Top 3 Expectations for 2025

By Kostya Etus, CFA®, Chief Investment Officer, Dynamic Investment Management

 

Market Review

The market went three-for-three in terms of strong quarterly performance this year. The S&P 500 increased by 10.6% in Q1, 4.3% in Q2 and 5.9% in Q3 — delivering a compounded 22.1% year-to-date annual growth rate through the end of the third quarter. This puts us on track for back-to-back annual returns of more than 20%. More importantly, we are starting to see strong performance from other areas of the market as small companies, international markets and real estate post double digit returns this year. And all these gains are happening despite some key uncertainties.

When markets begin to feel this euphoric, it may be time for investors to manage expectations for future market returns. After all, the market cannot persistently go up, and occasionally, the freight train needs to let out a bit of steam. Below are the key uncertainties that continue to weigh on investors, which may shape the outcome for Q4 and beyond:

1. Geopolitical Tensions: Geopolitical concerns between Israel and Iran as well as the ongoing conflict between Ukraine and Russia continue to be on investor minds. Any escalation could disrupt oil and energy supplies, as well as increase market volatility. That said, the U.S. has ramped up oil production in recent years, which means we are now much less dependent on imports.
2. Labor Market Strength: The latest labor update from the U.S. Bureau of Labor Statistics showed the unemployment rate stayed steady at a historically low 4.1%. While this is a great sign for the economy, it unfortunately may spell uncertainty for the markets. Federal Reserve (Fed) Chair Jerome Powell indicated that given current levels of unemployment and inflation, there is no hurry to cut interest rates as the economy appears to be resilient.
3. Presidential Election Outcomes: The results are in, and we have a new president in Donald Trump. While the elected president, or their political party, do not have a significant impact on long-term investment returns, there may be uncertainty about some of the policies which may be put in place, leading to shorter term volatility.

While some uncertainty remains in the markets, we are in the holiday months which tend to support market strength. November and December tend to be seasonally strong as holiday shopping heats up and investors worry less about the markets, instead focusing more on spending time with friends and family.

 

Source: Morningstar Direct as of 9/30/2024. Past performance is not a guarantee of future returns.

Top 3 Expectations for 2025: Stocks and Bonds, Asset Classes and Presidential election

 

1. What can we expect from stocks and bonds now that interest rate cuts have commenced?

Good News for Stocks and Bonds

Now that the Fed has initiated interest rate cuts, as well as reinforced the rhetoric of a lower interest rate policy for the foreseeable future, what can we expect from the markets? Rate cuts are often a tailwind for broad markets, although there have been times in the past when the Fed is lowering rates in anticipation of a recession, such as the situation during the Global Financial Crisis of 2008. Given recent economic data, as well as expectations from the Fed, a severe economic downturn is unlikely. Nonetheless, it is important to always be prepared, which is why we build diversified portfolios.

What has history told us about stock and bond returns after the first Fed cut, both with and without a recession? The chart below helps answer these questions:

1. Good for Stocks: If there is no recession, one year after the first Fed cut, U.S. stocks are up 18.5% on average. This is well above average annual returns for the stock market. Interestingly, even if there is a recession, the average drop is just over 3% for stocks. This reinforces the notion of just how valuable lower interest rates are for corporate growth.
2. Good for Bonds: Bond returns have generally been positive over the long-term given their focus on income generation. That said, their prices tend to go up when interest rates fall AND when there is market or economic turmoil, which is often seen in a recession. This is exhibited with the 8-10% returns after the first Fed rate cut, which is well above average annual returns for the bond market.
3. Good for Diversified Portfolios: The most important part of the chart is that a combination of stocks and bonds is positive in both situations. We build diversified portfolios because the future is unpredictable and often expectations don’t play out how we may have planned. Diversified portfolios smooth out the investment ride and help investors be ready no matter what the markets or economy throws at them.

 Stock and Bond Performance after a Rate Cut
With and Without a Recession
Average Annual Returns 1926-2024

 

Source: Morningstar, Federal Reserve, NBER as of 8/31/24. U.S. stocks are represented by the S&P 500 TR Index from 3/4/57 to 8/31/24 and the IA SBBI U.S. Lrg Stock TR USD Index from 1/1/26 to 3/4/57. U.S. bonds are represented by the IA SBBI US Gov IT Index from 1/1/26 to 1/3/89 and the Bloomberg U.S. Agg Bond TR Index from 1/3/89 to 8/31/24. Past performance is not a guarantee of future returns. Index performance is for illustrative purposes only. You cannot invest directly in the index. 

2. Which asset classes tend to perform best after various time periods in a lower rate environment?

Good News for Most Asset Classes

While evaluating long term data and trends is important, it may also be a good idea to see what happened during more recent interest rate cut scenarios. Additionally, most investors are not simply invested in broad based stocks and bonds, how do rate cuts impact more granular asset classes which investors may be exposed to? Lastly, which asset classes tend to do better than others over various time periods?

As always, let’s look at what history can teach us by evaluating the performance of various asset classes after the initial rate cut over the last seven rate-cutting cycles:

 

1. Most Asset Classes are Positive: Looking at stocks and a variety of bond types, we find that historically, all asset classes are positive after the first rate cut by the Fed over various time periods. More importantly, the longer the time horizon, the stronger the returns, reinforcing the need to stay invested for the long-term.
2. Bonds Beat Stocks: Another pleasant surprise is that broad based bonds (green bar) consistently beat stocks (blue bar) over all time periods. Given that bond prices increase as interest rates drop, this makes some intuitive sense. This reinforces the idea that the 60/40 is not dead and the importance of staying balanced and diversified with both stocks and bonds within portfolios.
3. Anything is Better than Cash: Perhaps the most important takeaway from the chart is that all asset classes presented beat cash (grey bar). As interest rates drop, it reduces the yield received on short-term cash investments, which have limited ability to appreciate in price. Thus, a falling interest rate environment may be a great opportunity to get off the sidelines and get back into investing with diversified, balanced portfolios for the long-term.

Asset Class Performance Following the First Federal Reserve Interest Rate Cut
Average of the Last 7 Cutting Cycles

 

Sources: Bloomberg Index Services Limited. Past performance is not a guarantee of future returns. Data represents the performance of the Bloomberg U.S. Aggregate, S&P 500, ICE BofA 1-3 Year Corporate Index, Bloomberg Muni Index, Bloomberg U.S. Corporate High Yield Index, and the ICE BofA U.S. Treasury Bill 3 Month Index over the 1-month, 3-month, 6-month, and 1-year, periods following the first Federal Funds rate cut in the previous 7 cycles by the US Federal Reserve. Start dates of the 7 periods are 10/2/84, 10/19/87, 6/5/89, 7/6/95, 1/3/01, 9/18/07 and 7/31/19.

3. How will the outcome of the presidential election impact investment portfolios?

Good News for Balanced Portfolios

A common question this year has been, “How will the outcome of the presidential election impact my investment portfolio?” To help answer this question, we can turn to research from Vanguard examining how market performance compares over the past 160 years based on the presidential political party.

Thus, we can use history to help guide our expectations for returns:

1. Republican vs. Democratic: It may come as a surprise, but the average annual return for a 60/40 stock-bond portfolio is about the same, close to 8% per year, whether a Republican or a Democrat president is in office.
2. Diversification Wins: What is perhaps more important from the chart is that positive years greatly outnumber the negative ones over the full time period. This would suggest that it is always a good idea to be invested rather than moving to cash, and it is always a good idea to be diversified by investing in a variety of asset classes such as a mix of stocks and bonds.
3. Presidential Elections Shouldn’t Dictate Your Investment Decisions: The presidential race and outcome creates sensational headlines and uncertainty, which often leads to market volatility. But, as history suggests, the markets don’t care who is president. The data shows the differences in performance are not statistically significant. What is significant, however, is tuning out the noise while staying invested and diversified for the long-term.

 Stay diversified, my friends.

 Presidential Political Party vs. 60/40 Portfolio Returns
Annual Returns 1860-2020

 

Sources: Vanguard calculations, based on data from Global Financial Data (GFD) as of Dec. 31, 2022. The 60% GFD US-100 Index and 40% GFD US Bond Index, is calculated by GFD. The GFD US-100 Index includes the top 25 companies from 1825 to 1850, the top 50 companies from 1850 to 1900, and the top 100 companies by capitalization from 1900 to the present. In January of each year, the largest companies in the United States are ranked by capitalization, and the largest companies are chosen to be part of the index for that year. The next year, a new list is created and chain-linked to the previous year’s index. The index is capitalization-weighted, and both price and return indices are calculated. The GFD US Bond Index uses the U.S. government bond closest to a 10-year maturity without exceeding 10 years from 1786 until 1941 and the Federal Reserve’s 10- year constant maturity yield beginning in 1941. Each month, changes in the price of the underlying bond are calculated to determine any capital gain or loss. The index assumes a laddered portfolio that pays interest monthly. Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

 

As always, we recommend staying balanced, diversified and invested. Despite short-term market pullbacks, it’s more important than ever to focus on the long-term, improving the chances for investors to reach their goals.