plan that accounts for the unexpected. We believe the best approach to an unknowable economic outcome is diversification. While diversification is often viewed as a defensive tool, we see it as an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag.

Wall Street wrap

Manufacturing shows some improvement: The latest headline reading from the Institute for Supply Management (ISM) shows that manufacturing activity is still in contraction but perking up. Manufacturing is an interest rate-sensitive part of the economy that has struggled over the past few years, so an uptick in activity is noteworthy. The December Purchasing Managers Index came in at 49.3, up 0.9 points from November but still at contractionary levels (readings below 50 indicate contraction for the sector). The latest level marks the eighth consecutive month of contractionary readings and the 24th time in the past 25 months that the reading has been below 50. However, readings for new orders improved and are now showing growth for a second month in a row with a reading of 52.5, up 2.1 from last month. The Production Index nudged into expansionary territory at 50.3, up from November’s 45.9 percent reading. Order backlogs came in at 45.9 compared to 41.8 for the prior month. An increase in new orders and order backlogs may be an early signal that the weakness in manufacturing has plateaued and may be inflecting.

Despite the improved activity, the employment index continues to signal shrinking payrolls. The latest reading of the employment index came in at 45.3, down 2.8 points from November. Weak demand for employees was widespread, with only two of 18 industries reporting an increase in employment and none of the six major industries reporting an increase. According to the report, companies taking part in the survey continue to pare payrolls through layoffs, attrition and hiring freezes.

The pace of increased input costs rose, with the latest reading coming in at 52.5, up from 50.3 in November. This measure has been volatile during the past several months. As such, it is too early to tell if the acceleration of input prices is the beginning of a trend.

Consumer confidence dips: The Conference Board’s Consumer Confidence Index released late last month came in at 104.7 for December, down 8.1 points from November’s final reading. Both views of current economic conditions and expectations for the future fell for the month. Consumers’ assessments of their present situation declined 1.2 points to 140.2. Notably, their expectations for the future dropped 12.6 points to 81.1. Much of the decline was driven by concerns about the impact of recessions, with 46 percent of respondents expecting tariffs to raise prices and just 21 percent thinking they will lead to more jobs in the U.S.

While overall confidence retreated, views of the labor market improved. The labor differential, which measures the gap between those who find it hard or easy to get a job, rose to 22.2 from November’s reading of 18.4 percent. Still, the level is well below the record high of 47.1 recorded in March 2022. For further context, this has been an uptrend since hitting a recent bottom of 12.7 in September 2024. While respondents are feeling better about the job market, they aren’t necessarily convinced it will last. More respondents expect the number of available jobs to decrease in the next six months and fewer expect their income to rise.

Mixed economic picture: While we typically discuss national economic data, regular readers know we also find value in indicators at the state level to assess whether trends in the national data are being distorted by a few outliers or represent a broad trend. One such report is the State Coincident Index produced by the Federal Reserve Bank of Philadelphia. The index looks at four state-level variables to calculate a diffusion index tied to each state’s economic growth. The latest reading based on November state data shows that the index increased in 31 states, decreased in 15 states and was stable in four, for a one-month diffusion index of 32, down from 36 the previous month (the lower the index reading, the weaker the employment picture and economy). The latest reading is at a level that has historically corresponded with broader economic weakness. However, during the current economic cycle, this indicator has often hit concerning levels, but overall economic growth has still been relatively strong. This likely is because of differences in the way higher interest rates are playing out in the economy. For example, some states are more influenced by interest rate-sensitive manufacturing, while others are tied to services that have remained strong. This indicator highlights the uneven nature of current economic growth and the risks/opportunities that exist moving into 2025.

The week ahead

Tuesday: The ISM will release its latest Purchasing Managers Services Index mid-morning. Given that the services side of the economy has driven much of the economy’s growth over the past two years, we will be looking for signs of any changes in underlying strength in this report.

The BLS will release its Job Openings and Labor Turnover Survey report for November. We’ll watch for whether the gap between job openings and job seekers has narrowed further, which could point to further easing of the employment picture. We’ll also keep an eye on the so-called quits rate to see if workers are feeling confident in their ability to find different or better jobs.

Wednesday: The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on the employment picture and wages as well as discussions about pockets of sticky inflation.

Thursday: Challenger, Gray and Christmas Outplacement Services will release its report on announced job cuts and hires. This report showed weak demand for workers for much of last year, and we will be watching to see if the trend continued.

Friday: Employment will be in the spotlight as the BLS releases the December jobs report. We’ll be monitoring the difference between the Nonfarm jobs numbers and the Houshold report. These two measures have shown significant discrepancies over the past several months, and we will be looking to see if the gap has narrowed.

The University of Michigan will release its preliminary report on January consumer sentiment and inflation expectations. We will be watching to see whether the rise in sentiment captured in the December report has staying power.

Follow Brent Schutte on X and LinkedIn.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.