Season of Uncertainty

The first few weeks have been eventful, especially for those of us in Los Angeles, and we’re obviously hoping for the best for those impacted by the fires. This month, to start the year, before we look forward to what to expect in 2025, let’s quickly recap 2024.

It was a positive year for equity investors and a great year for U.S. large-cap equities. As it usually does, it mattered last year what area of the equity markets one invested in.

International stocks had positive returns. The MSCI EAFE index, the developed market index, was up around 4%. Emerging markets, up around 7.5%. Closer to home, the Russell 2000 index, measuring small-cap stocks, posted just above 11% — all positive, but well below the S&P 500’s north of 20% return. We know that 20+% doesn’t come around very often, so let’s appreciate the past two years.

It wasn’t all smooth sailing. Recall that 2024 had numerous pullbacks, including one in April of about 5% and one in late July-early August around 8.5%.

So, what should we expect as we venture through the first quarter of 2025? City National Rochdale expects positive returns from the S&P 500 again this year, due largely to one, corporate earnings growth, two, a strong U.S. economy, and three, potential tax cuts. However, returns are expected to be more modest and volatility greater due to higher valuations, policy uncertainty and potentially higher than originally expected interest rates.

Chart(s) 1, 2:00— You will recall from last month that most of last year’s return was due to multiple expansion, leading to higher valuations. This year, it’s doubtful that we can expect similar multiple expansion. Higher valuations have not precluded strong returns over the near term, but the higher the valuation, the lower the incidence of positive returns and the higher the rate of volatility.

When valuations are high, doubts about corporate profits can lead to heightened instability in stock prices. That said, earnings growth is expected to be strong enough to propel stocks higher, albeit more modestly.

Tax cuts, if we get them, may turn out to be the biggest influence and push the fair value levels up. Solid earnings and pro-business policy should, we believe, support equity prices.

Chart 2, 2:45— Tax cuts are among the potential policy changes under the new administration. “Potential” is the key word. Despite the Republican majority in both chambers, there is ample policy uncertainty as to what and how much gets passed and implemented. As you well know, the market doesn’t like uncertainty. Uncertainty can lead to volatility. These early weeks have demonstrated that as markets adjust expectations to potentially higher than expected interest rates.

In the far-right column, you can see that a few of the potential policy changes could result in higher inflation and higher interest rates.

The Fed will have to navigate this uncertainty carefully and investors will be watching closely.

Chart 3, 3:41— We think that investors should be prepared for increased equity market volatility, but we maintain a positive outlook for U.S. stocks. It’s a good reminder that short-term periods can produce volatility not equal to risk over the long term.

This bar chart illustrates that relationship, and I’m reminded of the old adage, time is your friend.

We’re not trying to alarm anyone. Rather, we want to set expectations on the potential road ahead, especially following two strong return years. We are staying focused on U.S. equities. We expect a continued broadening in the equity market even with shallower Fed cuts.

The Fed is in no hurry to change monetary policy since economic growth remains above trend, inflation is slightly above its target rate, and uncertainty surrounds the changing political landscape and regulatory environment.

That said, we expect 50 basis points of cuts most likely in the second half of the year. Mid- and small-cap equities appear attractive for clients seeking additional capital appreciation. But given the less resilient outlook and geopolitical concerns, we believe that clients should avoid international equities for now.

To close, there are reasons to be optimistic. The economy is on solid footing, driven by solid consumer spending. Rising net worth and intergenerational wealth transfers have kept consumer spending at a solid pace. And policies from the new administration could boost growth due to tax cuts and regulatory reform.