December saw broad negative performance across asset classes with the exception of commodities. Markets pulled back from their November rally as a result of uncertainties around the new incoming administration, rising treasury yields, and potentially some impacts from seasonal rebalancing for year-end tax-loss harvesting and portfolio repositioning.
“Much of what kept the economy afloat in 2024 can be attributed to large fiscal deficits. Spending exceeded revenue by $1.83 trillion in 2024 [1], and the fiscal deficit amounted to 6.4% of GDP, up from 6.2% in 2023.”
In December, the Personal Consumption Expenditures (PCE) report indicated continued stability in inflation metrics. Year-over-year, Headline PCE edged up from 2.31% to 2.44%, while Core PCE saw a modest increase from 2.79% to 2.82%. However, looking at the more stable three-month annualized inflation figure, we saw a slight decline to 2.54%.
Last year was another strong year for equity markets, driven by the continued growth and enthusiasm surrounding the AI boom, which propelled the market higher for the second consecutive year. Market leaders such as NVIDIA, Amazon, Google, Meta, and Apple led the charge as excitement around AI innovation intensified. This enthusiasm was reflected in the S&P 500’s impressive 25.02% return, outpacing the 13.01% return of the S&P 500 Equal Weight Index. Growth, quality, and momentum factor segments remained dominant, with these companies significantly benefiting from the AI narrative, supported by robust revenue and earnings growth.
Furthermore, concerns about slowing growth and recession risks surprised to the upside, with economic growth exceeding expectations and recession fears easing. Coupled with falling inflation and the initiation of a rate-cutting cycle, these factors created a favorable environment for dominant equity market performance.
In contrast, bond markets had a relatively muted year, with the Bloomberg US Aggregate Index returning a modest 1.25%. This subdued performance reflected the market’s pricing of improved growth prospects and a smaller-than-anticipated number of rate cuts throughout the year.
In relation to growth and inflation, it is important to address the role of irresponsible fiscal policy. Much of what kept the economy afloat in 2024 can be attributed to large fiscal deficits. Spending exceeded revenue by $1.83 trillion in 2024 [1], and the fiscal deficit amounted to 6.4% of GDP, up from 6.2% in 2023. This figure significantly exceeds the 50-year average of 3.8% of GDP and has been surpassed only six times since 1946 (from 2009 through 2012, as well as in 2020 and 2021). [2]
What makes this deficit particularly striking is that it occurred despite strong headline economic metrics, as average unemployment rate was 4% in 2024, and inflation metrics have stabilized in response to active efforts by the Federal Reserve. Historically, deficits of this magnitude are rare without a recession catalyst. This suggests that the deficit likely provided an artificial boost to growth, which is neither sustainable nor prudent in the long-term and should not be expected to persist in the future without serious economic consequence.
Looking ahead to 2025, the new administration has signaled a focus on fiscal responsibility, with spending cuts and deficit reduction as key goals. While achieving meaningful cuts in federal spending may prove challenging, it remains a possibility given the administration’s stated priorities. A reduction in deficits as a percentage of GDP could remove the artificial boost to growth that large deficits provided in recent years, potentially tempering economic momentum in the short term.
However, efforts to counteract this effect may stem from less restrictive regulatory policies. Reducing regulations could stimulate business activity and investment, partially offsetting the headwinds from tighter fiscal policy. Additionally, the Federal Reserve is in a favorable position to lower interest rates if necessary, providing further support to the economy. That said, the uncertainty surrounding incoming policy changes could increase market volatility, as investors tend to react negatively to uncertainty.
It’s important to note that U.S. equity markets, especially the technology sector, appear to be trading at valuations well above historical averages. While less intrusive government policies can lay the groundwork for long-term economic growth – similar to the Reagan era – investors may need to recalibrate expectations for equity returns in light of stretched valuations, a shifting economic landscape, and the possibility of fiscal tightening. Looking to 2025, the laggards of the past two years, such as Value, could see a resurgence, with the market possibly rotating into other segments trading at more attractive valuations.
1. https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/
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Your Smarter Way Portfolio Management Team
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