The Importance of a Return to Balance for the Economy and Markets

Soft landing—investors have been fixated on those two words for the past 12-plus months. We think the words serve as good context as we look back at the economy and markets in 2024 and where we stand as the calendar rolls into the middle of the decade. 

To achieve the much-sought soft landing, the Federal Reserve needed to thread the needle by reducing interest rates fast enough to maintain economic growth but not so fast as to undo its hard-fought progress in bringing inflation down from its highest levels since the period of 1966–82. Putting this in the Fed’s terminology, could the Federal Open Markets Committee (FOMC) avoid cutting rates too early and risk reigniting inflationary pressures while not cutting too late and risking a deterioration of the labor market (which has historically been synonymous with economic contractions)?  

Although a rise in inflationary pressures in early 2024 delayed the arrival of Fed rates cuts until September, overall there appears to be good news. Inflation pressures cooled in late spring and throughout the summer, while overall economic growth continued. Most importantly, the labor market has wobbled but not by enough to harm overall economic growth. That’s despite the fact that the unemployment rate rose to 4.3 percent this summer, which tripped the much-discussed Sahm rule. Throw in the fact that we are now past the uncertainty of a highly emotional election season, and most would conclude the soft landing appears to be on target. Put bluntly, our base case outlook of a mild recession in 2024 did not come to pass.  

However, despite progress toward a soft landing, risks remain on the horizon. Most notably, despite the overall success of 2024, we believe the economy and markets are highly bifurcated beneath the surface. We don’t believe the economy or the markets have fully regained balance. The path forward is still uncertain.  

Beneath the surface  

There’s been good news on both the inflation front and the overall economic situation, which has more people seeing the economy’s wheels gently touching down on the runway. But when you look a little more closely, you can see risks that still remain as we head into 2025. 

Consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates are thriving, while those who are feeling the pinch of elevated rates are lagging.

First, while overall inflation has eased, it is not yet at a sustainable 2 percent level. Indeed, the Fed’s preferred measure, Core Personal Consumption Expenditures (PCE), which exclude volatile food and energy prices, remains at 2.8 percent on a year-over-year basis. Notably, this is just modestly below the 3 percent year-over-year level at the beginning of 2024. And while a restart of progress on the disinflationary front was heralded as good news during the summer, recent trends have raised questions about the future direction of inflation as captured by both PCE and the Consumer Price Index (CPI). Additionally, disinflationary trends vary widely, with most of the easing price pressures in goods, while the services ex-shelter readings are still sticky.  

Second, overall economic growth has remained strong, but it has been heavily bifurcated: Consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates are thriving, while those who are feeling the pinch of elevated rates are lagging. For example, consider higher-income consumers. Generally, they have: 

• fixed-rate mortgages on houses that have appreciated in value even as rates have increased.  

• savings that have benefited from increased rates.  

• investments that have likely grown as equity markets have also pushed to all-time highs.  

Contrast that against lower-income consumers. They’re more likely to have: 

• credit card debt that now carries an interest rate in excess of 20 percent. 

• faced increased rent and unaffordable home prices. 

• little to no investments.  

• dwindling savings.  

Indeed, we have seen this segment continue to struggle and, in many cases, become increasingly delinquent on auto and credit card debt. Student loan delinquencies will begin being reported in Q4 2024 and are likely to show higher delinquency rates.  

The upshot is that while overall economic growth appears strong, the aggregate view is masking the reality that the economy is not operating on all growth cylinders, which we logically believe increases economic risks.

A similar dynamic is playing out with businesses. Companies that are more cyclical or small businesses that have bank loans with rising interest rates are struggling compared to companies that had previously termed out their corporate debt at lower rates. Taking it a step further, consider manufacturing versus services. The manufacturing side of the economy, which is typically more interest rate sensitive, has been in a slump for much of the past couple years. Meanwhile, businesses that are tied to services or tied to the secular theme of artificial intelligence have excelled.  

The upshot is that while overall economic growth appears strong, the aggregate view is masking the reality that the economy is not operating on all growth cylinders, which we logically believe increases economic risks. Investors have been willing to look past this risk on the expectation that the Federal Reserve will continue cutting rates, which should alleviate pressure on the interest rate-sensitive areas of the economy. However, as the past few months have shown, the Fed controls only shorter-term rates, while market participants and banks determine rates on longer-term bonds. Indeed, since September the Fed has cut rates by a total of 75 basis points. Yet much of the Treasury rate curve is higher by about 60 basis points. To pull this impact back into economic “dis-equilibrium” terms, according to Bankrate.com, the 30-year fixed national average mortgage rate has moved from 6.58 percent on the day of the first rate cut in September to 7.12 percent as of the end of November. The Fed has cut rates, yet mortgage rates have moved higher, which continues to put pressure on the housing market and has led to existing homes sales hitting a 14-year low at the end of the third quarter.  

While there have been plenty of twists and turns throughout 2024, we believe that the biggest question in 2025 remains the same as it was this year. Will the direction of inflation allow the Fed to continue cutting rates, which would likely lead to a broadening of economic growth? Or will inflation remain stubborn? If inflation persists, this may force the Fed to leave rates higher, which would keep pressure on the interest rate-sensitive parts of the economy and raise the risk of the impact of higher rates seeping deeper into other segments of the economy as debt and debt-dependent assets like commercial real estate are repriced.  

The labor market 

Despite the overall strong 2024 narrative, economic scares have flared throughout the year. The labor market offers a prime example. Absent an unexpected shock such as we saw during COVID, economic weakness typically gains momentum gradually. A slowdown leads to further erosion of demand and weakness in the labor market. Eventually, layoffs reach a critical mass, and economic growth unravels into an economic contraction. We believe this is why the unemployment rate is a trending indicator. 

As the Fed continuously notes, there is a point at which gradual labor market weakness becomes non-linear, meaning the pace of job losses accelerates. The job market is typically the last thing to go, and once it reaches a certain point its decline, at least historically, the unemployment rate rises rapidly. 

We believe this is why the Fed not only cut rates in September after expressing doubt about rate cuts throughout the summer but did so by a surprising 50 basis points. We believe this was in direct response to the rise in the unemployment rate to 4.3 percent, up from 3.7 percent to begin the year and 3.4 percent in January and April of 2023. This push higher caused a breach of the Sahm Rule, created by former Fed economist Claudia Sahm to quantify where the risk of movement from gradual to trending had historically begun.  

While the past few months have seen the unemployment rate move down from 4.3 percent to 4.2 percent, the fact remains that the labor market has trended lower. While much has been made about the increase in the size of the labor market (the denominator) driving that increase, we note that total employment as measured by the Bureau of Labor Statistics’ Household employment data (the numerator) is nearly flat since June 2023 and down by 725,000 on a year-over-year basis.  We also note that the number of those unemployed for greater than 27 weeks has risen sharply since April, rising from 1.25 million to November’s 1.66 million. Historically speaking, these two realities have been warning signs of additional future labor market weakness.  

Many investors still point to the other measure of total employment (the Nonfarm payrolls figure as measured by the establishment survey) and note its relative strength over the same time period. We note that trends here are also slowing. The impacts of two major hurricanes that made landfall in late September and early October are evident in recent employment reports, but in June through August the Nonfarm payroll reports all showed monthly private payroll growth below 100,000, with August checking in at mere 37,000 added to private payrolls.  We note that the three- and six-month pace of private-sector job growth has slowed to 138,000 and 108,000, respectively. The reality is that despite the current optimism about a soft landing, a review of the labor market shows that risks remain.  

A brief word on politics  

While much has been made about the so-called “Trump trade” and the prospects for a more business-friendly economic backdrop, we believe that the impact of the entirety of the new administration’s policies remain uncertain. Investors appear to be currently focused on the pro-growth potential stemming from an expected business-friendly regulatory environment. While existing tax rates that were approved as part of the Tax Cut and Jobs Act are most likely to be maintained for the most part, given the current budget situation, additional tax cuts are unlikely. The impact of the other policy promises is highly uncertain. Most notable is how tariffs would affect economic growth and inflation. Lastly, immigration and its impact on the labor market remain uncertain.  

Additionally, as our research shows, the country’s position in an economic cycle when a president takes office is key to how the economy behaves during the administration’s tenure. The economic cycle is always ticking in the background, and that helps shape the impact of administrations. Once again, we point to the current economy, which appears to be late in a growth cycle, when inflationary pressures are elevated and interest rates have risen. 

Notably, the cost of servicing the deficit is expanding, with the federal government’s net interest outlays exceeding annual defense spending.

Most importantly, the U.S. fiscal situation may shape future policies. Currently, the U.S. is running a historically large budget deficit equal to 6.9 percent of economic output. In the past, similar levels have been reserved for economic contractions, not expansions. Notably, the cost of servicing the deficit is expanding, with the federal government’s net interest outlays exceeding annual defense spending. The average interest rate on current nominal Treasury debt is 3.36 percent. We note that the entirety of the Treasury yield curve is above this rate, which means that as debt matures and Washington adds more, the interest outlays will rise.  

Since the election, the markets have focused on the potentially positive impacts of the new administration’s expected market-friendly policies. While we aren’t making a judgment on whether this focus is right or wrong, given the economic realities that are ticking in the background, we think it’s prudent to take a wait-and-see approach. We also note that President-elect Trump embraces uncertainty and uses it as a negotiating tool, which in his prior term often caused market volatility. Policy is important, and we pay heed to it, but it is only one factor among many that we use to inform our decisions about asset weighting in our portfolios.  

Closing words on the economy 

The reality remains: The U.S. economy appears to be later in the business cycle with a large divergence between areas that are growing and those that are struggling. Later in the business cycle inflation often remains an issue. Any increase in demand must be met with the ability to create new supply. Despite recent increases, unemployment remains low at a time when new workers are hard to find. Historically, this can cause wages to rise to levels that are inconsistent with sustainable 2 percent inflation. Indeed, the Fed has previously noted that wage growth needs to be in the 3.0 to 3.5 percent range to keep inflation from exceeding 2 percent.  

The good news is that worker productivity has increased—likely thanks to artificial intelligence (AI)—and has muted the impact of wages on inflation. However, the question remains: What ultimately is the payback for companies currently rushing to get AI implemented? We are optimistic about AI and believe that, much like the internet in the late 1990s, the benefits will eventually shift from those that enable the technology to broader companies and society, which will reap the productivity benefits.  

Allow us to return to our earlier comments about the progression toward an economic contraction and tie it into our views on AI. Over the past few years, the Fed rate hikes seeped through the economy in a normal manner, starting with manufacturing and other interest rate-sensitive segments of the economy. However, this progression hit a brick wall likely tied to some combination of the following factors:  

• excess corporate and consumer savings that in many cases are tied to the government debt that has financed it  

• the reality that many consumers and corporations are interest rate-insensitive because they locked in longer-term fixed rate debt  

• corporate spending tied to AI implementation  

• a potential wealth effect driven by higher home and equity market prices  

Certainly, the current economic cycle could continue. Indeed, while we have been concerned about the potential for this cycle to end, we’ve also noted that it could go into overtime, much as it did in the late 1990s. However, we believe that a narrower economy increases risks and that those risks could persist absent a broadening of growth and a return to a better balance among industries, companies and consumers. But the question remains: How long can the cycle continue in its current unbalanced state?  

While the current environment seems calm, there are many questions yet to be answered, and we believe that at a minimum volatility is likely to tick higher in the coming year.

Unfortunately, there are always relative winners and losers, but the divergence appears to be growing. The housing market is unaffordable and undersupplied. Prices have fallen but remain elevated, which is pinching the budgets of many and pushing individuals into delinquency. Government debt has exploded, and the country is running large deficits that have likely helped fuel the growth of the recent past.  

The hope is that rates move lower, and the economy is able to broaden out. While the strong parts of the economy were resilient in 2024 and supported overall economic growth, how will the dynamic play out in 2025? While the current environment seems calm, there are many questions yet to be answered, and we believe that at a minimum volatility is likely to tick higher in the coming year. We believe that any outlook for continued economic growth in 2025 must include a broadening of its components.   

Stock markets are bifurcated  

Financial markets and the economy rhyme. Much as the U.S. economy has experienced extreme bifurcation in 2024, so too have the U.S. equity markets. For evidence, you need look no further than the second quarter of 2024, when markets were driven higher by an extremely narrow group of companies tied to the secular theme of AI while others faltered. We believe the prime reason investors focused on this small sliver of companies was that the economy and the corporate earnings outlook were narrowing, and investors were concerned that stubborn inflation would force the Fed to hold rates higher for longer, which would lead to further economic weakness and toppling. Just as we believe the economy needs to broaden for it to continue to expand, we believe that markets need to broaden for them to continue to move higher.  

Given this backdrop, we’ve maintained our focus on sectors and segments of the market, which should benefit as market strength broadens. These companies have generally felt the strain of higher rates and are priced accordingly. We believe that if there is a continuation of the current soft-landing optimism, it will be because the Fed has cut rates. However, if there is a recession, it will force the Fed to cut rates. 

We remain overweight fixed income with an underweight to commodities and a slight underweight to equity. Real estate equities account for the entirety of our underweight in stocks. Within traditional equities, we retain our overweight to the interest rate-sensitive and cheaper segments of equity markets, namely Small and Mid-Cap stocks. We are slightly underweight U.S. Large Cap stocks. In April, we repositioned some of our exposure from the market cap-weighted S&P 500 to an equal-weight version to not only reflect our belief in a broadening market but also address concentration risk. Overall, we are underweight international stocks with a preference toward international developed markets over emerging markets.  

While our base-case forecast of a mild recession did not play out as the Fed cut rates, we note that the optionality of this positioning has begun to prove its worth, as rate cuts have increased the odds of a soft landing. Since July 10, which was the day the market began repricing the timing of Fed rate cuts in the aftermath of weak inflation and jobs data, our positioning has gained traction as hopes of a soft landing have grown. From July 10 through the end of November the cap-weighted S&P 500 has returned 7.6 percent, while the equal-weighted S&P 500 has returned 14.1 percent. 

During the same span, the S&P Mid-Cap 400 Index rose 15.8 percent, and the U.S. S&P Small Cap 600 jumped 19 percent. While this is a short-term horizon, we believe it highlights the upside to our tactical positioning. What hasn’t worked is our overweight to fixed income, but we remain comfortable given our current concerns about the economy.  

Lastly, while the above comments about fixed income are more tactical with a focus on the direction of interest rates, we believe longer-term measures align with our current positioning. Consider once again this passage from our last asset allocation focus, and allow us to update the current valuation ratio to 38.6, which now places it above late 2021 and only bested by 1999.  

Contrary to the current narrative in the market, we believe valuation does matter, especially over the long term. We note that the Shiller Cyclically Adjusted P/E (CAPE) ratio, which was created to allow apple-to-apple comparisons of valuations across a typical economic cycle, is at historically high levels. The measure was created by Yale professor and economist Robert Shiller and divides the price of the market by the average of the prior 10 years’ earnings adjusted for inflation. The current CAPE ratio of the market is 35. In data going back to 1888 there have been only two occasions when the market has had a higher ratio—one in late 2021 and in 2000. In 1929, the ratio was just under the current level. Historically, this measure has provided a good guide for future returns and, at current levels, suggests subpar returns in the coming years.   

Similarly, the earnings yield for U.S Large Caps is now below that of the yield on the 10-year U.S. Treasury. Typically, comparing these two yields gives investors an idea of how much the market is compensating them for taking on the added risk inherent in owning stocks, which is not found in Treasurys. When the S&P 500 yield is lower than that of the 10-year Treasury, it means that investors are essentially “paying” for taking on the additional risk as opposed to being compensated for it. While this condition did exist from 1980–2002 and was not an issue for U.S. equities as they rose, we note that is because the yield on the 10-year Treasury pushed much lower—from nearly 14 percent in 1982 to just above 3.5 percent in 2002. The decline in yields boosted equities. Think about this reality in terms of our overweight to fixed income versus the S&P 500.  

The good news is that there are cheaper parts of the market, even within the S&P 500, which explains our move to the equal-weighted S&P position. Finally, U.S. Small and Mid-Cap stocks continue to trade at discounts relative to their Large Cap peers that haven’t been seen since 1999. Back then, the discount eventually ushered in a period of outperformance. We believe our positioning aligns with a return to equilibrium in equity markets that will be driven by a return of balance in the economy.  

U.S. Large Cap  

As we near the end of 2024 and the latest earnings season, it’s worthwhile to note the continued fundamental resiliency of U.S. Large Caps relative to the rest of the investable universe. Fundamentally, year-over-year revenue and earnings growth trends continue to show strength, clocking in at 5.4 percent and 8.4 percent respectively. These results comfortably surpass the fundamental trends of smaller U.S.-based companies as well as the international-based competition. This makes economic sense given the current macroeconomic environment. The goal of restrictive monetary policy is to create more challenging business conditions to slow inflationary pressures, and smaller companies are more sensitive to these challenges.  

We are positioned for a return to equilibrium, specifically where more sustainable fundamental participation is evident across business size and consumer income groups.

U.S. Large Cap companies are more often leaders in equity quality ranking and are more insulated from the ebbs and flows of the business cycle. The recent outperformance is likely attributed to that strong quality profile. Look no further for evidence of this dynamic than the interest expense trends for the largest companies in corporate America. Despite one of the fastest and steepest rate-hiking cycles in Federal Reserve history, the total net interest expense paid by U.S. Large Caps has barely risen, as large companies termed out their debt during the pandemic years at very low rates and many now earn healthy interest income on their sizable cash reserves. We see a similar dynamic with consumers, particularly the higher-income cohort that is earning strong interest income on excess savings and likely own their home outright or have it financed at attractive pandemic-era mortgage rates. We believe the combination of a K-shaped economic dynamic unfolding across businesses and consumers is creating a disequilibrium in the economy (that is, some parts of the economy thrive while others lag). We think this is unsustainable over the longer term.  

We are positioned for a return to equilibrium, specifically where more sustainable fundamental participation is evident across business size and consumer income groups. Additionally, valuations on Large Cap stocks that are insulated from a potential economic downturn are significantly elevated and, we believe, may slow intermediate- to long-term returns. Given this combination we continue to believe that more attractive intermediate-term investment opportunities remain outside of U.S. Large Caps. We remain modestly underweight. 

U.S. Mid Cap  

We continue to have a positive intermediate view on U.S. Mid-Caps given an attractive combination of relative valuation, a revived outlook for mergers and acquisitions, and a lowered bar of earnings expectations to clear. While the performance of Mid-Caps lagged that of U.S. Large Caps this year, they continue to perform well on an absolute basis, up more than 22 percent this year and with the second-best performance in our nine asset class portfolios. Looking out longer term, our long-standing overweight (since April 2020) to U.S. Mid-Caps has now delivered absolute performance well into triple-digit territory, which compares nicely to the blended benchmark performance of just more than 50 percent cumulatively over that same time horizon.  

Looking forward, we expect a more favorable macroeconomic environment specific to Mid-Cap companies to emerge. Couple this with historically favorable relative valuations, and we continue to favor an overweight to U.S. Mid-Cap equities. 

U.S. Small Cap  

Current labor market and inflation dynamics have led to an ebb and flow in investors’ expectations on the pace and size of future Fed rate cuts. The ever-changing rate expectations are likely, in our view, to translate to volatility in market leadership among equity styles. We expect the relative performance of U.S. Small Caps to be especially affected by these dynamics, as real interest rates are the most impactful to the relative performance of this asset class (as well as Real Estate). In the last quarter we wrote, “U.S. Small Caps are among the most sensitive to changes in real interest rates. As a result, some of the best performance historically on an absolute and relative basis for this asset class has come when the economy has been rising as real interest rates are drifting lower.” The likelihood of that specific economic environment continues to be the consensus opinion as we look to 2025. If that turns out to be correct, we expect the performance environment for the asset class will be strong on an absolute and relative basis as both earnings expectations and relative valuations would have material room to move higher. We remain overweight.  

International Developed Markets 

Economic growth in both the eurozone and Japan has been slow. While some sectors have been resilient, difficulties arising from weak global demand, geopolitical risks and disruptions to supply chains have kept overall economic performance subdued. 

In the eurozone, gross domestic product (GDP) growth remained modest. Third-quarter growth was 0.4 percent quarter over quarter and 0.9 percent year over year. The manufacturing sector has suffered due to weak global demand, especially in Germany and Italy, where supply chains for the automotive and machinery sectors are most disrupted. However, the services industry, driven by tourism and information technology, has been more resilient. In October, the unemployment rate in the eurozone was 6.3 percent, which is the lowest reading in the history of the eurozone. However, unemployment rates continue to vary significantly across the region. 

Inflation in the eurozone has fallen since its peak in 2022, and the annual inflation rate declined to 2.3 percent in November with core inflation at 2.7 percent. In response, the European Central Bank cut rates in October and is expected to cut by 25 basis points in December and an additional 125 basis points by October 2025.  

Japan’s economy has grown at a very slow clip—GDP grew by just 0.2 percent quarter over quarter in the third quarter. Like the eurozone, Japan’s manufacturing sector has suffered from weak global demand, especially from China. But its services sector, including tourism, has fared better. The unemployment rate was 2.4 percent in September, indicating a tight labor market. Inflation in Japan accelerated to 2.6 percent in October, above the target of the Bank of Japan (BOJ). The uptick stemmed from services prices rising as companies continue to pass along costs from higher wages and a weak yen. Against this backdrop, the Bank of Japan has kept interest rates negative and maintained asset purchase programs in support of growth due to its desire to end years-long deflationary pressures. Recent developments on the inflation front likely strengthen the central bank’s conviction that its 2 percent target is in sight. Markets remained unconvinced that the BOJ will raise rates at its December meeting but are fully pricing in a rate hike by March 2025.  

We remain cautious in our outlook for both regions amid inflation pressures and global uncertainties weighing on growth. Central banks in both regions will continue to navigate a tight balance between inflation and economic recovery. Despite the current caution, we believe these markets have attractive relative valuations that are reflective of the current economic conditions, and as such, we retain our neutral outlook relative to our benchmark given our overall lower equity allocation. 

Emerging Markets 

As noted in the last Asset Allocation Focus, the Chinese government instituted measures to boost the economy and property markets and support equity markets. This led to Chinese markets moving higher and touching two-year highs in late September. Since then, Chinese equity markets have declined as questions around the potential for substantial future stimulus measures grow. It is unlikely China will meet its 5 percent growth target this year, and growth is expected to slow in the low to mid-4 percent range in 2025. Slowing consumer and business spending and a struggling property market has rattled equity markets. Additionally, geopolitical risks between the U.S. and China, increasing debt and poor demographics all remain as short- and longer-term challenges for the Chinese economy. The election of Donald Trump in the U.S. and his proposal for across-the-board tariffs on Chinese goods has the potential to be a drag on Chinese economic growth. We caution that the magnitude of tariffs on China and the possible policy reaction from China is still uncertain. This uncertainty will likely lead to volatility in markets into 2025.  

The prospect of more protectionist policies in the U.S. coupled with expansionary fiscal policy has ramifications for U.S. interest rates. While the Federal Reserve has cut rates in recent months, bond yields have risen in the intermediate to long part of the yield curve. Higher interest rates have recently led to dollar strength, which makes it more expensive for emerging-market countries to service dollar-denominated debt. Emerging-market currencies have weakened as a result, which clouds the near-term outlook for emerging-market economies. Regardless of the strength or weakness of currencies, the currency impact on returns and portfolio diversification in general is something that we feel is underappreciated as dollar strength has persisted. This may not always be the case, and we believe it is a reason to have exposure to international developed and emerging-market asset classes. 

Lastly, the diverse nature of the Emerging Markets asset class is important to note, and as a group, these countries are different than those of 20 years ago, with technology and financials the two largest sectors. GDP growth is expected to be higher, and relative valuations versus the developed world continue to sit at historically cheap levels. Demographics in some developing economies (e.g., India) are very favorable as well. Given this, we believe it is important to have long-term exposure to Emerging Markets in a well-diversified portfolio. However, given our lingering concerns of currency stability, economic risk, tariffs and geopolitical risk tied to China, we continue to modestly underweight the asset class. 

Interest rates have been volatile in 2024 as investors’ opinions about the timing and size of potential Fed rate-cut actions have swung from one direction to the other. Not surprisingly, hopes of a soft landing have followed the trajectory of expectations surrounding rate cuts. These gyrations were captured in our last two Asset Allocation Focus reports.  

From the July Asset Allocation Focus:  

The lackluster returns compared to equity markets that have recently moved higher, coupled with increased volatility, have led to many investors becoming pessimistic and concerned about fixed income. While inflation risks remain, and we continue to express our concerns about the ever-expanding deficit and rising interest costs, we believe that bonds continue to play an incredibly important role in portfolio construction, especially given our recessionary outlook. While we may not know for a few years what is considered the new normal for interest rates, we believe investment-grade fixed income at current levels largely reflects existing risks and provides real opportunity for investors in the coming quarters.   

In the September Asset Allocation, we said:  

In the immediate aftermath of our move extending the quality and duration of our overall bond portfolio through the addition of long-duration U.S. Treasurys, the investment-grade bond market has outperformed U.S. Large Cap stocks. Importantly, despite the inverted yield curve at the time, lower starting yield longer-maturity bonds have outperformed those of higher-yielding shorter-term bonds. This included a sharp rally during the carry-trade unwind and a quick spike in recession fears following the July jobs report that led to volatility and equity declines.    

We believe the one consistent theme here is the direction of equity markets coupled with recession fear decreasing or expanding. Put simply, bonds have normalized after their 2022 decline and once again appear to have returned to a hedge against economic and equity market downside. We remain worried about longer-term inflation trends and the ever-expanding size and cost of the U.S. debt that politicians on both sides of the aisle are seemingly unwilling to address. Yet we continue to believe that bonds offer attractive yields in the current environment. 

We continue to overweight fixed income in our portfolios with a focus on quality and a modest overweight duration compared to the Bloomberg Aggregate Index. While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that fixed income has once again returned to its old roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices.  

Duration 

Coming into the year, the market was expecting up to 175 basis points of cumulative Fed Rate cuts throughout 2024. Not only did it take longer for those cuts to begin (September), but as of this writing we have seen only 75 basis points of rate cuts with a likely 50/50 chance of an additional 25-basis-point cut in December. We bring this up to highlight that expectations don’t often equate to reality and to remind investors that this is a data-dependent and reactive Fed. More importantly, we echo the sentiments expressed earlier in this document highlighting the fact that the Fed doesn’t control the entire yield curve. Since the Fed began cutting rates in September, all interest rates along the Treasury curve beyond one year are higher. This bodes well for rates staying higher than we have seen over the last 16 years. While this may sound counter-intuitive, we believe investors should capitalize on the benefit of time by adding modest duration to their portfolio and compound higher yields.  

Government Securities/TIPS 

Given remaining economic risks coupled with compressed credit spreads, we continue to favor higher-quality bonds, which include Treasurys and other government-sponsored debt. Implied volatility has, on average, slightly increased throughout the year. While parts of the curve remain inverted, many are more normal with a modestly positive slope, which could serve to reduce implied volatility and lead to more normal operations in the fixed income space than we've seen since the pandemic. We expect rates will hover in a range near current levels in the foreseeable future. This would mark an improvement over the past in both nominal and real terms. 

Break-even inflation rates fell dramatically through the second and third quarters; however, recently break-evens have risen with the one-year (the most volatile of breakeven rates) back above 2.50 percent from a low of almost 0.37 percent in the third quarter of 2024. This helps paint a picture of why we believe rates are likely stuck here for some time. We continue to believe current levels bode well for the coupon-clipping ability of nominal coupon-yielding bonds. We continue to favor nominal coupon-yielding bonds over their inflation-protection counterparts. But the potential for a future reignition in inflation keeps us actively monitoring the level of break-evens for any potential future investments. 

Credit 

Credit spreads are, by some measures, as tight as they ever have been. This is clearly a sign that investors expect the economy to keep chugging along. While there was a very modest rise in credit spreads through the middle part of 2024 as labor markets showed weakness and recession fears grew, spreads have recently compressed and are near record low levels. At current levels we don’t believe that investors are being adequately compensated for increased risk. We also remind that any such refinancing of debt will likely occur at higher levels, which could impact corporate fundamentals. Stay high quality to very high quality and have your excess duration in Treasurys or Treasury-like securities.  

Municipal Bonds 

Consistent with previous rate cycles, appetite for municipal bonds evaporated when yields were low and munis were cheapest relative to their taxable counterparts, which led to an 8 to 10 percent outperformance. Demand has spiked recently as rates have climbed, and munis are now actually expensive relative to their taxable counterparts. This likely occurs due to the reality that 70 percent of municipal bonds are owned by individual investors, who are often prone to overreact to interest rate movements.  

The muni curve has been inverted for the longest period in its history, but that is slowly working itself out as the Treasury curve is losing some inversion as well (steepening). One thing to always watch during times of political change is potential tax reform of any kind that may make the tax exemption in munis more or less attractive on a relative value basis. We continue to like municipals for investors in higher tax brackets.  

Real assets are an integral part of diversified portfolios due to their low correlation to traditional equities and fixed income. Additionally, real assets can provide valuable hedges against unexpected inflation and a strong sensitivity to real interest rates. We believe these are important considerations in constructing resilient portfolios over an intermediate- to long-term period. 

The standout performance of commodities in response to rising inflationary pressures and the Russian invasion of Ukraine in 2021–22 serves as a recent reminder of the value of diversification. The sharp decline in real interest rates from 2010–12 and eye-popping performance of real estate are another example of the value of this philosophy. Put simply, sharp changes on the inflation and real interest rate front are very difficult to time, which underlines the rationale for a structural allocation to real assets.  

We have consistently noted our concern for global growth in 2024, and despite our belief that inflation will likely be an intermediate-term issue, we forecast that a weakening global economic environment would likely put downward pressure on commodity prices. As a result, we have maintained an underweight position in commodities to fund an overweight position in fixed income. 

As noted earlier, real assets can be very sensitive to changes in inflation-adjusted interest rates, with real estate being the clearest example. While REITs experienced outsized impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates during the past two years. Further pressuring fundamentals is that banks are less willing to lend to the sector given rising vacancies and moderating rents across the asset class.  

Interestingly, during the third quarter REITS were the best-performing asset class as real interest rates moved lower. Conversely, during the fourth quarter REITS once again shifted to the bottom of the heap in our nine asset class models as real rates moved higher. This is likely because changes in real rates impact real estate more than any asset class in our portfolios, especially when overall REIT fundamentals remain weak. Given our desire to take slightly less overall equity market-like risks coupled with the group’s weak fundamentals, we continue to underweight REITs.  

Real Estate 

We've maintained a tactical underweight positioning in REITs for an extended period based on our analysis of not only the fundamentals of the asset class but the likely movements in interest rates and inflation. Real estate prices are influenced by several factors, not the least of which hinges on the anticipated trajectory of real long-term interest rates. As we know, real estate prices have a direct inverse relationship with the financing costs tied to buying an existing property or beginning a new project. Consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs. This is in stark contrast with the relatively favorable period for real estate prices during the ultra-low interest rate environment seen shortly after the onset of the COVID pandemic. 

In an attempt to curb inflation, the Federal Reserve undertook a record-setting rate hike cycle accompanied by quantitative tightening. These actions hurt the real estate market as mortgage and other financing rates surged to levels not seen in years. The elevated costs have led to reduced demand for new projects and sent affordability ratios for existing ones to levels rarely seen in decades. Lending standards have simultaneously tightened across banks and financial institutions, albeit with some recent easing. The tight conditions in the real estate market are likely to influence supply, demand and pricing dynamics for several more quarters. 

However, the REITs asset class is broad, and we note the considerable disparity in performance across various sectors within the marketplace. While single-family home prices have held up despite rising interest rates, segments like commercial office space have experienced significant pressure, with distressed sale prices highlighting the ongoing struggle to stabilize supply and demand. These troubled sectors have posed challenges for certain financial institutions, causing investors to consider whether the issues are isolated or indicative of systemic risk. Although we believe the chance of a systemic crisis in real estate to be low, the persistent volatility and stress within certain real estate lending and servicing institutions have made us cautious in our evaluation of this market. 

We are closely monitoring valuation differentials between the earnings multiples of U.S. equities and U.S. REITs to identify potential buying opportunities should REITs become attractively priced, and we are encouraged by recent trends that we are seeing. These trends, however, remain nascent, and we have not been prompted to act yet. We will continue to watch for developments that would prompt a shift in our position of a slight underweight to REITs. 

Commodities  

Commodity prices have generated modest gains this year, having bounced back into positive territory from their September lows. We believe that commodities are affected by three primary drivers: global growth, inflation expectations and the strength of the U.S. dollar. All three factors continue to be headwinds that support our decision to be meaningfully underweight the asset class. 

Energy commodities (such as crude oil) are down modestly over the last six months due to slowing demand and a scaling back of OPEC+ production cuts. Sizable U.S. production also puts pressure on prices. Natural gas prices have fallen sharply since the summer thanks to an elevated inventory buildup and projections for a warm winter. Industrial metals such as copper, nickel and aluminum have posted positive gains but have been volatile. Expectations of an aggressive stimulus package in China have been beneficial. Prices for agricultural commodities, such as wheat, corn, soybeans and cotton, have been weak due to the expectation of bumper crops this year. On the other hand, prices for livestock (such as cattle and hogs) have risen substantially. The Federal Reserve’s decision to cut interest rates was a boost for precious metals. Gold continues to trade near all-time highs as investors seek an inflation hedge.  

The outlook for commodities is still mixed. Market expectations for inflation have fallen significantly since its peak but are somewhat elevated and remain above the Federal Reserve’s target. Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, a return of higher inflation expectations and a weakening U.S. dollar. In the energy sector, persistent underinvestment, additional OPEC+ production cuts, potential disruptions related to the Russia/Ukraine conflict and the events impacting shipping in the Middle East could add additional pressure in the oil and grain markets.  

We remain meaningfully underweight the Commodities asset class, preferring fixed income and economically sensitive asset classes like Small and Mid-Cap U.S. stocks. For some time, we have expressed our view that global growth (excluding the U.S.) would remain sluggish and that inflation would moderate. We believe that recent Commodities asset class performance reflects these concerns. When economic growth and inflation soared in 2021, commodities gained 27 percent. Then, when stocks and bonds both fell in 2022, commodities pushed higher by 16 percent. With lower inflation and slowing global growth, commodities fell 8 percent in 2023 but have risen 4.3 percent year to date through November. Overall, we continue to believe the Commodities asset class retains positive return expectations and significant diversification benefits, especially if inflation rears its ugly head once again in the future. 

Every December, investment firms across the country pen their year-ahead outlook, with many even playing the unwinnable game of guessing where the market will finish by next December. The unfortunate reality is that an external event often arrives and creates a fork in the road, forcing them to rethink their forecast, often before the ink is even dry.  This is not to dismiss the importance of this exercise but rather to highlight the reality that it remains nearly impossible to model a complex and interconnected world over such a short period of time.  We would also note that most firms are currently unwilling to be different than the herd and point to the reality that nearly every S&P 500 target from major firms resides neatly in the 6500-6600 level for year-end 2025.   

Despite this seemingly near certainty that appears to exist in today’s market, we believe 2025 promises to be like every other year—filled with uncertainty and surprise. And while we always love to joke that we have never met a certain time, 2025 inherits lots of unanswered questions, many of which we have raised in this document. Put differently, there is a lot of contradictory economic and market data with a high degree of bifurcation.  

• Is the U.S. economy truly in a late cycle?  

• Does the business cycle still exist? 

• Does AI begin to pay its adopters back? 

• What happens to inflation and interest rates? 

• Do equity valuations no longer matter? 

• What happens to cryptocurrency? 

• Do tariffs materialize, and what impact do they have on all economies around the globe? 

• What happens to the Chinese economy? 

• Do U.S. rising debt and deficit levels begin to matter? 

These are just a few uncertain areas. While many of these questions have been out there for some time, many of them appear to be ready to come to a head.   

What does all of this mean?  First and foremost, you need to have a plan for how you are going to navigate these uncertainties. At risk of upsetting Mike Tyson, allow us to tweak his “Everyone has a plan until they get hit” to “Everyone needs a plan that readies them for getting hit.” At Northwestern Mutual that comes back to a financial plan and an asset allocation that has been designed with the benefit of an intermediate- to long-term time horizon that is grounded in principles that have worked over many decades.  This is not to say that you can’t or shouldn’t invest in newer things that are often shinier. The world is always moving forward, and every assumption of the past needs to be stress tested.   

However, we would note that in our collective experience on Wall Street, despite many innovations, productivity enhancements and even wrappers/delivery mechanisms, the investment world at its core looks a lot like it did in the past 30 years. How many times have we debated whether a 60/40 portfolio was dead? Think about the commentary as recently as 2019 that inflation was dead. How many times have people declared asset classes dead only to realize later on that asset classes don’t die (but can go to sleep for a while)?   

The bottom line is that the world is an uncertain place. To combat uncertainty, one needs a plan that they follow in both good and bad times. This is not set in stone but rather a living document that should be updated when your financial and personal situation evolves and/or when your risk tolerance or goals and objectives change. This doesn’t mean you can’t make tweaks to that allocation along the way; indeed, this document hashes out the tweaks that we believe—over a reasonable time period—will help you get to your goals and objectives a bit more comfortably and (hopefully) more quickly. And most importantly, be humble and acknowledge uncertainty. While it can be tempting to concentrate in certain companies or a sector or market, doing so suggests that you’re certain of their future performance. It’s easy to focus on the potential riches that can come from this. It’s also easy to forget the times this strategy didn’t work out. Do you want to take that risk with your financial future? The way we deal with uncertainty is not through concentration but rather through diversification. It’s important to remember that something not working in your portfolio is a feature—not a flaw—of diversification. You don’t want all your oars on the same side of the boat when, inevitably, the wave hits.  

We thank you for the trust that you place in us. We don’t take that lightly. Here’s to a happy, healthy and prosperous 2025. 

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.  

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services. 

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.  

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.  

With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk. 

Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. 

Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.  

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards. 

Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts. 

Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation. 

The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.  

The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.  

The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.  

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.  

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.  

The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.  

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements. 

The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.