Portfolio Insights & Outlook Q1 2025

The stock market’s rally since recovering from a bear market (a decline of more than 20%) in October 2022 has been nothing short of remarkable, gaining more than 70% through the end of 2024. Most notable was the lack of volatility, as there was only one correction (a decline of more than 10%) during the time period. Most interestingly, this rally coincided with tighter monetary policy (higher interest rates) and initially, limited support from corporate earnings growth. In 2023, corporate earnings growth in the S&P 500 index (large-cap stocks) only totaled 0.5%. Investors were willing to overlook the modest growth rate, instead focusing on an outlook that appeared to be improving. That came to fruition in 2024, as earnings growth accelerated to 10% and the stock market advanced by 25%. Looking forward, the earnings outlook remains positive. The real growth rate of the U.S. economy is expected to be more than 2% for the next two years, which is consistent with a low double-digit earnings growth rate. While earnings growth doesn’t necessarily guarantee positive stock market returns, as we saw in 2022, earnings growth is an essential prerequisite to sustained market rallies. There are three reasons we remain cautiously optimistic on risk assets: the Federal Reserve’s (Fed) focus is on jobs, the consumption backdrop is positive, and earnings growth in U.S. stock markets is broadening.

Annual S&P 500 Earnings: Consensus expects earnings to rise low double-digits next two years

FEDERAL RESERVE & THE ECONOMY

Since inflation started rapidly rising from 2020 through 2022, the Fed’s sole focus was price control. However, late last year Fed Chair Jay Powell acknowledged a shift in focus to the labor market. To begin 2024, nonfarm payrolls were rising at an exponential pace, as the three-month moving average totaled 242,000 jobs added in January 2024, only to fall to a level of 113,000 in August 2024. The labor market’s moderation was accentuated by labor force growth brought on by immigration. As a result, the unemployment rate increased to a level of 4.2% after starting the year at 3.7%. Closing out the year, the decline in labor market growth stabilized.

Unemployment Rate and Year-Over-Year Wage Growth

At the same time, the Fed’s shift from price control to jobs might have been a bit premature. The consumer price index’s (CPI) yearly change in inflation bottomed at 2.4% in September, eventually rising to 2.7% in November, but still above the Federal Reserve’s preferred level of 2%. Remember, the CPI has yet to reach 2% in this cycle. While shelter costs are consistently falling, the reinvigoration of other CPI components has increased alongside a reacceleration in economic activity.

Contributors to Headline CPI Inflation

This pivot in both jobs and inflation late in the year sparked volatility in the Fed Funds Futures, which tries to estimate the path of the Fed’s target policy. In 2024, the Fed cut its target policy rate by 1%, but the path of possible interest rate cuts in 2025 turned volatile. At the end of September, the target policy rate was expected to fall about 1.75-2% in 2025. By the end of 2024, the projected target policy rate in 2025 was only expected to fall in a range of 0.25%-0.50%. Federal Reserve officials are attempting a balancing act of setting rates to keep inflation from reaccelerating further and to keep job growth from weakening.

Fed Funds Rate Expectation: Market & FOMC

BACKDROP FOR CONSUMPTION REMAINS STRONG

Last year, consumer spending was the catalyst for the U.S. economy (growing at a rate of 3.7%), and the expectation for 2025 is for a continuation of that trend. Real gross domestic product is expected to rise 2.1% in 2025, with consumer spending carrying growth at a 2.4% rate. An ascension of consumer activity is consistent with last year’s stabilization in the labor market. On top of the job additions, wage growth has provided ample spending power. The real disposable month-over-month income growth averaged 0.2% in 2024, equating roughly to 2.4% for the entire year. Put simply, consumers are finally seeing purchasing power as incomes are growing faster than prices.

Consumer surveys appear to also support this trend, as the University of Michigan Consumer Sentiment Index rose from a level of 66.4 in July to 74 in December. The survey’s components that make up the overall index express this change in direction. After some uncertainty in the lead up to the election, the survey’s current sentiment index accelerated on top of an already elevated expectations index. The positive catalysts of income growth, overall job gains, moderation of inflation, and lower interest rates should support a risk-on environment, particularly in the U.S. 

Consumer Sentiment Index

U.S. EQUITY MARKETS REMAIN EXCEPTIONAL

Warren Buffett once said, “the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” Right now, the U.S. has a considerable technology advantage. The S&P 500 index is expected to have an earnings growth of 12% in 2025, led by the Magnificent 7’s (a segment of technology companies) earnings growth of nearly 18%. Following Warren Buffett’s insight, U.S.’s competitive advantage is most evident when profit margins are considered. The U.S. stock market retains 10.5% of all revenue, while international stock markets only retain just under 9% of all revenue. The explanation for the difference in profit margins is a direct result of U.S.’s reliance on technology. Typically, cutting-edge innovations found in the technology space retain a competitive advantage initially, relative to more commoditized industries like energy that rely on the market pricing of oil, for instance. 

Global Profit Margins

Not only does the U.S. retain an advantage through its relatively larger technology market share, but the U.S. economy is flourishing, relative to global economies. Europe and China have accelerated stimulus for their respective economies, whereas the U.S. economy has been able to navigate higher interest rates with only a modest loosening of its target policy. As the U.S. economy continues to grow and mature, historical evidence supports a broadening of earnings contributors to the stock market. While the U.S. stock market’s success can be attributed to the highest growing technology stocks, prolonged bear markets don’t occur until the majority of companies with positive earnings growth hits a capacity. At the end of last year, only 42% of companies in the S&P 500 index have positive earnings growth. It isn’t until the percent of companies with growth metrics hit a level of 60-70% that investors should be concerned about the earnings capacity in the S&P 500 index. Earnings growth in 2025 seems to be supporting this premise of earnings breadth. Not only are technology companies driving growth, but industrials, healthcare, and materials sectors are currently expected to outearn the stock market. Expanding earnings breadth should begin to shift attention of investors from the Magnificent 7 to underbought asset class of large-cap value and small-cap.

2025 Earnings Growth Led by Magnificent 7

 

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