North River Wealth - 2025 Market Outlook

How did our predictions hold up in 2024? To borrow a phrase from Larry David: "Prettttty, prettttty good." We anticipated a slower pace of Fed interest rate cuts, higher inflation sticking around, Trump winning the presidency, and artificial intelligence (AI) continuing to dominate the headlines—and for the most part, we were spot on. Investment markets thrived, exceeding even our expectations. While we didn’t fully predict just how well markets would perform, we certainly won’t complain. In 2024, we saw stocks, home prices, bitcoin, and even the national debt hit all-time highs.

So, where do we go from here? The chart below is a reminder of just how difficult it is to predict what will happen in markets as nearly every firm surveyed by Bloomberg was nowhere close to predicting the level of the S&P 500 last year. Enjoy the ride.

The Path of Interest Rates

The Fed funds rate ended the year in the 4.25%–4.50% range, and short-term interest rates are expected to move lower in 2025 as the Federal Reserve is projected to cut rates two more times during the year. If the economy is performing well, why would the Fed choose to lower short-term interest rates? On the surface, it doesn’t seem to make sense.

While most economic indicators, such as growth and employment, remain strong, the Fed is anticipating a slight slowdown in growth and aims to avoid the risk of keeping interest rates too high for too long. By lowering rates now, the Fed can reduce borrowing costs, support economic activity, and provide a cushion for continued growth.

The Fed operates with two main objectives: maximum employment and price stability. Recent years have seen price stability disrupted by rising inflation. However, with inflation showing signs of moderation (although still likely to remain above the Fed’s target rate), the Fed is now shifting its focus toward stabilizing short-term rates to better align with their dual mandate.

If interest rates are expected to decline, why are mortgage rates still elevated? Mortgage rates are not directly tied to Fed actions. Instead, they track longer-term interest rates influenced by growth and inflation expectations. The U.S. 10-year Treasury yield serves as a good proxy for mortgage rate trends. While mortgage rates are expected to decline over time, they are likely to do so more gradually than previously anticipated, reflecting ongoing uncertainties in long-term economic outlooks.

Our view: We would be surprised to see more than two rate cuts by the Fed. If the economy continues to do well, there is no need for continued cuts and will give the Fed some ammunition for when they actually need it.

Stocks: Another Year of Double-Digit Returns?

Driven largely by the Magnificent 7 stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta), the top 10 stocks in the S&P 500 now account for almost 40% of the index, underscoring their significant influence on market performance. Meanwhile, the labor market remains resilient, with unemployment at a low 4.2% as of November 2024. This strength, coupled with robust investment returns, has supported healthy consumer demand, and bolstered the overall economy.

The chart below does a great job summarizing the annual returns and drawdowns of the S&P 500 going back to the early 1980’s. While market downturns and periods of negative returns are inevitable each year (as noted in the chart below), double-digit returns (whether positive or negative) are more common than not. A well-diversified portfolio can help weather near-term volatility, hedge risk and help achieve long-term financial goals. As markets evolve, staying focused on strategic investments in smaller-cap stocks may position portfolios to thrive in the year ahead.

Our view: The U.S. market continues to show its dominance, offering a favorable environment for investors, leading us to reduce our international exposure. We aren’t predicting a three-peat of +20% returns for U.S. markets, but positive returns in the teens are not out of the question. We also like small- and mid-cap stocks as the market rally broadens.

Annual returns and intra-year declines (Through November 2024)

Bonds & Cash

The Federal Reserve's policy shift toward lowering short-term interest rates has led to a normalization of the yield curve, which had been inverted for more than two years. An inverted yield curve, where short-term rates exceed long-term rates, is often a signal of economic uncertainty. Now, with short-term rates below long-term rates, we see a more typical yield environment, aligning with expectations for a gradual easing of financial conditions in 2025.

 As the Fed continues to cut short-term rates, the yields on money market funds, certificates of deposit (CDs), and high-yield savings accounts are expected to decline over the next year. This shift presents an opportunity for fixed-income investments to regain their footing.

 Our view: After several challenging years for bond returns, we anticipate more stable performance, particularly from corporate bonds, as they benefit from a more favorable interest rate environment and improved market dynamics. In other words, bond returns should recover in 2025.

Trump 2.0

What might round two of a Trump presidency look like? Likely a continuation of the themes and policies from his first term in office.

Growth: Expect a focus on deregulation and an extension of tax cuts, both aimed at supporting U.S. businesses. Deregulation efforts are likely to target the financial and healthcare sectors, potentially spurring further mergers and acquisitions activity. Additionally, smaller companies could benefit from these policies, broadening the base of U.S. economic growth and fostering a more inclusive expansion.

Trade: Tariffs (or taxes on imported goods) are likely to remain a cornerstone of Trump’s trade policy. During his first term, tariffs were imposed on aluminum and steel imports from China. This time, the proposed tariffs include a 25% tax on all goods from Canada and Mexico and an additional 10% on Chinese goods, with the stated goals of addressing illegal immigration and drug issues. These tariffs, however, may act more as negotiating threats than lasting measures.

Taxes: The Tax Cuts and Jobs Act, set to expire at the end of 2025, is expected to be extended, though the details remain uncertain. This extension would likely benefit consumers, businesses, and markets. Additionally, there has been discussion of reducing the corporate tax rate on domestic production from 21% to 15%.

Our view: The U.S. economy continues to build off the strength of the last few years. While new tariffs are likely, the percentages and duration may be less severe than initially proposed. Individual tax cuts are likely to be extended, but significant changes to the corporate tax rate are less certain.

Summary

What will happen in 2025? The only thing we are certain about is you can’t get everything right. While we believe opportunities exist for continued growth, we would expect a pickup in volatility given the recent dominance in U.S. markets. Buckle up.

Authored by Stephen Blahovec and Michael Rausch of North River Wealth Advisors.  We are an independent, fee-only financial planning and investment management firm located in Pittsburgh, PA servicing clients locally and across the country.  To learn more, contact us here.

This content is developed by North River Wealth Advisors from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.