By
Linda Bakhshian
18 February 2025
4Q and 2024 recap
Equity markets in the US generally rose again during 4Q24, continuing the recent pattern of quarterly increases, with the S&P 500® Index returning 2.39%. Initially, market returns were dampened by uncertainties around the presidential election, interest rate trajectories, and geopolitical issues. However, following the November elections, in which Republicans won control of the presidency and Congress, US equity markets continued their march higher. Additionally, the significant drop in interest rates observed in 3Q was completely reversed in 4Q, as the US Federal Reserve (Fed) lowered the overnight borrowing rate by 25 basis points but indicated fewer rate cuts in 2025 than previously expected due to persistent inflation, a robust economy, and increased business confidence.
During the quarter, large-cap growth had a positive return, driven again by the “Magnificent Seven” (Mag 7). If excluded, the return of US large-cap growth was slightly negative. US large-cap value produced negative returns, while small- and mid-caps were flat, despite outperformance earlier in the quarter. The strongest-performing sector in the S&P 500 Index during the quarter was consumer discretionary at 14%, while the weakest-performing sector was materials at -13%.
The picture is somewhat different for equity markets outside the US. In local currency terms, returns during 4Q were mostly flat to negative. This weak performance was compounded by declines relative to the US dollar for most currencies, with particularly notable drops for the Australian dollar and the Japanese yen. In US dollar terms, the weakest performers were Australia, France, the Netherlands, and Switzerland, which all fell by more than 10% over the three months. It seems reasonable to assume that equity markets outside the US, and currency traders, have been responding to the new US administration and more specifically to its stated intention of introducing a broad range of protectionist policies.
Summing up 2024, it was another remarkable year for risk assets, with US strength driving developed equity market
returns higher. Emerging market equities also performed well, thanks to a late rally in Chinese equities and strong
results from India and Taiwan. The dominance of US mega-cap tech ensured global growth stocks led for the second
consecutive year, while prospects of deregulation post-US election helped global value stocks rise. Despite global
central banks starting to normalise policy, a strong consumer, resilient growth, and sticky inflation led markets to
adjust expectations for rate cuts, particularly in the US. The US economy outperformed other major regions, with
gross domestic product (GDP) averaging an estimated 2.6% quarter-on-quarter annualised growth, and the S&P 500
Index delivering a 25% return, thanks to a large-cap growth return of greater than 33%. The US exceptionalism was
offset by weakness in the European economy, as it battled high energy costs, lack of overall demand, and geopolitical
issues. Overall, it was a surprisingly positive year for investors in the US and globally.
2025 equity market outlook
As we look ahead in the new year, we remain cautiously optimistic that the equity markets will likely deliver
another positive, albeit more normalised, rate of return for 2025. However, we anticipate this will come at a cost
of higher volatility.
The US election results in November have boosted both business and consumer confidence. This optimism, combined
with supportive monetary and fiscal policies and underlying strong economic activity, has created a favorable market
environment for equities. Despite uncertainties surrounding new immigration and tariff policies, we believe that a more
favorable environment for mergers and acquisitions, deregulation, and the potential extension of the current tax policy
beyond 2025 will help mitigate fears of higher inflation. The primary driver of market volatility is likely to be the timing,
path, and extent of various policy implementations versus expectations. Additionally, index concentration underscores
the importance of disciplined, risk-based portfolio construction, as artificial intelligence (AI)-driven equity market
outperformance is likely to give way to opportunities beyond the mega-cap technology stocks.
Our expectation for more normalised returns in 2025 is based on a balance of healthy economic backdrop and current
equity market valuations, which are not cheap and appear relatively stretched. Historically, high valuation starting
points have led to lower forward-looking returns (Figure 1). However, compared with other bull markets over the
past 75 years, the current one looks neither particularly long nor particularly strong, at least not yet (Figure 2). While
valuations warrant some caution, as mentioned above, the arguments are balanced by a solid economic underpinning,
moderating global monetary policy, and the potential for the bull market to mature.
Figure 1:
US starting valuation and 10-year equity market returns
Source: Macrobond (November 2024). P/E ratio = price-to-earnings ratio.
Figure 2:
S&P 500 Index bull markets 1949-2024
Source: Macrobond (November 2024).
Figure 3:
S&P 500 Index earnings are expected to broaden out
Sources: Macquarie, Macrobond, Bloomberg, S&P Global, Russell Investment Group. EPS = earnings per share.
While earnings multiples are relatively elevated on an absolute basis in certain pockets of the market, the equity risk
premium currently sits comfortably at its long-term average (Figure 4), suggesting equity investors should still get
rewarded for taking measured risk in this cycle. While the now-higher level of interest rates has helped make fixed
income assets more attractive from an absolute perspective, the relative comparison suggests there are still plenty of
opportunities in global equities. Valuations remain a focal point in 2025, especially that of the Mag 7, and we like to see
earnings support to drive equity prices higher.
Figure 4:
US corporate profits as a % of GDP
Sources: Macrobond, Bloomberg Finance LP (October 2024). Shaded areas represent recessionary periods.
Figure 5:
Global equity risk premium
Sources: Macrobond, Bloomberg Finance LP (October 2024).
Within the US equity market, we prefer quality companies across market capitalisations, while valuation and policy
tailwinds are more pronounced in profitable small- and mid-cap stocks.
First, the value-growth dispersion has historically been mean-reverting, and on the surface, value appears cheaper than
growth (Figure 6). If this trend continues, it should support value stocks in the coming months and quarters. However,
there are also strong structural tailwinds for quality growth stocks, driven by secular themes such as electrification,
digitalisation, automation, and AI investments. Additionally, new deregulation policies are likely to benefit stocks in
general. Hence, a balance between value and growth is warranted, especially within passive investments.
Figure 6:
Value looks cheaper, but don’t abandon quality growth
Sources: Macquarie, Macrobond, Russell Investment Group. Russell 3000® Growth Index relative to Russell 3000® Value Index
Second, we believe that small- and mid-cap stocks remain attractive going into 2025, given their current valuations,
earnings growth potential, prospect of further rate cuts by the US Federal Reserve (Fed), and generally underweight
position by many investors to the asset class. The forward price-to-earnings (P/E) ratio for the Russell 2000® Index is
15.6, compared with 22.9 for the Russell 1000® Index. Historically, lower interest rates have been beneficial for equities
in general, as they reduce borrowing costs, ease interest expenses, and encourage investment. Small-caps, in particular,
have outperformed large-caps following a Fed rate cut because they are perceived to have lower interest coverage
ratios, a greater proportion of floating rate debt, and higher economic sensitivity.
We believe President Trump’s policy agenda will particularly benefit US small- and mid-cap equities. The combination
of lower taxes, deregulation, and reshoring/nearshoring activities is expected to boost domestic production, which
involves many small- and mid-cap companies. These initiatives could further enhance economic growth, improve profit
margins, and potentially increase mergers and acquisitions activity. However, tariffs and immigration policies might be
less favourable for small- and mid-caps, as they could raise input costs; however, the extent and timing of these effects
are still uncertain.
Figure 7:
Small-cap vs. large-cap
Sources: Macquarie, Macrobond, Russell Investment Group. Russell 2000 Index relative to the Russell Top 200 Index.
Figure 8:
Mid-cap vs. large-cap
Sources: Macquarie, Macrobond, Russell Investment Group. Russell Midcap Index relative to the Russell Top 200 Index.
Globally, we also see areas of opportunity. Valuations outside the US are much more attractive, although economic
stability is scarcer, and threats such as trade wars, geopolitics, inflation, and interest rates make selection more
fundamentally driven. We believe there are two equity markets that could be supported by global developments in the
coming year: emerging markets (EM) and listed real assets.
To begin with, EM stocks are fairly valued relative to their own history and are cheap compared with developed
markets. Following a volatile few years (some argue decade!), we are cautiously optimistic that active management
can drive higher potential alpha going forward in this area. Over the past few years, many nations have shifted their
focus towards boosting domestic consumption, enhancing infrastructure investment, and expanding digitalisation to
improve efficiency and productivity. Overall, the outlook for equity investors is supported by growing share buybacks,
improving dividends, and an underweight position of EM within a diversified portfolio. However, policy improvements
in China appear to be a critical factor for investors to go overweight in the region in the near term, and the threat of
tariffs remains high. Certainly, macroeconomic challenges persist in China, but domestic policies have turned much
more supportive, much of the issues are known, which should help mitigate tail risks.
Additionally, listed real assets continue to be an interesting asset class in an environment where inflation becomes
more of an ongoing, structural challenge. Considering the fiscal challenges faced both in the US and globally, the next
10-15 years of inflation could be markedly different from the previous 10-15 years. In such an environment, companies
that can pass inflation on to their customers should have a comparative advantage. Many real asset companies
have contractual or indirect links to inflation. Amid reasonable valuations, diversification in real assets may be an
opportunistic strategy to consider.
On the other hand, European equity market valuations have been comparably cheap for a long time and only became
cheaper in 2024. However, Europe is grappling with headwinds from China, geopolitics, and the potential impact of US
tariffs. Some sectors, such as the automotive industry, are particularly threatened by ongoing tariff discussions while
simultaneously facing increasing competition from China. With economic activity slowing, the European Central Bank
(ECB) might cut interest rates at a faster pace than the US Fed. However, as price stability is the ECB’s only mandate,
inflation rising as a result of US policies is a risk. While valuations are supportive, better visibility on any tariffs and a
turnaround in China seem to be necessary preconditions for European outperformance.
As we look forward to 2025, we continue to believe that quality investing is a prudent strategy for many investors. Our investment teams typically focus on both quality and valuation when constructing their portfolios. An important metric for assessing value is free cash flow yield, which is defined as net cash from operating activities minus capital expenditures, divided by the number of shares. Over the long run, companies ranked in the higher quintiles in terms of free cash flow yield have delivered stronger returns than those in the lower quintiles, and 2024 was no exception. Many of these higher free-cash-flow-generating companies are currently the mega-cap tech stocks.
Figure 9:
Cumulative return to Russell 3000 Index since December 1996, quintiled by free cash flow yield
Sources: FTSE Russell, FactSet (December 1996 to December 2024). Graph shows cumulative active total return in US dollars, cap weighted and sector neutral, with monthly rebalancing.
As discussed in our last quarterly update, we believe AI will continue to play a significant role in the equity markets and the broader economy. While we don’t advocate for abandoning high-quality AI and tech companies in 2025, investors may want to diversify because of high valuations and passive indices’ disproportionate weight in these stocks. We believe investors should aim to build a broadly diversified portfolio to achieve more stable long-term returns and mitigate risks associated with over-reliance on a few names. Many leading AI companies have incurred high capital expenditures, impacting their free cash flows. Similar to the growth of the internet, we expect AI to be the next productivity booster and deflationary force. However, as with the tech bubble, the companies that have been most successful recently may not continue to dominate equity market returns in the medium and long term.
Conclusion
Looking ahead, we maintain a cautiously positive outlook for US equities, driven by healthy economic activity, strong consumer trends, and robust corporate profitability. Despite the potential for many unforeseen economic twists in 2025, our focus remains on actual policy implications over political rhetoric.
We believe long-term equity market returns are primarily driven by underlying business earnings and fundamentals. Our teams are dedicated to identifying mispriced companies with attractive growth prospects, sustainable business models, and clear catalysts when constructing portfolios that yield positive, risk-adjusted long-term returns, irrespective of market, economic, or political conditions. By emphasising intrinsic value – assessing companies’ financial health, competitive strengths, and market positions – we uncover opportunities less susceptible to short-term fluctuations and uncertainties. We see promising opportunities in profitable small- and mid-cap companies, quality large-cap, select EM, and real assets. While index concentration is a concern, we support core strategies that leverage structural trends with a risk-aware approach. Valuations remain elevated and earnings growth will be crucial to support stock performance in 2025. And be prepared for volatility.
DeepSeek update
The first two years of the AI paradigm shift have benefited disproportionally the AI infrastructure supply chain, including chip makers (most notably NVIDIA), power suppliers, and semiconductor equipment makers. The release of DeepSeek, a Chinese AI model, which looks to be on par with US large language models (LLMs), trained at a fraction of the cost, however, has raised concerns that this could lead to a pullback in spending across these enabling companies, particularly those tied to hyperscalers. From a geopolitical context, it is clear that China is not far behind the US in AI development, and given DeepSeek’s use of high-powered chips, there will be further pressure on export restrictions to China.
Historically, cheaper technology has led to increased usage, a phenomenon known as the Jevons paradox. By reducing costs, DeepSeek could be the catalyst needed for the democratisation and mass adoption of AI. Lowering the expense of developing LLMs could expand computer demand for both enterprise and personal use, enabling more applications and increasing the utilisation of AI features. Additionally, AI infrastructure could drive demand for AI software products. In the long term, the commoditisation of AI benefits big tech, consumers, and the overall economy, although there will be companies that are left behind.
DeepSeek is a reminder to stay nimble and employ a selective approach to identifying high-quality opportunities across the innovation curve, as well as look ahead to the next AI phases as this new tech wave develops.
Perspectives.
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