TOO MUCH OF A GOOD THING?

Friday’s nonfarm payroll report gave a meaningful upside surprise against the consensus forecast of 160,000 growth in payrolls: The seasonally adjusted December payroll count grew by 256,000 — the highest pace of job creation since March. This pushed the unemployment rate down to 4.1% as labor force participation — the percentage of the population that is either working or looking for work — remained steady.

Investors closely watch both the headline number of job creation and the pace of corresponding wage gains: In December, average hourly earnings rose 0.3% month-over-month to a 3.9% year-over-year rate, which represents continued moderation in wage gains. This provides solace for those concerned about a wage price spiral driven by an unhealthy tightness in labor markets. We seem to have a jobs market that is in much better balance, with demand for employees remaining positive and supply available to meet that demand.  

Low unemployment translates to higher consumer confidence, which in turn supports consumer spending. Recent data reflects this strength, with consumer spending on credit and debit cards up 2.2% year-over-year in December, according to the latest consumer checkpoint from Bank of America Institute, which reflects the pulse of 69 million consumers. This represents the strongest monthly growth since February.

Services spending in December was strong as consumers continue to lean into experiences. Moreover, retail spending, which had been relatively weak in the waning months of 2024, was another area of strength: According to BofA, retail spending gains were broad based. With strong income growth and continued health in labor markets, we can anticipate that consumer spending will remain strong. The Federal Reserve no doubt has this data on its policy dashboard, and the positive trends across consumers may be taken as another sign that a pause in the rate cutting cycle is warranted.  

Markets are finally starting to prepare for the Trump administration “2.0,” and this preparation is manifest in nervous equity markets and a rise in both interest rates and interest rate volatility. On the equity side, many are trying to gauge the impact of some of the Trump agenda as it relates to trade and tariffs — remember, roughly 40% of revenue for the S&P 500 comes from overseas, and the technology sector has an even bigger reliance on non-U.S. sources of demand. Investors worry not only about the impact of tariffs on imported parts and supplies driving up costs but also about the inevitable retaliation, as foreign governments engage tit-for-tat with the U.S. Economists and strategists alike view tariffs and their consequences as both inflationary and a growth headwind.

With current inflation and inflation expectations elevated and sticky, and with bond yields having risen sharply and quickly, equity investors are starting to become more cautious. In a classic “too much of a good thing,” the constructive growth backdrop is leading to a higher-for-longer interest rate forecast. Looking back at recent history, we see that when the 10-year Treasury yield approaches 5% it reveals a vulnerable equity market. There are two reasons for this. First, a 5% yield for a U.S. Treasury with falling inflation represents a solid return on a risk-adjusted basis, and potentially one that competes for equity assets. Investors may just prefer to de-risk their portfolios using the prevailing higher interest rates. Second, there is a point at which companies will have to refinance their debt, and many had been hoping for relief in the form of lower rates — those lower rates may take much longer to arrive.

U.S. economic exceptionalism has fed through to U.S. equity market exceptionalism. U.S. equities outpaced their non-U.S. peers again in 2024, extending a long streak of dominance. We will get the first view into corporate fundamentals next week as the U.S. Q4 earnings season kicks off — some of the big banks are reporting on Wednesday. We will be watching keenly for clues about the 2025 outlook, and fundamental results for the S&P 500 will be even more important this year for equity returns. As in 2023, valuation/multiple expansion provided a tremendous tailwind to total equity market returns in 2024. However, with valuations starting 2025 at extremely elevated levels,  it is more likely that earnings growth will have to do the heavy lifting: Analysts are expecting roughly 14.8% earnings growth for calendar-year 2025 on revenue growth of 5.8%.

We can anticipate that the contribution from strong expected earnings growth this year may be offset somewhat by a contraction in today’s high market multiple, and this belief is reinforced by the headwind of much higher interest rates. Although we don't mark our forecasts to one-day moves in the market, Friday’s market action provides a case in point — we can clearly see the equity market reaction to higher interest rates, particularly across the areas of the market that are the most interest-rate sensitive. For example, small cap stocks have fallen nearly 2.5% today and are officially in correction territory, having fallen over 10% from the late November highs.  We anticipate that the combination of higher interest rates, political/geopolitical risk, and elevated valuations may keep investors on their collective toes this year. And, although we maintain an overall constructive outlook, we foresee a positive return environment coupled with a higher volatility.