Despite the solid economic performance, the Federal Reserve is trying to ensure the expansion continues. Accordingly, they have cut rates by 100 basis points since last September, and they are currently biased towards additional rate cuts in the coming year. 

The economy is in a good position as we progress into 2025, given strong fundamentals and a supportive Federal Reserve policy engineered to maintain the recent momentum. That said, we are concerned about the trajectory of inflation and the persistent increase in our government’s debt. Inflation has declined dramatically from its peak but has recently been increasing. In terms of government debt, the debt level has increased significantly in recent years, and while there is no imminent risk, the long-term trajectory is a concern. We will monitor these risk factors closely, but the other drivers of the economy are generating favorable conditions, and we maintain our positive view.

Inflation has declined significantly from its peak in June 2022, and the latest reading of the Consumer Price Index indicated that inflation is running at a pace of 2.9 percent. That report showed that prices for shelter, food, autos, insurance, and airline fares increased significantly. 

Despite the progress in reducing the inflation rate from the 2022 peak, it remains above the Federal Reserve's 2.0 percent target and has been steadily increasing in recent months. Rising price levels are a risk factor that we are monitoring closely, as the strength in the economy may limit the degree to which inflation declines.

The U.S. dollar increased significantly in the fourth quarter of 2024, driven by the relative strength of our economy and expectations for fewer Federal Reserve rate cuts in the coming year. Looking forward, we expect these dynamics to continue, resulting in persistent dollar strength.

With inflation proving to be sticky, investors have reduced their expectations for the number of rate cuts in 2025. The expected federal funds rate for the end of this year has increased to the 4.00 to 4.25 percent range, up from the previous level of 2.75 to 3.00 percent. Yields on short-term bonds and cash-like investments closely follow central bank rate targets, highlighting the reinvestment risk of these investments. Accordingly, aligning your cash needs with your investment strategy is essential to ensure you have sufficient liquidity but not too much.

We continue to have a favorable view of high-quality intermediate-term bonds. With the increase in rates over the past few years, the current yield levels present an attractive entry point. A combination of short- and intermediate-term bonds provides an opportunity to realize attractive income while mitigating rate volatility. Corporate profits remain near record levels, and companies' balance sheets are generally healthy. Spreads, the extra yield corporate bonds offer above comparable U.S. Treasuries, have fallen to near record lows, making the risk/reward trade-off less attractive with low-rated bonds. Given that dynamic, we prefer to blend U.S. Treasury bonds with high-quality corporate debt to limit credit risk and diversify holdings.

The debate surrounding changes in our country’s tax policy will likely be a prominent theme in the coming months. However, we do not anticipate that the government will repeal the municipal tax exemption. The additional revenue generated from that change is minimal compared to the cost of extending the Tax Cuts and Jobs Act. Additionally, it would likely increase borrowing costs and curtail infrastructure investment. From a valuation perspective, we expect municipal bond yields to stay low relative to U.S. Treasury yields. Demand for tax-exempt debt has remained steady while supply has only marginally increased. In contrast, the supply of Treasury and corporate bonds has ballooned over the last few years.

The S&P 500 Index generated substantial gains in 2024, resulting in the second consecutive year with a total return of 25 percent or more. Growth stocks, led by the Magnificent 7, were again the market drivers last year, generating substantial gains and propelling the S&P 500 Index to a record high. Stocks in the value and small/mid-cap styles also participated in the rally and provided solid returns. 

The strength in the equity market is being driven by expectations for solid earnings growth in the coming year. During this bull market, stocks of the largest companies in the artificial intelligence ecosystem have generated much higher profit growth rates than the rest of the equity universe. However, there are expectations for a sustained acceleration in earnings growth across the stocks outside the artificial intelligence segment. That normalization is serving as a positive driver of equity prices. 

A sustained period of earnings growth is critically important, given today's high valuations. As of the end of 2024, the market was trading at 22 times the expected earnings for the coming year. At this level, stocks are trading well above their long-term average of 16 times earnings. Accordingly, valuations should function as a headwind for equities, and the growth in corporate profits should be the driver of stock prices this year. These dynamics also suggest that unusually large gains in the equity indexes are less likely in the coming year. 

Foreign stocks generated modest gains last year. A closer look reveals that the gains reported in the local currencies were generally favorable, but a strong rally in the dollar reduced the total return for U.S. investors. In developed and emerging markets, stocks in Asian countries were the best performers.

The economic expansion outside the U.S. has been uneven, with weakness in China, soft conditions in Europe, and an improving environment in Japan. Given the mixed tone, governments and central banks have been employing stimulus measures. In addition, the expansion in the U.S. should help provide support, and the equity valuations in foreign markets are attractive. We are encouraged by these factors but mindful that low growth rates hamper many foreign economies, and we expect the U.S. dollar to remain strong. Accordingly, we are biased toward domestic equities.

Commodities provided mixed results last year, with gold prices up significantly and prices for many agricultural products declining. The strength in gold was driven by concerns related to the long-term impact of rising government debt. Oil prices were volatile but finished the year close to where they started. Elevated geopolitical risks have threatened to increase oil prices, but there is plenty of supply, and that has kept prices contained.

The short-term outlook for commodities is mixed, given the soft backdrop in the global economy. However, we are maintaining our positive long-term view. Commodity prices, as a group, have declined significantly from their highs. In addition, many governments and central banks worldwide are providing stimulus measures to support higher growth rates. That should help the global economy gradually improve, placing upward pressure on demand. Commodities are also a good hedge against geopolitical risks and the associated supply shortages that can accompany them.

The emergence of artificial intelligence and other innovative technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change how we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing. 

A productivity boom—According to some estimates, technology was pulled forward two to three years during the pandemic. That development, coupled with a persistent labor shortage, is leading companies to invest in new technologies to boost productivity, automate processes, and adapt to today's constrained labor markets. Higher productivity allows for a faster pace of economic growth without a sustained increase in inflation.

The evolution of finance—Technological advancements are disrupting the financial services industry. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards and the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, and electronic bill-paying services are also experiencing strong demand. This shift is still in its early stages and has a long runway as it is occurring across both developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry, creating opportunities for new entrants and risks for the firms currently dominating this space.

Expansion of robotics—5G communications, sensors, and artificial intelligence are facilitating technological advancements to expand robotics in healthcare, restaurants, construction, and other industries. Some estimates project that global robotics spending will jump from $40 billion in 2023 to $260 billion in 2030. 

Personalized healthcare—Advancements in technology support tailoring treatments to each patient, streamlining the drug discovery process, providing continuous data analysis in real-time, and improving clinical trials through digitization. Investment opportunities across the healthcare spectrum will be enhanced as artificial intelligence and machine learning increasingly result in better healthcare experiences.

Rising government debt—Sovereign debt levels were rising before the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt outstanding has increased more than 60 percent since the end of 2019. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East and the relationship between the West and China.

Inflation—Given the recent increase in monetary stimulus, persistent federal budget deficits, a high level of government debt, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may return to a sustained upward trend and remain above the average of the last thirty years.

Deglobalization/protectionism—Rising geopolitical tensions across many parts of the world have reversed the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and a race to establish global dominance in certain technologies have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, a rising cost structure for some industries, and the potential for moderation in economic growth.